Tag: Abenomics | Vivek Kaul

19 November, 2014

Yen carry trade from Japan will drive the Sensex higher

Vivek Kaul

John Brooks in his brilliant book Business Adventures writes “The road to Hell is paved with good intentions!” One country on which this sentence applies the most is Japan. The country has been trying to come out of a bad economic scenario for two decades and it only keeps getting worse for them, despite the effort of its politicians and its central bank.
In the previous column, I wrote about how the prevailing economic scenario in Japan will ensure that they will continue with the “easy money” policy in the days to come, by printing money and maintaining low interest rates in the process.
But it looks like the situation just got worse for them. The Japanese economy contracted at an annual rate of 1.6% during the period July-September 2014. This after having contracted at an annual rate of 7.1% in April-June 2014. Two consecutive quarters of economic contraction constitute a recession.
Shinzo Abe was elected the prime minister of Japan in December 2012. His immediate priority was to create some inflation in Japan in order to get consumer spending going again. The Bank of Japan cooperated with Abe on this, and decided to print as much money as would be required to get inflation to 2%. This policy came to be referred as “Abenomics”.
In April 2013, the Bank of Japan decided to print $1.4 trillion and use it to buy bonds, and hence, pump that money into the financial system. The size of the Japanese economy is around $5 trillion. Hence, as a proportion of the size of Japan’s economy, this money printing effort was twice the size of the Federal Reserve’s third round of money printing, more commonly referred to as the third round of quantitative easing or QE-III.
Sometime in April this year, the Abe government decided to increase the sales tax from 5% to 8%. The idea again was to raise prices, by introducing a tax, and get people to start spending again. Nevertheless, this backfired big time and the economy has now contracted for two consecutive quarters. Elaine Kurtenbach writing for the Huffington Post points out “Housing investment plunged 24 percent from the same quarter a year ago, while corporate capital investment sank 0.9 percent. Consumer spending, which accounts for about two-thirds of the economy, edged up just 0.4 percent.”
Towards the end of October 2014, the Bank of Japan decided to print $800 billion more because the inflation wasn’t rising as the central bank expected it to. Now with the economy contracting again, there will be calls for more money printing and economic stimulus. In fact, after GDP contraction number came out, Etsuro Honda, an architect of Abenomics, told the Wall Street Journal that it was “absolutely necessary to take countermeasures.”
While the “easy money” policy run by the Japanese government and the central bank hasn’t managed to create much inflation, it has led to the depreciation of the yen against the dollar and other currencies.
In early November 2012, before Shinzo Abe took over as the prime minister of Japan, one dollar was worth 79.4 yen. Since then, the yen has constantly fallen against the dollar and as I write this on the evening of November 18, it is worth around 117 to a dollar.
Interestingly, some inflation that has been created is primarily because of yen losing value against the dollar. This has made imports expensive. The consumer price inflation(excluding fresh foods) for the month of September 2014 came in at 3%. Once adjusted for the sales tax increase in April, this number fell to a six month low of 1%, still much below the Bank of Japan’s targeted 2% inflation.
Analysts believe that the yen will keep losing value against the dollar in the time to come. John Mauldin wrote in a recent column titled The Last Argument of Central Bankers “The yen is already down 40% in buying power against a number of currencies, and another 40-50% reduction in buying power in the coming years is likely, in my opinion.”
Albert Edwards of Societe Generale is a little more direct than Mauldin and wrote in a recent research report titled Forecast timidity prevents anyone forecasting ¥145/$ by end March – so I will “The yen is set to…[crash] through multi-decade resistance – around ¥120. It seems entirely plausible to me that once we break ¥120, we could see a very quick ¥25 move to ¥145 [by March 2015].”
