Japan: The Rising Yen and the Falling Markets
STRATFOR TODAY » October 24, 2008 | 1706 GMT
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Summary
Equity markets fell worldwide Oct. 24, for two reasons having to do with the Japanese yen. First, the recent jump in the yen’s value has spooked “carry traders” who are now unwinding their positions in a massive sell-off of assets. Second, it has also spooked Japanese investors, who have been driven to dump their overseas assets. The long-term outlook for Japan’s economy is grim.
Analysis
Global markets engaged in panic trading Oct. 24 with nearly all exchanges registering heavy losses. Obviously, there is a great deal of fear and uncertainty in the markets. This is what recessions look like: all but the most stable of investments experience volatility as inefficiencies are brutally crushed. But the day’s market crash appears to have two particularly contributing causes.
First of these is investment unwindings related to the Japanese carry trade. Interest rates in Japan have been within reach of — and often at — zero percent for most of the past decade. Since economic opportunities in Japan are thin, many investors in Japan and elsewhere take out low-interest yen-denominated loans in Japan, but then move the money abroad and invest in more profitable ventures. They then not only can use de facto subsidized capital to fund their investment, but they often make even more money as the yen depreciates and the currency in their target country appreciates. They are particularly enamored of small countries, where it does not take much incoming capital to drive the target currency up.
All goes well until something goes wrong with their investment — for example, getting broadsided by a global financial crisis. This forces them to liquidate their holdings and scramble to buy enough yen to be able to pay off their loan back in Japan. Should they fail to do so, not only will they face a loss on their original investment, but as their target currency drops they will lose even more. The entire trade will turn against them. One of the things that has been happening for the past several weeks is that this “carry trade” has been unwinding, and for every investor who has to seek yen to unwind his position, the yen goes up a little more.
The yen is rising particularly violently against currencies which the carry traders targeted — the New Zealand dollar, the Icelandic krona and even the Hungarian forint. It is also experiencing sharp gains against the euro, much more so than against the U.S. dollar. This is for two reasons. First, the European Central Bank is treaty-bound to consider only inflation concerns when making policy: the result is perennially higher interest rates, which make Europe more attractive to carry traders — it is similar logic that pushes carry traders to consider places like relatively high-interest-rate New Zealand. Second, the U.S. dollar is a natural safe-haven in times of economic distress while the euro is not.
The other major driver behind the selloff in the markets is that the gains in the yen are now strong enough that another class of investors seem to be unwinding their positions: average Japanese citizens. Japanese investors have very few options for their nest-eggs due to Japan’s perennial economic funk. The economy essentially has been addicted to government spending for 17 years — all of which has been funded by deficits. The money to finance the deficits has to come from somewhere; the Japanese government, therefore, does what it can to prevent the average citizen from investing money anywhere but in Japanese government bonds, which traditionally earn less than 1 percent. Thus, many average Japanese citizens evade government restrictions and squirrel away what they can in overseas bonds, even if that means investing into things no more exotic than U.S. Treasury bills.
This is all well and good until there is a global crunch and the yen starts to rise very quickly; then these overseas holdings start to lose value. The Japanese citizen then gets understandably frightened and starts to pull the money back home. The net effect magnifies the currency distortions of the unwinding carry trade and the yen rises still more.
The specific value of these unwinding investments is open to debate, with most estimates putting the carry trade in the $2 trillion to $3 trillion range. The value of private individuals’ overseas holdings is even less well known, but it is probably larger than the total value of the traditional carry trade.
And all of it seems to be unwinding with a vengeance. Within the past three months the yen has risen 30 percent against the euro and more than 10 percent against the dollar. On Oct. 24, as of this writing, the dollar has fallen 4.6 percent and the euro 6.1 percent against the yen. That single day’s change alone is enough to have wiped out two years of interest earnings on most euro-based accounts.
The immediate impact is a massive downward pressure on all assets everywhere. Japanese citizens and yen carry traders alike are ditching their assets, dumping shares on stock exchanges and removing capital from markets — all of which complicate the ongoing global liquidity crisis and stock market crashes.
In the longer term, most of the pain will be felt in Japan. Westerners will be less likely to purchase Japanese exports not simply because they are spooked, but because the rising yen is making those exports much less attractive. Japan faces the probability of a protracted and deep recession from which it cannot recover until Western demand for Japanese goods revives. Remember, the Japanese government is already chronically in debt to the tune of roughly 175 percent of Japan’s gross domestic product, and already is engaged in deep deficit spending. There is thus no more room for the government to create a domestic stimulus, even before one considers that the average Japanese citizen is deeply shell-shocked.
