PART 1: ANALYSIS ON THE MOVEMENTS IN THE VALUE OF THE JAPANESE YEN (JPY) AGAINST THE US DOLLAR (USD) SINCE

2000

TABLE OF CONTENTS

Part 1.1 Introduction3 JPY/USD Spot rate Graph January 2000-August 2011.4 Trend 1 Analysis5 Trend 2 Analysis.9 Trend 3 Analysis Trend 4 Analysis Conclusoin Part 2 .. Technial Analysis ()Econometrics model) RELATIVE PURCHASING POWER THEORY Internation fisher effect.. Forward rate Figures

INTRODUCTION The Yen/US$ exchange rate has been a target to many researchers since early times due to its unique trend. The report seeks to analyze these movements in regard to the period between January 2000 and October 2011. With the aid of published macro economic data and a wide range of sources including news events, articles and journals the movement of this Bi-lateral exchange rate can be explained in much detail. The analysis will be divided into trends, as seen in the JPY/USD graph in the next page the trends to be analyzed are as follows: I. TREND 1: 2000-2002 II. TREND 2: 2002-2005 III. TREND 3: 2005-2007 IV. TREND 4: 2007-2011(to-date)

Part 2 of the report seeks to forecast the JPY/USD exchange rate for the 30th April 2012 using technical and fundamental methods of analysis. This rate will be used to estimate how much Yen will be obtained in converting the USD 10 million sale of machinery in 6months time to Yen.

TREND 1 ANALYSIS: 2000-2002 The Yen was quite stable against the dollar between the late 1990s and the beginning of 2000 before it began to depreciate towards the end of 2000. The Yen could be exchanged for as low as 108.34 per US$1 (as of October 2000), and ended at a high of highest of 133.53 per US$1 in February 2002 (illustrated in the graph below). From our analysis on this trend; this short-term depreciation in the Japanese Yen against the US Dollar was caused by some series of events that occurred in the US and the actions of the Japanese Monetary Authority.

Graph 1 JPY/USD exchange rate graph (Trend 1)

Trend 1

Summary of the Main causes for the Yen/US trend in 2001-2002: 10th March 2000 The US stock market collapse and the Japanese intervention 19th March 2001 Bank of Japan Quantitative Easing and Carry Trade

The US stock market collapse and the Japanese intervention According to (Heiney, 2011) the 10th march, 2000 was the day the dot com bubble burst, which led to the collapse of the NASDAQ US stock market. A fall in investor confidence on the profitability of the IT industry brought about the panics among investors ultimately leading to the collapse of the stock market and a fall in demand for the US$. Logically we would expect the YEN/USD exchange rate to appreciate but this did not happen hinting that there were other factors that could be attributed to this phenomena. News, articles, and several reports show evidence that the bank of Japan interfered in the FOREX markets to prevent the yen from appreciating. The table below shows the gradual increase in the foreign reserves during this period.

TABLE 1 Japans GDP growth rate, Yen/Dollar exchange rate and Foreign Exchange Rate Reserves 1970- 2007

Source: (Nanto, 2007) After the September 11 attacks of the world trade center, the Dow Jones industrial average also began to fall and ultimately crashed in the final two quarters of 2002 thus worsening the US condition. To protect their foreign industries, the Japanese government amplified its foreign market intervention regime to prevent the Yen from

appreciating against the dollar and to lift the US economy out of the dot com recession. The Japanese government sold Yen and purchased US dollars in the FOREX market and simultaneously invested in the US treasuries, which helped keep US interest rates as low as 1% (Appendix 1) also helping in moving the US out of recession.

Quantitative easing monetary Policies and The Carry Trade (March 2001) The Japanese government initiated the Zero interest rate policies in the 1990s to combat deflation and slow economic growth by boosting expenditure to drive its economy out of recession. The policies were not successful, as the economic situation did not strengthen. (Reuters, 2011) reported that BOJ adopted Quantitative Easing (QE) strategy in 19th March 2001 where it expanded the variety of securities they would purchase such as long-term treasuries, asset-backed securities and equities.

