2005 tipped as year of the yen

In currency circles, 2004 was the year of the euro. Europe's grand experiment with monetary integration silenced the sceptics once and for all as its single currency gained 7.61 per cent against the United States dollar.

Five years ago, the euro's weakness had Europeans biting their nails. Today, it's the euro's strength that's inspiring angst. And, for the first time in decades, traders buzz about whether they now have a credible alternative to the world's reserve currency.

Yet if 2004 was the euro's year, this one may belong to the yen.

Here in Tokyo, tensions are rising over the yen's brawn.

While Japan has not sold yen since March 2004, traders who dismiss the risk may regret it. Even so, it's hard to see how Japan can stop the yen from building on its 4.48 per cent rise. Whether Japan likes it or not, its currency may strengthen to 90 yen versus the US dollar or even more from today's 104 level.

Here are three reasons.

* If investors are to believe that Japan's 15-year malaise is over, the yen should be rising. It's only natural for investors to try to ride Japan's recovery by putting capital into Nikkei 225 stock average shares, which rose 7.6 per cent in 2004.

* The determination to run a trade surplus will continue pushing up the yen. Exporting more than it imports has always been Japan's security blanket - a sign its economic model still works. Yet more money flowing into the economy than out on a consistent basis increases pressure on the currency to rise.

* Record US current account and budget deficits make the greenback increasingly vulnerable. The trade deficit swelled to a record US$609 billion last year and the White House expects the budget shortfall to reach an all-time high of US$427 billion in the year ending in September.

Of course, the opposite could be true. "It sounds like time to buy the US dollar," says Ken Courtis, Goldman Sachs' vice-chairman in Asia. Why? "The best time to buy is when there are only sellers."

Even Federal Reserve chairman Alan Greenspan, not a man known for criticising the Bush Administration, has grown antsy. On November 19, his comments on the current account gap pushed the US dollar down 1 per cent against the yen.

Greenspan's concerns that "international investors will eventually adjust their accumulation of US dollar assets or, alternatively, seek higher greenback returns to offset concentration risk, elevating the cost of financing the US current account deficit and rendering it increasingly less tenable" raised eyebrows the world over.

The US Treasury has yet to scrap its strong-dollar policy; it doesn't want to trigger a crash or appear to pursue a beggar- thy-neighbour policy.

Yet here in Asia, Treasury Secretary John Snow's campaign to force countries to let their currencies trade freely is often seen as a veiled attempt to devalue the US dollar.

Efforts to strong-arm China into letting the yuan rise have become particularly ridiculous.

A fragile financial system gives China a good argument for not altering its currency policy - one Japan cannot make.

In fact, a stronger yen is no longer the problem it once was for the world's second-biggest economy.

For one thing, Japanese deflation since 1998 means that the inflation-adjusted US dollar/yen exchange rate has depreciated, says Ashraf Laidi, New York-based chief currency strategist at MG Financial. He argues that in today's terms, a yen at 100 to the dollar is nearly equivalent to 110 about seven years ago.

For another, there's the China factor. Considering the surge in Japanese foreign direct investment into China's manufacturing sector, companies here have grown increasingly hedged against a rising yen. Rising Chinese demand means Japan is growing more dependent on trade with its own continent and less on the US.

A rising yen is also a sign of confidence that attracts more foreign capital, boosting stocks and holding down bond yields. Letting exchange rates rise puts more pressure on governments to implement reforms to increase domestic growth and on executives to innovate.

Getting that point across here in mercantilist Japan is easier said than done and renewed efforts to weaken the yen cannot be ruled out. Not that it will do much good in 2005, the year of the yen.

- BLOOMBERG

* Fran O'Sullivan's column will return next week.