This morning, the Japanese yen has weakened to 160 against the dollar. This is the weakest level for the Japanese currency since 1990. Depending on how close or far one is from the screen, the movements in the yen might seem dramatic. However, the truth is that in real terms—considering relative purchasing power parity (PPP)—the yen has been consistently weakening over the past three decades.
Long-term movements in the real exchange rate, similar to those in the ‘natural’ real interest rate, are influenced by the underlying economic growth of a nation. Here, demographics often play a pivotal role. In Japan, the population of working age has been declining for almost exactly 30 years, in stark contrast to the rapid growth of the Japanese workforce in the 1970s and 80s.
As the graph below shows, there is a fairly close correlation between workforce development and changes in the real yen rate. Additionally, it’s important to note that the Bank of Japan (BoJ) allowed deflation to take hold for many years but has recently shifted its policy significantly, now targeting a 2% inflation rate—mirroring the Fed and the ECB. When adjustments in the real exchange rate cannot be achieved through differences in inflation rates (as happens when Japan has deflation while the rest of the world has moderate inflation), then the nominal exchange rate must adjust.
Therefore, there is nothing particularly surprising or alarming about the weakening of the Japanese yen. It is primarily a reflection of two more permanent conditions—negative demographics and a higher inflation target than before.
Furthermore, there is currently speculation in the market about a potential devaluation of the Chinese yuan, which is essentially more of the same scenario. China is like Japan but with a 20-25 year delay—and in a worse position. The Chinese demographic outlook is also extremely negative, and the workforce has been shrinking for over 15 years—a trend set to continue. This suggests a continued real weakening of the Chinese yuan. If the People’s Bank of China (PBoC) does not allow the yuan to weaken, China will face the same deflationary pressures as Japan, with similar debt and housing market issues.
Consequently, it is natural to expect that the yuan will weaken over time, both nominally and in real terms.