Under QE, The BOJ increased its monthly purchases of long-term government bonds steadily from 400 billion to 1.2 trillion yen between March 2001 and October 2002 (Ito & Mishkin, 2011). This strategy flooded Japans financial system with liquidity, which lowered interest rates (Call rates) and hiked prices of financial assets, lowering their yield. The Nikkei dropped by 28% (Lien, 2008), because investors were not finding Japan assets any profitable, thus liquidating their yen-assets to invest in other high-yielding earning countries. The supply of the yen increased thus weakened the JPY/US$ by roughly 18.5%. The Q.E strategy succeeded but gave rise to Carry trade. Carry trade is an investment strategy in which an investor borrows from a country with a low interest rate and invests it in a country with a high interest rate. The currencies involved are

called funding currency and target currency, respectively (Tosborvorn, 2010). As the Japanese interest rates were low relative to other countries, (graph 2), investors began borrowing in Yen and purchasing US securities. This resulted in the depreciation of the borrowed currency (the Yen), which is evident in the trends 1995-1998, 20002001 and 2004-2007 all displaying the same relationship (ticker, 2008).

Graph 2 Interest Rates of the worlds largest economies

Source:( Reserve bank of Australia, 2011)

TREND 2 ANALYSIS: 2002-2005 The Yen/US dollar exchange rate hit a high of 133.53 per US$ in February 2002 before it began to appreciate not so sharply as expected, possibly because of Japanese government forex interventions revealed later in the year reaching a low of 103.27 per US$ in January 2005. Graph 3 JPY/USD Exchange Rate Graph (Trend 2)

Trend 2

The Main causes for the Yen/US trend fluctuations in 2002-2005: Early 2001- late 2003 11 September 2001 20th March 2003
th

2003 2000-2005

Early 2000s US recession Terrorism and Iraq war prospects Massive interest rate cuts by the US Federal reserve Inflation differentials between US and Japan

Early 2000s US recession (2001-2003) The effect of the FOREX intervention by the BOJ in the previous trend did not last for long as the Yen began appreciating in 2002. This was due to a fall in investor confidence on the receding US economy coupled with the 9/11 attacks and accounting scandals by many listed companies in the stock market. The foreign demand for US based securities declined leading investors to liquidate US stock holdings of these companies as seen in the graph 4 below showing the decline in FDI investments, net purchase of dollar assets, stocks between 2001 and 2004. This led to the increase in supply of the dollar depreciating the dollar relative to the Yen. Graph 4 US Capital Flows

Source: (Optometrica, 2008) Terrorism: Prospects of War with Iraq, and uncertainty regarding North Korea (11th September 2001- 20th March 2003) The beginning of Iraq war pioneered by George Bush caused the US to engage in massive spending and printing of money that involved issuing of debt securities. This increased US net foreign debt and accelerated the depreciation of the US$. Substantial

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foreign debt raises default risk probing risk-averse investors to shift their investments to assets with lower risk. Investors began selling out some of their US$ denominated securities thus decreasing the demand for the US$. Prospects of a nuclear war with North Korea in January 2002 increased investment risks to investors (BBC, 2001) as US political risk grew.

Massive interest rate cuts by the US Federal reserve (2003) Due to the early US recession in 2003 the US Federal Reserve cut the interest rates rapidly from 6.5% to 1% in June 2003 to encourage spending (Graph 5) by increasing the monetary base to about $753 billion. This lowered the yield on the US securities making them less attractive to investors, therefore the US dollar demand fell, leading to depreciation in the US$ vis--vis the Yen. Graph 5 US federal fund rate

Source: (Reserve Bank of Australia, 2011) During 2001-2002 the interest rate differentials between Japan and US were high of about 5.5%. Which resulted in the carry trade that led to the appreciation in the

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US$, but since the federal reserve lowered their interest rates to a differential of 1% as explained in the previous page, the reasons for carry trade became obsolete and stopped. This is good explanation as to used to why the direction of the Yen/US$ exchange rate changed in 2002 and began appreciating.