Edwards further writes that he expects “the key ¥120/$ support level to be broken soon and the lows of June 2007 (¥124) and Feb 2002 (¥135) to be rapidly taken out.” The note was written before the information that the Japanese economy had contracted during July-September 2014, came in.
This makes the Japanese yen a perfect currency for a “carry trade”. It can be borrowed at a very low rate of interest and is depreciating against the dollar. Before we go any further, it is important that we go back to the Japan of early 1990s.
The Bank of Japan had managed to burst bubbles in the Japanese stock and real estate market, by raising interest rates. This brought the economic growth to a standstill.
After bursting the bubbles by raising interest rates, the Bank of Japan had to start cutting interest rates and soon the rates were close to 0 percent. This meant that anyone looking to save money by investing in fixed-income investments (i.e., bonds or bank deposits) in Japan would have made next to nothing.
This led to the Japanese looking for returns outside Japan. Some housewife traders started staying up at night to trade in the European and the North American financial markets. They borrowed money in yen at very low interest rates, converted it into foreign currencies and invested in bonds and other fixed-income instruments giving higher rates of returns than what was available in Japan.
Over a period of time, these housewives came to be known as Mrs Watanabes and, at their peak, accounted for around 30 percent of the foreign exchange market in Tokyo, writes Satyajit Das in Extreme Money.
The trading strategy of the Mrs Watanabes came to be known as the yen-carry trade and was soon being adopted by some of the biggest financial institutions in the world. A lot of the money that came into the United States during the dot-com bubble came through the yen-carry trade.
It was called the carry trade because investors made the carry, that is, the difference between the returns they made on their investment (in bonds, or even in stocks, for that matter) and the interest they paid on their borrowings in yen.
The strategy worked as long as the yen did not appreciate against other currencies, primarily the US dollar. Let’s try and understand this in some detail. In January 1995, one dollar was worth around 100 yen. At this point of time one Mrs Watanabe decided to invest one million yen in a dollar-denominated asset paying a fixed interest rate of 5 percent per year.
She borrowed this money in yen at the rate of 1 percent per year. The first thing she needed to do was to convert her yen into dollars. At $1 = 100 yen, she got $10,000 for her million yen, assuming for the ease of calculating that there was no costs of conversion.
This was invested at an interest rate of 5%. At the end of one year, in January 1996, $10,000 had grown to $10,500. Mrs Watanabe decided to convert this money back into yen. At that point, one dollar was worth 106 yen.
She got around 1.11 million yen ($10,500 × 106) or a return of 11 percent. She also needed to pay the interest of 1 percent on the borrowed money. Hence, her overall return was 10 percent. Her 5 percent return in dollar terms had been converted into a 10 percent return in yen terms because the yen had lost value against the dollar.
But let’s say that instead of depreciating against the dollar, as the yen actually did, it instead appreciated. Let’s further assume that in January 1996 one dollar was worth 95.5 yen. At this rate, the $10,500 that Mrs Watanabe got at the end of the year would have been worth 1 million yen ($10,500 × 95.5) when converted back into yen.
Hence, Mrs Watanabe would have ended up with the same amount that she had started with. This would have meant an overall loss, given that she had to pay an interest of 1 percent on the money she had borrowed in yen.
The point is that the return on the carry trade starts to go down when the currency in which the money has been borrowed, starts to appreciate. Since its beginnings in the mid-1990s, the yen carry trade worked in most years up to mid-2007. In June 2007, one dollar was worth 122.6 yen on an average. After this, the value of the yen against the dollar started to go up over the next few years.
With the yen expected to depreciate further against the dollar, it will lead to big institutional investors increasing their yen carry trades in the days to come. This will mean money will be borrowed in yen, and invested in financial markets all over the world.
Some of this money will find its way into the stock and the bond market in India. Moral of the story: The easy money rally is set to continue. The only question is till when?
Stay tuned!

