Why the Yen Is Killing Japan Inc.

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Businessmen pray for prosperity in their businesses for the year at Kanda Shrine, known as the god of business, on Jan. 5, 2009, in Tokyo

With Japan's recession deepening, the country's central bank could intervene in currency markets for the first time since 2004, in a bid to prevent further appreciation of the yen — a rise that is hammering Japan's export-driven businesses.

The yen hit a 13-year high against the U.S. dollar last month. While the Japanese currency has weakened somewhat recently, Bank of Japan governor Masaaki Shirakawa said Sunday that currency-market intervention was possible if the yen's rise resumes. "The strong yen at a time of rapid decline in the global economy has a big negative impact on our economy in the short term," Shirakawa said. (See pictures of Japan and the world.)

Of primary concern is the financial health of major Japanese exporters such as Toyota, Honda and Sony. Many of Japan's most important companies are hurting as a result of collapsing demand and the soaring yen, which has risen 15% against the dollar over the past 12 months. A strong yen makes Japanese products more expensive, and hence less competitive, in overseas markets.

Japan's exports declined 14.5% in November, the largest monthly drop since the country started compiling such data in 1975. Toyota recently warned that in its coming fiscal year it would suffer its first annual operating loss in the company's 70 years. The carmaker also plans to suspend production at all 12 of its Japanese factories for 11 days in February because consumers worldwide aren't buying. Masafumi Yamamoto, head of foreign-exchange strategy for Japan at Royal Bank of Scotland, says a 10% appreciation of the yen slashes the GDP growth rate by 0.3 to 0.4 percentage points.

The yen's value has hovered at around 90 to the dollar for the past two weeks. But currency experts predict it could climb to 85 over the next few months — a level that could trigger intervention by the Ministry of Finance and the Bank of Japan, which would buy dollars in currency markets to boost the greenback and undercut the yen. Some analysts say the exchange rate could soon reach 80 yen to the dollar. That would almost certainly spark another plunge in Japan's beleaguered stock markets — another concern for Japanese authorities.

Still, it's unclear whether intervention will be necessary. Some argue that the dollar-yen exchange rate is reaching a sustainable equilibrium and that the yen isn't as strong as it appears. "The yen's level until last year was abnormally weak," says Tohru Sasaki, chief currency strategist in Tokyo at JPMorgan Chase & Co. "Now it's coming back to normal."

Sasaki attributes the yen's recent strength to the unwinding of the yen carry trade, referring to the widespread practice by investors over the past several years of borrowing yen at a low interest rate and investing the funds in currencies paying higher interest rates. That was an easy way to make money until central bankers in the U.S. and other countries began slashing borrowing costs as the credit crunch hit and their economies faltered. The carry trade "is a very strong and powerful movement, and it's difficult to stop it," Sasaki says. "I think that Japanese officials understand that, and that's why they haven't intervened."

Sasaki argues that, compared with a period in the mid-1990s when the yen hit a postwar peak against the dollar, today's negative impact on the Japanese economy is "not that large." That's because the U.S. over the past decade has seen higher inflation than Japan, where prices have been relatively flat for many years. To have the same effect as the peak in 1995 — when the exchange rate reached 79.75 yen to the dollar — Japan's currency would have to soar to 48 to the dollar, he says. "If we think about the inflation-rate differentials, the yen is not that strong right now." Tell that to Toyota.

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