Inflation differentials between US and Japan (2000-2005) The Table 2 below shows that while Japan still faced deflation between 1999-2005 the US faced a mild inflation. These inflation differentials made the Japanese

companies more competitive than the US exports, mostly gaining their advantage from low inflation rates that result in cheaper prices than those of the US. This translates to a higher demand for Japanese products thus a higher demand for the yen, The U.S trade gap in November 2002, for example, ballooned to a record $40 billion (Ito & Mishkin, 2011). Table 2 Inflation rate of the US and Japan
Country
United States Japan

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2.2 -0.8 3.4 -0.7 2.8 -0.8 1.6 -0.9 2.3 -0.3 2.5 -0.1 3.2 -0.3 2.5 0.3 2.9 0.1 3.8 1.4 -0.3 -1.4 1.4 -0.7

Source: (CIA World Factbook, 2011)

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TREND 3 ANALYSIS: 2005-2007 From the constructed exchange rate graph below we see that the Japanese yen went through a period of depreciation between the years 2003 to mid-2007 during which it attained a low of 124.14 against the dollar. The percentage depreciation of the yen hit a staggering 19.37% during this period. Graph 6 JPY/USD Exchange Rate Graph (Trend 3)

Trend 3

The Main causes for the Yen/US trend fluctuations in 2005-2007: Early 2004- Late 2006 Expansion of the US economy 2005 onwards Carry Trade

Expansion of the US economy Having gone through a depreciating period between the years 2002 to 2004 because of weak economic performance in the United States, 2005 highlighted a strong economic growth compared to other countries and the dollar was able to change its course and appreciate steadily. Increases in domestic interest rates by Federal Reserve

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by a quarter of 1% and large wealth storages by oil rich countries in the United States were the main reasons for this rise. According to (Elwell, 2008) this led to an increase in net inflow of foreign funds from $186 billion in 2004 to $585billion in 2005 hence the dollar appreciated. As supply of dollar remains constant, increasing demand resulted in a strong appreciation of 14% against the yen and 11% against the euro (Craig Elwell, 2008). Carry Trade The yen vs. USD exchange rate was largely affected by the carry trade incidence that heightened in the years between 2005 and 2007. The Yen appreciated to around 105 yen per dollar beginning of 2005 but depreciated to 121.4 yen per dollar at the end of the year before rising slightly to 119 yen by 1st quarter of 2007. This was due to the Japanese soaring carry trade between 2005 and 2007 as there was large scale borrowing of the Japanese yen by investors and speculators who sold it off and invested in riskier assets. These assets ranged from US subprime mortgages and volatile commodities, emerging markets bonds and stocks and high yielding currencies like the Euro. Source: A vicious circle began as the carry trade sky-rocketed leading to the depreciation of the borrowed Yen whilst the US risky assets prices soared from high demand. Massive carry trades of the yen saw the dollar appreciating to 124.14 yen in 2007 which took the yen to a 22nd low on real effective exchange rate basis. In comparison to 2005 value, the yen had gained about 25% its value on the real effective exchange rate as seen on the Graph below.

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Graph 7 The JPY/USD Real Effective Exchange Rate (REER)

Source : Bank of Japan, 2011

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TREND 4 ANALYSIS: 2007-2011 The following is an analysis of the downward trend shown by the JPY/USD exchange rate for the period between June 2007 and August 2011. In the mentioned period, the yen strengthened by 37.14% to a record high of 77.09 against the dollar. Graph 8 JPY/USD Exchange Rate Graph (Trend 2)
JPY/USD Spot Rate (Mar 07 - Aug 11)
130 y = -0.7725x + 118.21

118

JPY/USD Rate

106

94

82

Spot rate

Linear Trend

70 Mar-07

Jul-07

Nov-07

Mar-08

Jul-08

Nov-08

Mar-09

Jul-09

Nov-09

Mar-10

Jul-10

Nov-10

Mar-11

Jul-11

Time Period

The Main causes for the Yen/US trend fluctuations in 2007-2011: Trigger Reason 2007 US Financial Crisis Unwinding of Yen Carry Trade Falling confidence in the US Dollar March 2011 Earthquake

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Trigger reason - Financial Crisis caused an appreciation in the Yen. The trigger of this sharp increase in the exchange rate was the financial crisis that begun in the US in the summer of 2007. This collapse had a direct impact on confidence of investors in the US economy and the carry traders.