The article originally appeared on www.equitymaster.com on Nov 19, 2014

2 October, 2014

Get ready for a real mess: A new chapter may be opening in currency wars

Vivek Kaul

The Japanese yen recently touched a six year low against the dollar. One dollar is currently worth around 108-110 yen. This many experts believe will lead to the start of a new round of currency wars. As Albert Edwards of Societe Generale writes in a recent research note dated September 22, 2014 “the yen has slipped below a key 15-year support level against the dollar…The next phase of global currency wars may have begun.”
The term “currency war” was first used by Guido Mantega, the Brazilian finance minister, in 2010. It refers to a situation where multiple countries start driving down the value of their currencies against the dollar in a bid to drive up exports and inflation.
Before we try and understand Edwards’ statement in detail, it is important to go back a few years. The Bank of Japan joined the money printing party rather late in the day towards the end of 2012. Before this the balance sheet of the Japanese central bank had expanded only 30% since the start of the financial crisis. Interestingly, in January 2012, the total assets of the Japanese central bank had stood at 128 trillion yen. Since then, it has more than doubled to 275.9 trillion yen at the end of August 2014.
The Bank of Japan plans to inject $1.4 trillion into the Japanese financial system by April 2015 by buying Japanese government bonds every month. This is pretty big, given that the size of the Japanese economy is around $5 trillion. Currently, it is printing 5 trillion yen every month and pumping that into the financial system by buying bonds. That explains why the total assets held by the bank have more than doubled.
The Bank of Japan entered the money printing party only after Shinzo Abe was elected as the prime minister on December 26, 2012. Abe promised to end Japan’s more than two decades old recession through some old fashioned economics, which has since been termed as Abenomics.
Abenomics is nothing but money printing in the hope of driving down the value of the yen against the dollar in the hope of increasing exports and also creating some inflation.
As James Rickards writes in The Death of Money “Japan…had another reason to support the money printing…Money printing was being done not only to promote exports but to increase import prices. These more expensive imports would cause inflation to offset deflation…In Japan’s case, inflation would primarily come through higher prices of energy exports.”
The Bank of Japan decided to get in bed with the government on this and is targeting an inflation of 2 percent. It wants to reach the goal at the earliest possible date. And how does that help? In December 2012, Japan had an inflation rate of –0.1 percent. For 2012, on the whole, inflation was at 0 percent, which meant that prices did not rise at all. In fact, for each of the years in the period 2009-2011, prices had fallen in Japan.
When prices are flat, or are falling, or are expected to fall, consumers generally tend to postpone consumption (i.e., buying goods and services) in the hope that they will get a better deal in the future. This impacts businesses, as their earnings either remain flat or fall. This slows down economic growth.
On the other hand, if people see prices going up or expect prices to go up, they generally tend to start purchasing things. So a moderate inflation helps businesses as well as the overall economy. Hence, by trying to create some inflation the idea is to get consumption going again in Japan and help it come out of a more than two decades old recession.
The money printing has helped create some inflation in Japan. In July 2014, the consumer price inflation in Japan stood at 1.3%. One reason for this rise has been the fall in the value of yen against the dollar. In early November 2012, one dollar was worth 79.4 yen. Currently, one dollar is worth 108-110 yen, as mentioned earlier. This has made imports expensive and pushed up inflation. As John Lanchester writes in his new book How To Speak Money “The yen has dropped, which is a good thing for Japanese industry, and inflation is showing signs of returning, which is also a good thing, though some commentators are worried that the process could quickly go out of hand.”
The question here is how can the process quickly go out of hand? Allow me to explain. The inflation hasn’t led to people spending more money. In fact, the gross domestic product (GDP) of Japan contracted at an annualized rate of 6.8% during the three month period of April to June 2014. It was also expected that a falling yen will boost Japanese exports. But that doesn’t seem to have happened either. Exports have fallen in three out of the last four months. In August 2014, exports fell by 1.3%, in comparison to the same period last year.
