For many, the strength of the yen is a conundrum. How can the currency of a
country with such a weak economy as Japan's, such a high level of debt, weak
leadership, poor demographics, combined with an ever deteriorating economic
outlook be so strong?
Many market participants did not anticipate 24 months ago that the yen would
demonstrate such strength. Now, many commentators focus on Japan’s "safe haven"
status as a key reason why the currency has appreciated. True, at the onset of
the financial crisis the Japanese banking system was viewed as being amongst
the soundest globally, but as risk came back into the markets in March 2009,
through most of that year the yen
continued to appreciate.
In a period where we witnessed a substantial reversal in risk aversion (the
S&P 500 returned over 50% from the end of February 2009 through December
31, 2009), the Japanese yen's safe haven status does little to explain its
strength.
S&P 500 and yen
So what has driven the strength of the yen? While the reasoning behind currency
price movements is inherently multi-faceted, we believe some of the more
relevant drivers of Japanese yen strength have been: 1) weak leadership; 2) low
reliance on foreign investment; and 3) relative attractiveness of Japanese
yields.
Weak leadership
Japan has been through nine finance ministers and five prime ministers since
2006. Let me repeat: nine finance ministers, five prime ministers. Suffice to
say, it has been an incredibly unstable political situation. With Japan's
leadership in flux, policy makers lacked any central cohesion. As a result,
those policy makers were less focused on printing and spending money. This is
particularly evident through Japan's monetary policies: while other central
banks around the world were printing money like there was no tomorrow in
response to the global credit crisis, the Bank of Japan was conspicuously
absent in its ability to bloat its balance sheet.
Cumulative change in central bank balance sheets
The change in a central bank's balance sheet can be thought of as a proxy for
the additional money (currency) that central bank has printed; central banks
can purchase securities (whether Treasuries, mortgage-backed securities or any
other financial asset) with a few simple keystrokes. Creating money out of thin
air may be an apt description of this process. This increases the supply of
that currency printed.
When the supply of any asset increases, this naturally creates downward price
pressure on that asset; all else equal, that asset will fall in value. While
the Bank of England and the US Federal Reserve printed vast amounts of money,
the Bank of Japan did not. Between August 31, 2008, and September 30, 2010, the
Japanese yen appreciated 30.25%, whereas the British pound declined 13.70%
against the dollar.
Not reliant on foreign investment
There is a common misconception that a country requires strong economic growth
to have a strong currency. That is not necessarily true. When a country runs a
current account surplus, it doesn't necessarily need economic growth to have a
strong currency. Japan is the perfect example. Japan is not reliant on foreign
investors to support its currency; it has had lousy economic growth yet a very
strong currency.
Let's put it another way. In 2009, the US had a current account deficit of
US$378 billion, meaning that the US required foreign investors to purchase
approximately $1.5 billion worth of US-dollar denominated assets every single
business day just to keep the dollar from falling.
In contrast, the Japanese current account surplus for 2009 was 13.3 trillion
yen, or using the average exchange rate for the year, $142 billion. Japan
required foreign investors to sell over $500 million worth of yen-denominated
assets every single business day just to keep the Japanese yen from rising.
The point here is that a country with a current account deficit, such as the
US, needs to display economic growth in order to attract investment from abroad
to underpin strength in its currency, whereas a country with a current account
surplus, such as Japan, does not.
At approximately 200% of GDP, Japan has by far the highest level of government
debt of any "developed" nation. However, the vast majority of this debt is
financed domestically. In other words, Japan is less reliant on international
investors to finance its fiscal deficits. In the US, over 50% of privately held
Treasury securities are owned by international investors, while in Japan, only
around 5% of Japanese government securities are owned by international
investors.
Japan simply has had a much higher savings rate than the US and therefore its
domestic population has been able to support the fiscal largess of the
government.
While pressure has mounted globally over the unsustainable deficits many
governments are running, Japan is an acute case and has been for sometime;
Japan's fiscal situation was considered by many to be chronically unsustainable
well before the global financial crisis took hold in 2008. Arguably, Japan's
unique domestic savings situation has protected it somewhat from international
political pressures to instigate meaningful austerity measures, though we
believe these dynamics are changing, as we will explain below.
Relatively attractive yields
The term "attractive Japanese yield" sounds like an oxymoron given the
extremely low rate environment that has prevailed for the past decade, but let
us elaborate. Leading up to the financial crisis of 2008, one of the more
common currency trading strategies employed was the carry trade. At its most
basic level, an investor following a carry trade strategy would short a
low-yielding currency and buy (go long) a high-yielding currency.
It just so happened that Japan had very low rates, and countries like Australia
had relatively much higher rates. As such, one of the most popular carry trade
strategies was to short the Japanese yen and go long the Australian dollar.
Once the financial crisis took hold, the carry trade fell apart, as central
banks around the world rushed to cut target interest rates and provided
unlimited liquidity to the financial industry.
However, this did not happen in Japan. Rates were already close to zero and
weak leadership meant that the Bank of Japan did not print as much money as its
global counterparts. While Japanese yields remained low, yields elsewhere fell,
and as such, the low yields in Japan became less unattractive, or, canceling a
double negative, relatively more attractive. Indeed, it appears the US dollar
became a more attractive substitute for the short side of the carry trade when
risk came back into the market in 2009.
