The Trump administration seems to be stepping up the pressure on the Japanese yen, accusing Japan of manipulating the exchange rate to its advantage.

In our view, the accusation is essentially valid. Japanese policy makers have been guiding, if not manipulating, the yen lower in the last four years. Japan’s central bankers do not admit it, but it is a common knowledge among economists that the most important transmission mechanism through which BoJ’s quantitative easing affects the economy is the exchange rate. A weaker yen makes Japanese manufacturers more profitable, raises stock prices and help reflate the price level in Japan through higher import prices.

Less careful policy makers in Japan explicitly mention their preference for a weaker yen. Taro Aso, Japan’s finance minister, commented on January 31^stin the parliament that he is absolutely certain that yen will depreciate in the first half of 2017. As the minister officially in charge of Japan’s currency policy, his comments carry weight in the exchange rate market.

Prime Minister Shinzo Abe himself won the leadership election of his party pledging he will take measure to weaken yen (Japan’s Abe Calls for Weaker Yen – WSJ, Dec/23, 2012)

While it is true that Japan has not directly intervened in the foreign exchange rate market, Japanese government clearly seem to prefer weaker yen, its policy makers say so explicitly from time to time and have taken measures they know would influence the yen to weaken. It is fruitless to debate whether these measures amount to a “manipulation”, but it is fair to say that they have certainly guided yen lower in the past four years.

Japan has not directly intervened in the FX market since 2011

Is the yen unusually weak as a result of the Japanese government’s guidance?

The depreciation of yen in the last four years was partly a reflection of US dollar strength due to the monetary tightening by the U.S. Federal Reserve. However, the current level of yen does seem unusually weak. Real effective exchange rate of yen, a measure of the strength of a currency after adjusting for international inflation differentials, show that yen is close to 40 years low.

The Yen is close to its 40 year low in a real terms

Analysis by the IMF also indicates that the Japanese yen is undervalued by 10-30%, depending on the valuation measures. While it is difficult to attribute how much of the weakness is due to Japanese government’s action, their action certainly helped exacerbate the weakness of the yen.

Will there be a currency war between U.S. and Japan?

It is still unclear how strongly the Trump administration feels about the yen. In terms of trade deficit, Japan is no longer the largest trade partner with whom U.S. has a deficit. According to the U.S. Census Bureau, U.S. ran 62 billion USD trade deficits with Japan between January and November 2016, far smaller than the 319 billion USD trade deficits with China during the same period. However, Japan does seem uniquely vulnerable to the currency manipulation accusation. China is nowadays intervening to support its currency. Germany has been against the ECB’s monetary easing that has been weakening the Euro. In terms of international imbalances, Japan does boost large current account surplus, 4% of its GDP, and the surplus should strengthen the yen.

In November, Japan’s current account surplus reached 4% of GDP on an annual terms

If the Trump administration is to pick a fight with Japan over its trade deficit with Japan, the exchange rate market could be significantly affected. In the past, Japanese yen hit the highest level in real term in the mid-1990s when the Clinton administration brought the trade issue as the thorniest issue between U.S. and Japan.

Faced with an explicit pressure from the U.S. government to let the yen appreciate, Japanese policy makers will find it difficult to fight back. The monetary policy, the main policy tool through which they have been influencing the yen, has little room to be employed further. Due to its aggressive quantitative easing, the Bank of Japan is already set to own over 50% of the government bond market by early 2018. If anything, they need to be tapering its purchase in order not to destroy the interest rate market. Its policy rate can be lowered from the current -0.1%, but only by one or two notches, and such a move could backfire if the exchange rate market perceives the move as an act of desperation. Japan can directly intervene in the exchange rate market, but it will only give more ammunition to the Trump administration’s accusation.

BoJ set to own 50% of the JGB market by early 2018

In our view, the Trump administration is quite canny to set its eyes on the yen. The threat to put an upward pressure on yen will prove to be a valuable bargaining chip to force Japan to open its domestic market to US exports, such as agricultural products and service sectors.