Axel Merk
submits:
By Kieran Osborne, CFA
For many, the strength of the Japanese yen is a conundrum. How
can the currency of a country with such a weak economy, 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 that the yen would demonstrate such
strength 24 months ago. 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.
(Click to enlarge)
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:
- Weak Leadership
- Low Reliance on Foreign Investment
- 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, Japanese 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.
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 (Fed) 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.
(Click to enlarge)
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 $378 billion, meaning that the US required foreign
investors to purchase approximately $1.5 billion dollars 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, or using the average exchange rate for the year,
$142 billion. Japan required foreign investors to sell over half a
billion dollars 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.
(Click to enlarge)
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 ("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. Policy makers 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 REITs, ETFs, 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 ageing, 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 policy makers 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 Mr. 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 they
don'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, 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.
Disclosure:
No positions
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