In August 2024, currency markets briefly remembered how they were supposed to work. The Bank of Japan had begun raising interest rates. The Fed was signaling easing. The yen surged – USD/JPY dropped from around 160 to 140 in weeks. Narrower rate differentials, stronger currency. The old playbook seemed intact.
Then reality reasserted itself. The yen gave it all back. By early 2025, it was drifting toward 160 again—despite a macro backdrop that should have supported yen strength. Rate differentials were compressing, not widening. The Fed had moved. The BOJ had moved. And yet the yen had not.
Most investors remain puzzled because they assume interest-rate differentials should dominate everything else. But the yen was not merely trading against the dollar. It was trapped inside a three-body currency problem involving the dollar, the yen and the Chinese yuan. And once China’s prolonged deflationary shock entered the equation, bilateral rate logic alone became insufficient to explain the yen’s behavior.
Two forces, one exchange rate
Exchange rates simultaneously balance two distinct forces:
- cross-border financial flows, driven by interest rate differentials and capital account dynamics, and
- real-economy competitiveness, reflected in real effective exchange rates, relative purchasing power, and trade balances.
When the two align, currency behavior is intuitive. When they diverge, the results confound conventional models. For the yen, they are pulling in opposite directions.
China’s deflationary turn
Since 2022, China has experienced persistent producer-price deflation, weak domestic demand and excess industrial capacity. The “Three Red Lines” policy triggered a systemic deleveraging of the property sector. Post-pandemic consumer confidence never recovered. China’s PPI has remained negative since late 2022. The GDP deflator has declined for multiple consecutive quarters. This is not a transitory soft patch. It is a systemic deflationary adjustment.
Crucially, deflationary economies pass through two distinct phases of currency behavior. In Phase 1, the central bank cuts rates, capital flows out and the currency weakens. This is the part conventional frameworks describe well.
For China, this played out from 2022 into 2023 as the PBOC eased while the Fed tightened. The yuan depreciated against the dollar. The story was straightforward.
But in Phase 2, rate cuts reach practical limits. If the central bank does not resort to aggressive unconventional measures, chronic deflation sets in – and its compounding effect on the real economy begins to dominate. Year after year of falling domestic prices widen the gap between China’s price level and those of its trading partners.
This cumulative divergence amounts to a de facto depreciation of China’s real effective exchange rate, making Chinese goods ever cheaper relative to foreign competitors. At some point, the sheer weight of this price-level divergence overwhelms the financial channel and reverses the direction of currency pressure: from depreciation to appreciation.
This is where China stands today, roughly four years into its deflationary adjustment.
Why Japan
This is not collateral damage hitting Japan at random. Japan and China compete head-to-head across mid-to-high-end industrial segments—automobiles, steel, petrochemicals, batteries and, increasingly, electronics. Toyota versus BYD. Nippon Steel versus Baowu. China’s expanding capacity is entering markets Japan still depends on for export revenue.
Since 2022, the divergence in producer prices between the two economies has approached roughly seven percentage points per year on a cumulative basis. Chinese exporters may now enjoy an effective price advantage approaching 25-30% relative to Japanese competitors in overlapping sectors. That kind of structural divergence cannot be neutralized by modest interest-rate adjustments.
The three-body mechanism
On the financial side, Japan’s monetary conditions should support a stronger yen. The BOJ exited negative rates, bond yields rose and the Fed began easing. Under ordinary rate logic, USD/JPY should have declined.
But the real economy was moving in the opposite direction. Because USD/CNY is managed and does not appreciate to reflect China’s improved real competitiveness, the adjustment pressure is displaced onto other currencies – and JPY/USD absorbs the bulk of it.
Many investors assume that because CNY/USD appears stable, China is not exporting currency pressure. In reality, the stability of CNY/USD may itself be the mechanism transmitting that pressure outward.
Under normal conditions, years of cumulative deflation would push the yuan substantially stronger. But Beijing has strong reasons to maintain exchange-rate stability.
If CNY/USD is prevented from appreciating while China continues gaining competitiveness through deflation, neighboring currencies must absorb the adjustment burden. The yen becomes the primary shock absorber – not because of Japanese policy failure, but because the system has no other release valve.
A self-reinforcing dynamic
The deeper question is why the imbalance does not self-correct. China’s current strategy emphasizes supply-side industrial expansion over near-term demand stimulus. As industrial output rises faster than domestic absorption, excess production is channeled outward. Weaker demand feeds deflation, deflation feeds a weaker real effective exchange rate, a weaker REER feeds more exports and more exports sustain the overcapacity. The dynamic is self-perpetuating – increasingly referred to as “China Shock 2.0.”
No bilateral solution
USD/JPY can no longer be understood without considering CNY/USD. And CNY/USD is increasingly shaped by China’s domestic deflationary pressures, capital management and export dependence. What appears irrational under bilateral currency logic becomes coherent once the triangular system is recognized.
Investors waiting for rate differentials to “fix” the yen are solving the wrong equation. The resolution will require not incremental monetary adjustments, but a structural shift in the economic model of the world’s second-largest economy. That is a question of political economy, not central banking. And it is, to say the least, not imminent.
Steven Linsley is an independent macroeconomic commentator.