Interestingly, one of the key learnings in the aftermath of the financial crisis has been that if a policy does not work for a central bank, it is likely to try more of it. Given this, it is expected that the Bank of Japan will print more money in the hope of inflation reaching the targeted 2% and to get exports going as well. Diana Choyleva, head of macroeconomic research at Lombard Street Research, writes in a research note that the Bank of Japan “is also likely to redouble its QE [quantitative easing] efforts if it is to achieve its 2 percent inflation target.”
This will lead to further depreciation of the yen against the value. As Edwards of Societe Generale puts it “One of the few things I have learnt over 30 years in this industry is that when traders decide the yen/US$ starts to move it can jump by Y10 or Y20 very, very quickly indeed.”
In this scenario other countries are also likely to print money so that their currencies lose value against the dollar, in order to keep their exports competitive. The thing to remember here is that money printing in the hope of driving down the value of currency is not something that only Japan can indulge in. Interestingly, this is precisely what had happened when Japan first made its first moves towards printing money in December 2012.
In fact, politicians in South Korea by early February 2013 had started voicing their concerns about the depreciating yen. South Korea and Japan compete in several export-oriented industries, like automobiles and electronics. Korean export companies like Samsung and Hyundai compete with Japanese companies like Sony and Toyota.
At the end of December 2012, one dollar was worth 1,038.1 Korean won. Soon, the Korean won also started depreciating against the dollar, and by late June 2013, one dollar was worth around 1,160 Korean won. The Thai baht started depreciating against the dollar in April 2014. The Malaysian ringitt joined the club from May 2013 onward. By early 2014, China had also entered the currency war by allowing the yuan to depreciate against the dollar.
Nevertheless, the depreciation of this currencies against the dollar did not continue. The South Korean won is back to where it started and currently quotes at around 1063 won to a dollar. But there is nothing that can stop these countries from starting to cheapen their currencies against the dollar, all over again. The currency wars might break out all over again.
The joker in the pack is China. Currently, one dollar is worth around 6.14 Chinese yuan. It is interesting to look at the trajectory of the Chinese yuan over a period of time. In 2005, one dollar was worth around 8.27 yuan. By 2011, one dollar was worth around 6.82 yuan. The appreciation of the yuan against the dollar continued at a measured pace and by mid-January 2014, one dollar was worth 6.14 yuan. This is when things turned around and the yuan started to depreciate against the dollar, something that had not happened in a very long time. By April 30, 2014, one dollar was worth 6.25 yuan.
Among other things the depreciation of the yuan was also a response to Abenomics which had led to the depreciation of the yen against the dollar. One dollar was worth around 80 yen in November 2012, before Shinzo Abe had taken over as the Prime Minister of Japan. By January 2014, one dollar was worth 105 yen, thus making Japanese exports more competitive in the international market. China’s yuan had to be adjusted to this new reality. As China is trying to move up the value chain, its products are competing more and more with Japanese products in the international market.
Nevertheless, since June 2014, the yuan has been appreciating against the dollar. But if the Japanese keep printing money and driving down the value yen against the dollar, the Chinese are also likely to have to start pushing the yuan down against the dollar.
This would mean Chinese exports more competitive. As the yuan depreciates against the dollar it would allow Chinese exporters to cut prices of their products. Let’s understand this through an example. A Chinese exporters sells a product at $100. He ends up getting paid 614 yuan for it, at the current rate. But if one dollar is worth seven yuan, he would be paid 700 yuan. This situation will allow the Chinese exporter to cut the price of his product. Let’s say he cuts it to $90, even then he ends up earning 630 yuan ($90 x 7), which is more than earlier.
As Choyleva of Lombard Street Research, writes in a recent research note “If both Japan and the euro area go for extensive QE, emerging markets in Asia would suffer as their currencies appreciate. There would be no way China could restart its sputtering growth engine without major yuan devaluation.”
In order, to stay in competition, prices of products from other countries will have to be cut. And this will end up exporting deflation (a situation where prices are falling) to large parts of the world. Of course, it is worth remembering here that everybody cannot have the cheapest currency. Once countries start devaluing their currencies, it becomes a race to the bottom and is not good for anyone. In technical terms this is referred to as beggar thy neighbour policy.
As a senior official of the Federal Reserve once remarked: “Devaluing a currency is like peeing in bed. It feels good at first, but pretty soon it becomes a real mess.”