Unwinding of the Yen Carry Trade (YCT) The only cache to the YCT is that if the yen strengthens (or the opposite currency weakens), the investors will receive a much lower yen amount after converting. This may sometimes not be enough to service the borrowed yen and the investors would get huge losses (most of the YCT flows were leveraged, with losses or profits increasing in magnitude proportional to the leverage ratio). Investors were confident that an undesirable movement of the either the yen or the opposite currency was unlikely - Japan's real economic growth rate was between 0% and 3% in the period from 2000 to 2007 and not much expectation of strengthening. The Bank of Japan would not interfere with depreciation in the yen because it helps boost demand for the exporters. As most investments were in countries with large and stable economies such as the U.S and the U.K (before 2007), the proponents of the YCT dismissed it as unlikely for any unfavorable movement of their currencies. This went well until the global financial crisis began in the U.S. The U.S. treasury rates went from 5.25% in June 2007 to almost 1.5% at the start of 2008 while the dollar began to weaken. Investors panicked and liquidated their holding (estimated $900bn) then converted them into Yen to repay their loans. The high demand for the yen spiked it against the dollar hence the sharp downward trend in the figure above. The U.S. Treasury rates fluctuated between 0% and 0.5% from 2009 to date - making the YCT less valuable as during the pre-2007 period. In the conclusion of their paper, Masazumi, H. and

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Hyung Song (2009) remark that in the lead-up to the credit crisis of 2007/8, purchases of mortgage assets and related securities by hedge funds and their intermediaries was financed (at least in part) by money that was ultimately borrowed in Japan. At the credit bubble burst the borrowers had to unwind such bets by selling mortgage assets and repaying their Japanese creditors. The result was the conjunction of a fall in asset prices and a fall in the US dollar.

Falling confidence in the US dollar (also, reference to China' purchase of Japan Debt).

High demand for the yen in the foreign exchange market strengthened the yen. The Treasury Secretary in the U.S. announced to the Congress that the U.S. government had officially reached its $14.3 trillion debt limit in May 2011 but was raised up to $2.4 trillion. The US image was tainted by the initial threats in July by Moody's of a credit downgrade and warnings by Standard & Poor's of a 50 percent chance of downgrading the U.S. credit rating within three months because of the tussle. For the first time in history of the U.S, the credit rating was downgraded to AA+ from their normal AAA. Market confidence in the U.S. declined substantially and investors sort safer and attractive investments elsewhere. With the inflation in Japan averaging to 0.23% this year with deflation in some months (-0.10% in January and -0.20% in June), Toyoo Gyohten (2011) argues that the rising purchasing power of the yen is attracting investors now wary of the U.S economy. Even the European markets are quite unattractive with the sovereign debt crisis still unfolding. By August 2011 (after the U.S. credit rating downgrade), China had bought a net of 345.6 billion. This coupled with investors diversifying away from the dollar increased the demand for the yen and reduced the demand for the dollar, causing the yen to appreciate considerably. 18

March 2011 Earthquake In the aftermath of the Thoku earthquake and tsunami in March this year, Japan received an influx of donations for relief in various countries currencies. Conversion of the various currencies to the Yen pushed up the demand for the yen and strengthened it. The total figure of the donations is difficult to compile. To cover such bills, the multinational insurance companies in Japan had to liquidate their foreign assets, thus adding to the appreciation.

Conclusion: Our analysis of the JPY/USD trend over the past decade illustrates that overall the yen has been appreciating. This has primarily been due to the current economic instability in the US and European countries. The non-ending credit crunches, continuous speculation and long term debts in both Japan and Us weigh heavily on the trend followed by their currencies. The PPP theory holds that ignoring the short-term trends, and looking at long run, the Yen should appreciate. Furthermore Japans inflation rates are very low and the current account is in surplus which signals an appreciation.

