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Monday, Jan. 21, 2002

Understanding new forex risks key to coping with expanding volatility


The Sept. 11 terrorist attacks on the United States reminded the world that a new type of risk can hit the global economy in the new century. Risk factors multiplied beyond economic fundamentals, adding greater volatility to markets.

Since October, the yen has depreciated against other major currencies, falling not only against the dollar but the euro as well.

While foreign exchange rates reflect economic conditions and the comparative risks of the countries involved, the dollar-euro rates have remained relatively stable. What is happening in the currency market is the fall of the yen.

True, a weaker yen serves to stimulate the Japanese economy by boosting exports, but it is also an indicator of the market's growing perception of the risk surrounding the nation's economy. We must realize that it would be difficult to control exchange rates just for Japan's convenience.

Despite expectations that the yen's fall could boost the economy, Tokyo share prices remain mired in a slump. The TOPIX index has fallen to its lowest point since the collapse of the bubble and many issues have dipped below 100 yen.

Japanese government bonds have also been downgraded to a level that, if reduced further, would drop it below the standards of the industrialized world. In addition to the prospect that the national debt may reach 175 percent of gross domestic product if the government continues to run up fiscal deficits, the crawling progress that has been made on structural reforms during the "lost decade" and Japan's inability to deal with changes in the global business environment have earned it the distrust of financial watchers.

What is happening is the so-called triple fall -- the depreciation of the yen, a slumping stock market and the possibility of a bond market collapse -- despite the ultra-easy monetary policy being maintained by the Bank of Japan. Investors, domestic and foreign alike, no longer see the nation as an attractive place to keep money.

Everybody knows that Japan needs structural reforms, but resistance remains strong in three categories: politicians, bureaucrats and big business -- especially the first two.

Unlike in the past, Japan is part of the global market. If the country is unable to act voluntarily, the market will force it to take action.

Coupled with the economic concerns is a growing perception that Japan's security is at risk, as exemplified by the recent "mystery ship" incident. This has all set in motion a vicious cycle of "Japan-selling," in which the yen, stocks and bond prices fall.

The government reportedly plans to submit legislation to the Diet when it opens today that enables it to respond better to security emergencies. It is one step forward in the government's effort to help the nation cope with its ever-riskier international situation. The Diet should approve the bill as early as possible.

The United States also faces a growing risk. The Sept. 11 incident -- the first attack on its territory in more than half a century -- is symbolic of that risk, and further terrorist attacks, protracted military operations and expansions into other regions cannot be ruled out. The U.S. economy has not responded much to large-scale monetary easing and additional steps are anticipated. Earnings forecasts by U.S. firms are also not looking bright.

Foreign exchange volatility is likely to increase this year.

As the world's economies suffer low growth, industrialized nations are expected to ease monetary policies and inject excessive liquidity into the market, boosting the flow of funds seeking speculative gains. This will add volatility to the market.

Diversification of assets is the key to risk-aversion, and the euro, despite lingering problems, has the potential to become such a tool. But redistribution of assets can cause major changes to the currency market, making it another factor that could increase volatility.

Foreign exchange rates are sensitive to a variety of elements, and security factors tend to have bigger impact than economic ones. Due to revolutionary progress in information technology, currency markets respond to such factors much quicker than in the past. Once exchange rates move out of the range anticipated by market participants, however, even coordinated action by monetary authorities of industrialized nations cannot stop them.

One example is the appreciation of the yen caused by the 1985 Plaza Accord, which called for international action to correct the dollar's strength. The rise of yen, which stood at 240 against the dollar at the time of the Plaza Accord, became unstoppable even by the Louvre Accord of 1987 and continued for 10 years until it reached 80 against the dollar in April 1995.

Also still fresh in our memory is the Asia crisis, which began in mid-1997 with a massive retraction of foreign capital that had been pouring into the region.

What the market needs overall is a correct understanding of the new types of risk it will face in the new century and appropriate governmental action -- as well as prompt international cooperation -- to deal with the growing volatility in the currency market.

Teruhiko Mano is an adviser to Tokyo Research International Ltd.


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