The article originally appeared on www.FirstBiz.com on Oct 2, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

11 May, 2013

As yen hits 100 to US$, get ready for more currency wars

Vivek Kaul
Ushinawareta Nijūnen or the period of two lost decades for Japan(from 1990 to 2010) might finally be coming to an end. Or so it seems.
And Japan has to thank Abenomics unleashed by its current Prime Minister Shinzo Abe for it. Abe has more or less bullied the Bank of Japan, the Japanese central bank, to go on an unlimited money printing spree, until it manages to create an inflation of 2%.
The Japanese money supply is set to double over a two year period. And all this ‘new’ money that is being pumped into the financial system, will chase an almost similar number of goods and services, and thus drive up their prices. Or so the hope is.
The target is to create an inflation of 2% and get people spending money again. When prices are rising or are expected to rise, people tend to buy stuff, because they don’t want to pay a higher price later (This of course is true to a certain level of inflation and doesn’t hold in the Indian case where retail inflation is greater than 10%). As people go out and shop, it helps businesses and in turn the overall economy.
In an environment where prices are stagnant or falling, as has been the case with Japan for a while now, people tend to postpone purchases in the hope of getting a better deal. The situation where prices are falling is referred to as deflation.
In 2012, the average inflation in Japan was 0%, which meant that prices neither rose nor they fell. In fact, in each of the three years for the period between 2009 and 2011, prices fell on the whole. This has led people to postpone their consumption and hence had a severe impact on Japanese economics growth. To break this “deflationary trap”, Shinzo Abe and the Bank of Japan have decided to go on an almost unlimited money printing spree.
A major impact of this policy has been on the Japanese currency ‘yen’. As more yen are created out of thin air, the currency has weakened considerably against other major currencies. One dollar was worth around 78 yen, on October 1, 2012. Yesterday, yen weakened beyond 100 to a dollar for the first time in four years. As I write this one dollar is worth around 101.1 yen.
This weakening of the yen has helped Japanese businesses which have a major international presence spruce up their profits. As the news agency Bloomberg reports “The weaker yen helped Mazda, Japan’s fifth-largest car company, post a profit of 34 billion yen for the fiscal year that ended March 31, compared with a loss of 107.7 billion yen the previous year. A one-yen change against the dollar, euro, Canadian dollar and Australian dollar has a 9.1 percent impact on Mazda’s operating profit…That compares with 4.7 percent at Fuji Heavy Industries Ltd, which makes Subaru cars, and 3.1 percent at Toyota.”
When yen was at 78 to a dollar, a Japanese company making a profit of $1 million internationally would have made a profit of 78 million yen. Now with the yen at 101 to a dollar, the same company will make a profit of 101 million yen, which is almost 29.5% more.
This increase in profit it is hoped will also encourage Japanese companies to pay their employees more. Albert Edwards of Societe Generale writing in a report titled Thoughts on Asia will a yen slide trigger an EM currency crisis? 1997 redux dated April 17, 2013, cites a survey which suggests that Japanese companies may be short on labour. “This suggests that Prime Minister Abe will indeed get his way on a rapid return of wage inflation to boost consumption,” writes Edwards.
And this boost in consumption will get the Japanese economy going again. So does that mean Japan will live happily ever after? Not quite.
As the Japanese central bank prints more and more yen, the returns from Japanese government bonds are expected to go up. As Edwards writes “if the market really believes that it is committed to the 2% inflation target (and I certainly do), then Japanese bond yields(returns) will quickly attempt a move above 2%.” In early April the return on a ten year Japanese government bond was at 0.45% per year. Since then it has risen to around 0.69% per year.
And this can lead to a major crisis in Japan. If returns on existing bonds go up, the government will have to offer a higher rate of interest on the new bonds that it issues to make them interesting enough for investors.
