International | Oct 03 2006
By Chris Shaw
While signs such as this week’s Tankan survey of business conditions suggest the economic outlook in Japan continues to brighten, the yen continues to confound currency analysts by remaining weak, as in real terms the currency is trading close to its weakest level since 1985.
This is often attributed to the carry trade, but as Morgan Stanley points out such a summation is actually at odds with the evidence, leading the broker to suggest there are alternative reasons why the yen may stay weaker for longer than it had expected.
Firstly, the broker points out none of the three main forms of the carry trade, where fixed income outflows take advantage of interest rate differentials; where investors fund their Japanese bond positions with short-term credit and loans; and where non-Japanese residents borrow in Japan to invest elsewhere; have actually increased in size over the course of this year.
As a result the broker suggests there are other reasons for the currency’s weakness, with any recovery in the yen requiring a reversal in such factors. The first is a sharp downturn in net equity inflows into Japan – the broker notes from the middle of 2003 to the end of 2005 inflows averaged US$7.7bn per month but this year the average has fallen to US$4.2bn per month and in July the flow was actually negative.
Secondly, the broker notes the fact cross-border investment has increased and countries now hold more of each others assets than previously was the case means it makes sense to reduce the risk from these holdings via hedging. Given the differential in interest rates between the US and Japan for example, it suggests Japanese investors rightly look to reduce their hedge ratios on US assets and for non-Japanese investors to do the same for their Japanese assets.
Finally, the broker refers to what it classes as the funnelling of money globally, which is a reflection of the US dollar’s position as the global currency. As excess savings from oil exporters and Asian exporters are funnelled into US dollars because this is the currency of settlement, the impact in the broker’s view is for the yen to be artificially depressed as there is a constant transfer of other currencies into the greenback (and to a lesser extent the euro and pound). As an example of this, the broker notes the UK pound has now overtaken the yen as a reserve currency in official holdings.
What this means in the broker’s view is fundamentals are, for the time being at least, not the drivers of the yen’s value, as if they were driving the currency the yen would be stronger than is currently the case. Evidence of this comes as the broker estimates two-thirds of Japan’s growth in recent years is due to an increase in total factor productivity growth, which means both aggregate supply and demand have rising in tandem.
The effect of this is to reduce inflationary pressures, which in turn has allowed the Bank of Japan (BoJ) to act more slowly in normalising interest rates than might otherwise have been the case.
This leads the broker to suggest the fundamentals supporting a stronger yen are currently being ignored and the state of the economy is allowing this to be the case. Eventually it expects such a situation will correct itself and fundamentals will again dominate, so while in time the yen should go up it now appears likely this will take longer to occur than it had previously expected.
