Hearts pound lest the yen should rebound

In the 1990s Japan’s economy was put through the wringer. Plunging asset prices and deflation seemed to be condemning to perpetual stagnation an economy which futurologist Herman Kahn projected in 1970 might, by 2000, surpass America’s in terms of income per person. The Asian focus shifted steadily to China.

Last weekend, however, the world’s third largest economy was back centre-stage as several participants at the Group of Seven (G7) finance ministers’ meeting in Essen - but not the US Treasury Secretary Henry Paulson - signalled that the Japanese currency was a problem. The question is, what sort of problem?

The plunging yen - it hit record lows against the euro this week - is certainly becoming a source of trade tensions. According to Citigroup economist Jürgen Michels, the euro has soared by around 70% against the yen since October 2000. By making Japanese goods much cheaper this is having an adverse impact on the competitiveness of EU exports, not only in Japan but also in Europe’s biggest export market, the US. Japanese imports into Europe have also become much more price competitive.

Japan may be a relatively small EU trading partner: in 2006, 2.5% of EU exports went to Japan and about 4% of euro area imports came from there. But in certain sectors, notably transport equipment, especially cars, and electrical and mechanical machinery, Japan is a much more significant competitor. Japanese exports of these goods to Europe have soared recently, putting pressure on German business in particular.

The figures involved, while significant, are not yet big enough to do much damage to a euro area described by G7 finance ministers as "experiencing an increasingly broad-based upswing". So why was there all the hand-wringing about the yen in Essen?

What is really bothering the Europeans is not just the real economy and trade implications of the slumping yen, but also the financial market implications.

There is a real concern that the yen is now "overshooting", that is to say its value has lost touch with economic fundamentals and that, like an overstretched rubber band, it might suddenly spring back. The worry voiced by, among others, European Central Bank (ECB) President Jean-Claude Trichet, is that too many hedge funds and bank speculators have placed "one-way" bets on the weak Japanese currency, borrowing it at near- zero interest rates and then selling it in order to invest outside Japan. This drives the yen down and exposes them, if the elastic snaps, to what could be a traumatic currency risk. Trichet described such one-way bets as "not appropriate".

Japan may not be a source of much extra growth in the world economy, but it is contributing significantly to excessive global liquidity, too low global interest rates and dangerous speculation. A sudden yen reversal could cause huge losses for those speculators who have been making the one-way bets, perhaps even triggering a global economic crisis. Hence the repeated warnings in Essen for investors to prepare now for the yen to bounce back and steadily unwind these risky positions before everybody rushes for the exit at once.

Because of this financial market risk, G7 finance ministers’ confident projections about economic growth are - as in 2000, just before the dot- com collapse, hostage to events which their economists can neither model nor predict.

The Americans have long believed that they could use the threat of damaging currency movements to put pressure on EU states to accede to US economic policy priorities - as they did regularly in the last decades of the 20th century.

After the ECB’s Council meeting on 8 February, just before the G7 meeting, Trichet signalled the bank’s "strong vigilance" against inflationary pressures, a hint that the ECB would probably raise interest rates in March. This sent a firm message to eurogroup finance ministers. It also told the Americans that, in the absence of co-ordinated action, Frankfurt would run a monetary policy focused primarily on what it sees as the needs of the euro area economy.

• Stewart Fleming is a freelance journalist based in Brussels.

In the 1990s Japan’s economy was put through the wringer. Plunging asset prices and deflation seemed to be condemning to perpetual stagnation an economy which futurologist Herman Kahn projected in 1970 might, by 2000, surpass America’s in terms of income per person. The Asian focus shifted steadily to China.