Outlook: Why yen's revival should concern us

IT IS a touch ironic that the currency markets yesterday responded to calls from Keizo Obuchi, Japan's Prime Minister, for stability in exchange rates by delivering the biggest one-day rise in the dollar against the yen in five years. It was what the Bank of Japan wanted when it spent billions on intervention in an attempt to halt the painful rise in the yen since last summer. But is this really what is meant by stability? Hardly.

Over the past four years the yen/dollar exchange rate has been all over the place. During the summer the yen was so weak that Tokyo actually became an affordable holiday destination. Since then it has risen by nearly a third in value - which is far too much for struggling Japanese exporters.

As that swing followed the loss of about four-fifths of its value between April 1995 and last summer, however, you can see why yen stability and even exchange rate "target zones", as mooted by Mr Obuchi on his tour of Europe this week, would appeal to the Japanese government. These are damaging swings even for the strongest economy, and Japan certainly is not that. Why is it happening, and what is its importance to us here in the West? Curiously, given how badly a strong yen would damage economic recovery in Japan, the Japanese authorities have themselves been encouraging the yen's recent rise, again in the name of stability. Eisuke Sakakibara - "Mr Yen" - has been talking the dollar down in recent weeks because it had earlier looked as though the yen was falling too far, too fast.

Even so, most economists would have urged the government to stick with a weak yen policy. The trough of 146.52 yen to the dollar is more or less where currency experts think it ought to be given the fundamental weakness of the Japanese economy. So why has the trend been back to high ground? One possible cause is that the Japanese have begun repatriating money from the US. There are two reasons why they might do this. The greatest chunk of Japanese overseas indirect investment is in US Treasuries, which have had a terrific bull run in recent years. Plainly this cannot go on for ever, and as doubts grow about the sustainability of the US economic miracle, as well as the whopping current account deficit America runs with the rest of the world, now seems as good a time as any to sell.

Secondly, long-bond yields have doubled in Japan in the past four months. They are still tiny by Western standards, but if product and asset prices are falling, as they are in Japan, Japanese government bonds certainly begin to look much better value than they did. A flight of capital to the perceived safety of the Japanese motherland spells big trouble for the US, which seems to be living more and more on borrowed foreign money. The arrival of the euro as an alternative reserve currency further turns up the heat.

More worrying still, the US current account deficit is growing like topsy. This year it could be heading for a mind-boggling $300bn, equivalent to 4 per cent of GDP. Basic laws of economics dictate that the currency must fall to compensate for this, and this indeed is what is beginning to happen. Unfortunately, dollar weakness could also retrigger inflationary pressures within the US economy, and that might bring the boom quite quickly to an end.

What's bad for Japan may therefore be bad for the US too. But even the mighty Alan Greenspan cannot buck the market for ever, and while some of the more apocalyptic predictions of the consequences of these trends look a tad exaggerated, we are obviously heading for quite dangerous waters.