Japan is falling into a trap in defending its currency against the US dollar, like Thailand in 1996. Japan’s large forex reserves make the yen a juicy target, rather than deterring currency predators. Its fundamentals are weak and deteriorating, making the yen’s further decline inevitable.

Japan can’t raise interest rates aggressively to defend its currency due to its high national debt. It could fall into an inflation-devaluation spiral, greatly profiting yen short-sellers.

The yen is trading above 160 to the US dollar again, just a month after a massive government intervention. Japan’s foreign exchange reserves stand at over US$1.3 trillion but further interventions will only cost more and be less effective, allowing short-sellers to build larger positions.

Some yen short-sellers are likely to have also shorted East Asian currencies in the lead up to the 1997 Asian financial crisis. They are orders of magnitude bigger today and will need far more to satisfy their appetite. Japan fits the bill. The country has earnings from US$3.5 trillion in net foreign assets, covering it for the negative impact of a national debt twice the size of its gross domestic product, a fiscal deficit that is 4.6 per cent of its GDP and stagnant exports.

The negative case for the yen stems from Japan’s deteriorating trade account due to declining competitiveness and rising defence expenditure. Japan’s exports are likely to be entering a structural downtrend. After missing out on electrification, its most important export product, the automotive, is becoming obsolete. And US tariffs are forcing some of Japan’s export industries to relocate there, further shrinking its exports.

Meanwhile, Japan’s imports are rising. As the crisis in the Middle East drags on, Japan is being forced into liquefied natural gas and oil contracts with the United States, possibly locking in high energy costs for a decade and beyond. Japan is also rapidly increasing its defence expenditure, much of it to buy US weapons.