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PART 2: FORECAST ON THE VALUE OF THE ANALYSIS ON THE EXCHANGE RATE JAPANESE YEN (JPY) AGAINST THE US DOLLAR (USD) ON 30TH APRIL 2012

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In this section, we will attempt to forecast the rates for the JPY/USD for the month of April 2012. The methods used will be a combination of technical and fundamental analysis. In our opinion these will have a much higher weight than forward rates, which are the known unbiased estimators of future exchange rates. The arguments will be outlined after each method has been used stating their possible weaknesses.

FORWARD RATES: These forward rates quoted below from banks and trading sites are to be used as a proxy (Baseline) for the forecast estimate. Soneri bank ltd (Pakistan)- April 2012 Maybank SDN BHD FX street Forexpros *Estimated using cross rates. 76.52/$* 73.73/$* 76.46/$ 74.67/$

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THE TECHNICAL ANALYSIS METHOD: We made use of the econometrics approach to forecasting. It is widely accepted that no matter what the fundamentals could be, there is always an underlying trend. The trend is identified by observing past exchange rate movement in the hope of being able to predict the future rates. The forecast here is for 6 months, which is sometimes known as the 'medium term'. In our analysis, we used the exchange rate movements from 2007, and not 2000. The main reason for this is the fact that the fundamentals had changed in 2007, during and at the aftermath of the global financial crisis. It was a unique event that led to major changes in the regulation systems, capital mobility, investor confidence and other crucial determinants of the foreign exchange rate. It would be unwise to use data that stretches too far back because it is unable to capture the important changes after 2007. Also, by careful observation, it is clear that after 2007, the JPY/USD exchange rate shows a trend not observed before. The technical analysis software we use is dependent upon every data point and cannot differentiate between such observations, we decided to omit pre-2007 data because it would compromise our medium term forecast. Another important point to note is our selection of variables. Our analysis of the 11-year trend in the first question led us to believe that the most important observable determinants of the JPY/USD foreign exchange were: the interest rates, the inflation rates and the economic growth rates. Almost all of the reasons that we used to explain the trend had an element of either all or some of these variables. However, these were not the only variables - there are others (quite important), both observable and non-observable variables that also explained the trend. We cannot

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include all of them because the software dictates that adding more variables will compromise the accuracy of the forecast - we wish to avoid this. Lastly, the data is a time-trend data that is subject to serial correlation according to the econometricians. The main cause of serial correlation is 'omission of variables that follow some kind of trend over time'. Because we omitted such variables as explained above, we had to get over the problem of serial correlation by using the Cochrane-Orcutt model. The results of our regression are as follows:

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Econometrics model (Spot rate equation): Spot rate (/$) = 80.678 + 3.648usintr + 8.550jpintr + 0.104usinfr + 1.523jpinfr + 0.265usrgdpgrwth + 0.045jpgrdpgrwth Key: usintr - US interest rate jpintr - Japan interest rate usinfr US inflation rate jpinfr Japan inflation rate usrgdpgrwth - US real gdp growth rate jprgdpgrwth Japan real gdp growth rate

Table 4.Forecated Variables Forecasted Variables US Interest rates 0.16 Inflation rate* 0.9 US real gdp growth rate** -0.4 * The inflation rate was adjusted for April 2012(monthly wise) Japan 0.1 0.2 0.55

**The real gdp growth rate was quoted quarterly but was adjusted to monthly in line with our model by dividing by quarterly rates by 3

Source: forecasts.org, Bank of Japan. Substituting the forecasted variables in the econometric model above gives a forecasted spot rate of 82.43/$ for 30th April 2012.

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RELATIVE PURCHASING POWER PARITY: Demirag and Goddard (1994) state that relative Purchasing power parity takes into account the necessary adjustments in exchange rate between two countries by comparing the changes in the ratio of domestic prices relative to foreign prices from a time when exchange rate is in equilibrium. RPPP holds that relative variations in prices between two countries over specified period of time tends to determine the exchange rate for those countries. US Inflation rate 0.9% Japan 0.2%

JYP/USD Spot rate as at November 2011(average)=77.52 per US$1 Table 5.Source: Forecast.org, Tradeeconomies.com, XE currency (2011) Given the Data above; If the RPPP holds, we expect the US$ to depreciate against the Japanese yen in April 2012 by the 0.7% (the differential) Therefore, the current spot rate being S1 = 77.52, RPPP forecast (Yen/US Spot rate) S2= S1 x (1-0.7%) S2= 77.52*0.993 S2= 76.98 RPPP forecast (Yen/US Spot rate): 76.98/$.