The following chart, which depicts the spread between Japanese three-month
government securities and equivalent maturity US Treasuries on the left axis,
and the value of the yen on the right axis, may help illuminate this dynamic.
US dollar-yen 3-month yield spread and yen
The high correlation between the yield spread and the price of the yen is
evident from even a cursory glance at the above chart. What's more, these are
nominal yields; given the deflationary environment in Japan, Japanese real
yields are quite a bit higher than the US
Where to now?
Has the yen run its course? Possibly, though relative to the US dollar there
still may be upside potential given the vast amounts of money the Fed appears
ready to spend (ie more quantitative easing, or "QE2").
We believe that many of the factors outlined above are losing steam, and from
this perspective, the upside potential for the yen appears less compelling. For
one, the leadership structure seems to be strengthened. While Naoto Kan has
only been Prime Minister since June 2010, he appears to have solidified his
position, successfully fending off a challenge to his leadership by defeating
Ichiro Ozawa earlier this year. Kan appointed Yoshihiko Noda as minister of
finance, a position Kan himself filled before becoming prime minister.
While a stronger leadership structure might be a net positive for many other
countries' currencies, we believe the opposite may be true for Japan.
Policymakers have already attempted to exert their influence to weaken the
exchange rate, unilaterally intervening in the currency market selling the yen.
While this attempt appears to have been somewhat fruitless (the yen has since
appreciated) it does show that the Japanese are actively willing to intervene
to weaken the yen.
Moreover, the Bank of Japan recently announced an expanded asset purchase
program (aka quantitative easing) that could raise the eyebrows of even the
most liberal proponents of QE; the expanded program includes purchases of real
estate investment trusts, exchange-traded funds and lower quality corporate
bonds.
Combine this with the recent semi-annual Outlook Report, where the Bank of
Japan outlined its inflation expectations, which were much higher than
consensus estimates, implying they believe the expanded program may be
successful in generating inflation.
We consider it very likely that we will witness an expansion of the Bank of
Japan's balance sheet over the medium term. Contrast this with most other
central banks that are either tightening policy, or openly discussing
tightening (with the obvious exception of the Fed).
Demographically, Japan faces extreme challenges. In our opinion, the
demographics of the country are such that the government will be increasingly
reliant on international investors to fund its fiscal deficits. Japan has an
aging, shrinking population. Retirees make up an ever-increasing proportion of
the population, while the working population is decreasing.
In our view, domestic demand for Japanese government bonds (JGBs) must
decrease. As the population ages, retirees move from net savers to net spenders
and will be required to sell bonds to supplement their retirement income
(either directly, or indirectly via corporate pension plans or Japan Post
Bank). At the same time, a shrinking working population means a lower
population base to substitute the retiree sellers, and less tax revenues at a
time when entitlement expenditures are increasing.
Put simply, the Japanese government faces an increased need for funding
(increased supply of JGBs) while there will be a decrease in domestic demand.
As such, Japan is likely to have to rely on foreign investment to fund its
fiscal deficit going forward. We would contend that when this point is reached,
it may represent an inflexion point for the currency.
Japanese policymakers appear aware of this threat, recently embarking on an
aggressive (if not somewhat humorous) marketing campaign to sell government
bonds to the younger domestic market. In what is reminiscent of a cheesy
infomercial, the government has hired models and TV personalities to promote
government bonds, with such slogans as "Men who hold JGBs are popular with
woman!" You couldn't make this stuff up. Wait a second ... If the same
relationship holds for US Treasuries, there must be a lot of broken hearts in
Washington over the fact that Fed chairman Ben Bernanke is already spoken for.
But I digress ...
On a more serious note, the Japanese government has announced plans to rein in
government spending, to implement more austere measures over the long-term,
presumably realizing that if it doesn't do something now, international
investors will force it upon them down the road, at which stage it may be too
late and/or the situation may have deteriorated to such a point that the
government simply will not be able to access funding internationally at
interest rates it can stomach.
However, the real problem is the size and scope of the issues Japan faces. It
may already be too late.
By implication, when Japan becomes reliant on foreign investment to fund its
fiscal deficit, it will be in a worse situation than present. To get to such a
point, the supply of JGBs and domestic demand will have moved in opposite
directions (supply up, domestic demand down).
Investors are likely to demand an increased risk premium given the size of the
fiscal debt, which in itself may start a vicious cycle, given more tax revenue
will need to be spent on interest charges, while overall tax receipts are
likely to decline as the population continues to shrink, driving up the need
for even greater levels of debt.
Make no mistake about it: Japan may face a very scary future going forward, and
it may only be time before these risks are adequately factored into the price
of the Japanese yen.
Kieran Osborne is co-portfolio manager of the Merk Absolute Return
Currency Fund, part of the Merk Mutual Funds that include the Merk Hard and
Asian Currency Funds. Merk Insights provides the Merk perspective on
currencies, global imbalances, the trade deficit, the socio-economic impact of
the US administration's policies and more. See
http://www.merkfunds.com.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
