In the past few years, different currency valuation models have offered different conclusions for the Japanese yen. However, since summer 2020, short-term drivers of the currency have pushed the yen to be undervalued when measured across this same suite of valuation models.
Purchasing Power Parity and Real Effective Exchange Rate (REER) models are common starting points for both financial markets and policy makers for measuring a currency’s fair value. This family of models has for many years screened the Japanese yen as being cheap and getting cheaper. However, whilst these models capture tradable goods, they exclude other important factors. Financial flows and external cross-border balances are captured within Fundamental Equilibrium Exchange Rate (FEER) models. Using these models, and accounting for Japan-specific dynamics such as a large Net International Investment Position (NIIP) and the consequent foreign income, the yen was fairly valued as of summer 2020. The magnitude of the NIIP (the largest in the world as a percentage of GDP and foreign income: as much as 4% of Japanese GDP per year which is larger than both the goods and services balances) suggest that a valuation framework that considers cross-border balances may be more appropriate than one focusing on the relative price of tradable goods.
Our modelling of the Fundamental Equilibrium Exchange Rate is consistent with the IMF External Sector Report’s FEER model in finding the yen’s fair value as of August 2020 within a range between 8.3% undervalued to 9.7% overvalued in REER terms, giving a midpoint insignificantly different from 0%. Since August 2020 the yen has depreciated 11% on a REER basis to below the error band. The depreciation has been inconsistent with long-term fundamentals, and instead driven by shorter-term factors, namely interest rate differentials, as higher inflationary pressures in the rest of the world compared to Japan led yield differentials to widen.
Overall, the depreciation of the yen over the past year is well explained by shorter-term market drivers, but has left the currency undervalued when measured by a variety of NB and external models. The consistency of valuation assessment provides longer-term investors attractive levels to be overweight the yen.