Another Piece of the Yen Puzzle

Investors and policy makers are befuddled by the yen. Its strength continues to defy the traditional explanatory models that typically give a privileged position for the risk appetite, interest rate differentials, or external positions.

Earlier in October, the BOJ announced that it would purchase JPY5 trillion (~$61 bln) of various assets, including corporate bonds, exchange traded funds, real estate investment trusts and government paper. On October 28, it provided a bit more detail and indicated it would lower the minimum rating of the corporate bonds it may buy to BBB. Proportionate to the size of its economy, this would be roughly equivalent to the Federal Reserve buying around $250 bln of securities.

While most expect the Fed’s QEII to be larger, the quality of the assets that the BOJ is buying is widely perceived to be lower than what the Fed is expected to buy (Treasuries). Moreover the BOJ brought forward the meeting that was regularly scheduled for the middle of next month to the end of next week, shortly after the Fed makes its announcement on asset purchases. Although the ostensible reason for the change was to allow the board more time to discuss the details of the asset purchases, clearly it also positions them to respond to the Fed's move, and signals to the market that the BOJ is at the ready.

Consider the recent string of news: The BOJ purchasing less than AAA assets in a new quantitative easing exercise, the near-zero interest rate policy, which was the result of an unexpected interest rate cut earlier this month, and a recent string of disappointing economic data, including September's decline in retail sales, the first in four month, declining exports (on a seasonal adjusted monthly basis) which have fallen every month this year except for January and April, and four consecutive months, through September of contraction in manufacturing output.

And still the yen rises.

US Interest Rates

Some attributed the yen’s strength to the decline in US interest rates as the US economy weakened and the Fed signaled a new round of asset purchases. Yet the yen has remained strong even though the US 10-year yield rose about 35 bp between Oct 7 and Oct 27.

Moreover, our review of Japanese investors foreign bond purchases indicate that during the current fiscal year through August, US bond purchases accounted for a little more than half. Japanese investors have purchased about JPY15.75 trillion ($180 bln) of foreign bonds in the first five months of FY10, of which JPY8.5 trillion was accounted for by US bonds, according to Ministry of Finance data.

These bond purchases compare with a cumulative current account surplus during this period of about JPY6.4 trillion. The yen should decline if Japan were successfully re-cycling its current account surplus by offsetting it with capital exports. Japanese purchases of foreign assets are concentrated in fixed income and these figures clearly illustrate Japan’s prodigious export of capital.

And still the yen rises.

Since the end of August the US S&P 500 is up around 15%. The Dow Jones Stoxx 600 in Europe is up a little more than 8%. Under the risk-on/risk-off matrix the yen would be expected to fall, but it doesn’t.

Foreign Exchange Forensics

The enigma of the yen’s rise requires foreign exchange forensics. The demand for yen has to be large. But the speculators at the IMM are too small though they hold roughly JPY587 bln (~$7.3 bln) of net speculative long yen positions in the futures market. And the position has generally been flat since July so it cannot help shed light on the recent strength of the yen

So where is this large demand for yen coming from? Not from foreign purchases of Japanese stocks and bonds. Those are actually quite meager considering that due to yen appreciation we may still be talking about the world’s second largest economy, and the largest stock and bond markets in the world.

Using weekly MOF figures, foreign investors have bought about JPY1.4 trillion (~$17.2 bln) of Japanese stocks and bonds (30 weeks) thus far during the fiscal year. In the same period in FY09, foreign investors were net sellers of nearly JPY1.6 trillion of Japanese stocks and bonds.

However, the MOF also reports weekly on bill purchases, which are often passed over by economists focusing on stock and bond purchases. While this simplification may make sense most of the time, now it is an exception. Foreign investors have bought about JPY7.6 trillion (~$89 bln) in Japanese bills through late October. During the same period in FY09, foreign investors sold almost JPY700 bln (~$8.6 bln) worth of Japanese bills.

Now we are getting closer.

Excess Reserves

Foreigner investors prefer Japanese bills because the Japanese stock market has generally under-performed, and bond yields are too low to contribute much to a portfolio while at the same time exposing investors to market risk. Besides, the real play is the yen, and the bill gives the most direct exposure for many institutional investors who may be prohibited from taking on naked currency exposure.

Foreign banks are implementing a version of this strategy in much larger magnitude. Non-Japanese banks appear to be using the swap market to secure yen funds at less than 10 bp, which is what the Bank of Japan pays on excess reserves and is about the rate that a 3-month bill pays.

At the end of September foreign banks had JPY45.7 trillion (~$562 bln) of excess reserves sitting with the BOJ. Their required reserves are only JPY260 mln. If we want to understand the yen’s appreciation in recent months, we need to look at how much foreign banks have increased their excess reserves in Japan. At the end of May, foreign banks held JPY20 trillion (~$246 bln) in excess reserves with the BOJ.

This JPY25.7 trillion (~$316 bln) increase in excess reserves has not been smooth. A little less than half (JPY11 trillion or ~$136 bln) came in the month of September alone. Recall that during the mid-September intervention, the BOJ sold about JPY2 trillion. September also saw a flood of money flow into emerging markets. This is roughly 40% of the money taken in by emerging market equity funds this year, and also took place in September, according to the fund-tracking company EPFR.

Foreign banks had more excess reserves at the BOJ at the end of September than did the rest of the Japanese banking and financial system. The total amount of excess reserves was a little less than JPY84 trillion (~$1.04 trillion), domestic institutions accounting for about 45.5%.

Policy Response

A greater understanding of what is driving the yen can help policy makers address its causes and allow investors to better manage their yen exposures. The yen is rising because Japanese investors are not exporting enough capital to offset Japan's current account surplus nor also to offset the hot money that has flowed into the bill market and excess reserves.

Japanese officials could call officers from the large foreign banks and explain to them why they should not be gaming the system. Moral suasion is polite and diplomatic. But there is a range of stronger actions officials can take. The BOJ could, for example, stop paying interest on excess reserves. During the BOJ's past quantitative easing efforts, it suspended interest payments on excess reserves. As the banks do not keep excess reserves at the BOJ as a yield play, this may not have much direct impact, but it would send a signal that such funds are not desired.

To underscore this message, officials could also impose a penalty for holding excess reserves with the BOJ, like Sweden’s Riksbank negative deposit rate did most recently. Germany and Switzerland imposed a negative rate on foreign deposits in the 1970s to discourage speculation in their currencies. It is therefore not unprecedented and could prove to be more effective (and less antagonistic) than direct intervention in the foreign exchange market.

Japanese policy makers could also take measures to discourage foreign purchases of government bills. To combat short-term capital from affecting their currency, Taiwan officials have barred foreign investors from owning certain short-term financial instruments. Officials could stop shy from a ban and instead use a tax disincentive to discourage using the bills as a way to speculate on the currency. While some may object that these are forms of capital control, they are largely benign varieties and arguably preferable to intervention.

The Bank of Japan has revised down its growth forecast and now does not expect price stability (1% CPI) to be achieved until at least FY2013. If the dollar falls sharply in reaction to QEII, and the JPY80 level gives way under the strain, the risks increase that the BOJ will feel compelled to do something. Intervention, especially so close to the G20 heads of state meeting, would raise political hackles, and the BOJ buying foreign bonds, as some have suggested, would be thinly veiled intervention. Going instead directly after the hot money would be more effective and politically palatable.