Most researchers have found PPP to be highly inaccurate in short term forecasting due to great and frequent deviations from the actual exchange rate and the forecasted amount. They mostly regard its credibility towards medium and long-term estimates. Henley Forecasting Centre and Webster (1987) backed these claims.

Edison (1987) studied the exclusiveness through the dollar/pound exchange rate for the years 1890 to 1978. After considering the variations in the structural

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factors she found out that the proportionality between exchange rate and relative price levels is only significant in the long run. She advocates that PPP holds for medium and long-term periods and fails in the short run. Since our forecast is for six months, the RPPP forecast may be somewhat unreliable. Hence, less weight will be put on it as a good forecast measure.

THE INTERNATIONAL FISHER EFFECT: The relative interest rates of the U.S. and Japan play an important role in the determination of the JPY/USD rate. Here we use the international fisher effect parity condition that relates the interest rates between Japan and the U.S. and their spot exchange rates. The forecast formula for the fisher effect is:

Data collected: Japan Interest rates (November 2011) = 0.05% US Interest rates (November 2011) = 0.13% JPY/USD spot rate (November 2011) = 77.69

The resulting spot rate should be 84.10/$ in 6 months time.

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Our advice to the Firm: We would like to highlight a few factors that are of considerable importance but not reflected in our forecasts. 1. There is planned intervention in the yen by the G7 countries. This is to weaken the yen in the hope of boosting exports that would support the Japanese companies. The magnitude of this intervention is still unfolding in the current news. The impact cannot be estimated yet and we cannot, at this point know how the yen would be affected but we are confident it would weaken the yen considerably. Minister Fumihiko Igarashi the Vice Finance Minister in Japan made statements in August that he was watching the rate closely and that the government was ready to intervene (Bloomberg). 2. The EU sovereign debt crisis is still unfolding. The direction it is going, and its ultimate end is still a mystery there is news that the EU zone will be divided. The EU countries are expecting cash rich countries like China and Japan to buy off the debts. There is strong evidence that Japan is ready to help. This will flood the market with yen and depreciate it. We cannot estimate to what level of commitment Japan is willing to go, but we are confident that the depreciation of the yen will be higher than forecasted. 3. Japan is hit by natural disasters every now and then. We cannot be held responsible if our forecasts get distorted by an unforeseen disaster(s) between now and April next year. 4. Unrest in the US and the violent occupy Wall Street movements add to the negative political bleakness, which makes investors re-consider their positions in the US financial assets. If this situation worsens we expect depreciation in the US$. This may distort our econometric forecast of the depreciation in yen.

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Conclusion: Summary of the forecast for the JPY/USD exchange rate on 30th April 2012 Forward rates* 75.35/$ Technical analysis method (Econometrics) 82.43/$ International Fisher effect 84.10/$ Relative purchasing power parity 76.98/$ *Average of the 4 quoted market rates (bid price) given we are selling
$10,000,000 and buying Yen in 6 months time

The technical analysis and the international fisher effect hint that the JPY/USD exchange rate will begin to depreciate in the 6 months. While the other two methods still insist that the exchange rate will continue to appreciate. Taking into consideration of the qualitative factors mentioned on the previous page, we expect the Yen to depreciate as the actions of the G7 and Japanese government weigh more importance in future expectations hence the JPY/USD exchange rate will range between 82.43/$ and 84.10/$ on 30th April 2012.

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US Chamber of Commerce (2011) Corporate Aid Tracker - Japanese Earthquake and Tsunami, March 2011, [online] Available at: http://bclc.uschamber.com/Programs/disaster/corporate-aid-tracker-japaneseearthquake-and-tsunami-march-2011 [Accessed: 1st November 2011].

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