Yen Strength: FX Forensics

Japan's economy has recovered after three consecutive quarters of contraction.  The recovery is sharp but is likely to be short-lived with much of the pent up demand satiated and new disruptions in the form of the floods in Thailand and the fragility of the world economy. 

The yen and the Swiss franc were seen as safe haven currencies during the tumultuous crisis in Europe.  The Swiss National Bank has effectively and apparently cheaply took the franc out of the game.  This may have increased some speculative pressure toward the yen. 

Yet dismissing the yen's strength as speculative in nature makes analysis superfluous. It misses the underlying imbalance that the yen's strength reflects.  

To begin, one needs to recognize that Japan's current account surplus is not driven by exports or the trade balance.  In fact, using the balance of payments, Japan recorded a current account surplus of about JPY8.5 trillion ($110 bln) in the Jan-Sept period this year.  The real driver of the current account surplus is the income from investments.  This was JPY10.5 trillion in the same period, meaning that the other components of the current account balance (e.g. trade,, transfers) were a modest deficit.

In addition to the import of capital through its current account, foreign investors bought JPY16 trillion of Japanese stocks, bonds and bills in the Jan through Sept period.  Together this is JPY26.5 trillion of capital inflows.  

Japanese investors have exported JPY7.1 trillion of portfolio capital over the same period.  The other components, including net speculative positions captured in the CFTC data and the margin positions in Tokyo as well as direct investment and assistance do not fundamentally change this picture.  The fact that Japan is importing more capital than it is exporting offers insight into the yen's persistent strength.  

This critical imbalance also sheds light on the BOJ's intervention.  There have been three clear intervention operations this year.  There has been talk of more covert intervention, but let's reserve judgment about it.  All told BOJ intervention is estimated at JPY15.2 trillion, with a little more than half conducted on October 31.  

The BOJ's intervention was a recycling operation.  It was not recycling its trade surplus as had been the case in the 1980s and 1990s.  It was recycling its capital surplus.  Private sector investors either could not or would not export sufficient capital; the BOJ filled the breach.  Even with the BOJ intervention, the JPY26.4 trillion inflow is offset by JPY22.3 trillion outflow, still suggesting  some imbalance remains.  

Given that the yields are non-existent, foreign demand for Japanese bills could be a function of two other considerations.  One is that it is a place to park funds before deploying them.  The second is the bill is wanted as a way to profit from yen appreciation.  Under the former hypothesis, one would expect the a positive correlation between the demand for bills and the demand Japanese bond and stocks.    That was the case for most of last year and the first quarter of this year.  

Under the second hypothesis, if foreign purchases of Japanese bills is a way to play the yen, then one might expect an inverse correlation.  This has been the case since the first quarter.  Since 2005, which is as how far back as Bloomberg has the data, the correlation has been more inverse than it is now only a few times.  

How have Japanese investors responded to the record intervention at the end of last month?  Since then Japanese investors have sold about JPY2 trillion of foreign bonds, stocks and bills.  It is almost as if Japanese investors took advantage of the BOJ inspired pullback in the yen to repatriate investment.  It is almost as if Japanese investors absorbed a quarter of the BOJ's intervention, adding to the dilution of the effect.  

Of course, this brief note cannot be the final word.  It seeks to shed light on the mystery of the yen's strength. It points to part of the current account and capital account where the key imbalance lies now rather than in   the trade account previously.  Simply put Japan has to recycle its investment income and the foreign investors purchases of Japanese assets; otherwise the yen appreciates.  

There are other factors but they are either small or wash each other out.  This analysis suggests upward pressure may remain on the yen and, although the BOJ has intervened in unprecedented scale, it may not have been sufficient to correct the imbalance.  That said these figures may give a sense of precision that is not really there.  Finally, the note suggests a path of official action that could be more effective and less costly than intervention and that is a small nudge/tweak of the incentive structure for foreign investors to buy Japanese bills.