As Satyajit Das writes in a research paper titled The Setting Sun – Japan’s Financial Miasma “Higher interest rates will increase the stress on government finances. Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan’s interest payments will be an unsustainable proportion of tax receipts.”
Now that’s just one part of it. If the government has to spend more of the money than it earns towards interest payments that means there will be less left for meeting other expenditure. So it will either have to borrow more or ask the Bank of Japan to print more money to finance its expenditure, given that there is a limit to the amount of money that can be borrowed. Either option doesn’t sound good. Das estimates that Japan’s gross government debt will reach around 250-300% of its gross domestic product by 2015, a very high level indeed.
Also as things stand as of now it looks like the Bank of Japan will have to finance a major part of Japanese government expenditure in the years to come by printing money. As Dylan Grice wrote in an October 2010, Societe Generale report titled Nikkei 63,000,000? A cheap way to buy Japanese inflation risk “Japan’s tax revenues currently don’t even cover debt service and social security, persistent and growing fiscal burdens. Therefore, once the Bank of Japan is forced into monetisation of government deficits, even if only with the initial intention of stabilising government finances in the short term, it will prove difficult to stop. When it becomes the largest holder and most regular buyer of Japanese government bonds, Japan will be on its inflationary trajectory.” And this is not an inflation of 2% that we are talking about.
The yen weakening against other international currencies is making Japanese exports more competitive. A Japanese exporter with sales of a million dollars in early October, would have made 78 million yen (when one dollar was worth 78 yen). Now the same exporter would make 101 million yen.
The weakening yen allows Japanese exporters to cut their prices in dollar terms and become more price competitive. If a price cut of 20% is made, then sales will come down to $800,000 but in yen terms the sales will be at 80.8 million yen ($800,000 x 101). This will be higher than before. Also a cut in price might help Japanese exporters to increase total volumes of sales.
The trouble of course is that this will hit other major exporters like South Korea, Taiwan and Germany. As Michael J Casey points out in a column on Wall Street Journal website “Japan might be a hobbled economy but it is still the third largest in the world, accounting for almost one-tenth of world gross domestic product. So when the Bank of Japan prints as much yen as this, it provokes a worldwide adjustment in relative prices. Electronics producers in South Korea, Taiwan and, to an increasing degree, China, automatically face a price disadvantage versus their Japanese competitors, for example.”
Also interest rates on American and Japanese bonds are currently at very low levels. And this has sent investors looking for return to other parts of the world. Take the case of New Zealand. Foreign money has been flooding into the country. When foreign money comes into a country it needs to be exchanged for the local currency (the New Zealand dollar in case of New Zealand). This leads to a situation where the demand for the local currency increases, leading to its appreciation.
One New Zealand dollar was worth around 64.6 yen on October 1, 2012. It is currently worth around 84.4 yen. An appreciation in the value of a country’s currency hurts its exports. On Wednesday (May 8, 2013), the Reserve Bank of New Zealand, decided that it will intervene in the foreign exchange market to weaken the New Zealand dollar.
How does any central bank weaken its currency? When a huge amount of foreign money comes in, it increases the demand for local currency. The central bank at that point floods the foreign exchange market with its own currency, to ensure that there is enough of it going around. This ensures that the local currency does not appreciate. If the central bank floods the market with more local currency than the demand is, it ensures that the local currency loses value against the foreign money that is coming in.
The question is where does the central bank get this money from? It simply prints it.
The thing to remember is that if Japan can print money to cheapen its currency so can other countries like New Zealand. It is not rocket science. Its what Americans call a no brainer. In fact, yen started appreciating against the dollar once the Federal Reserve of United States, the American central bank, started printing money to revive economic growth. And this has also been responsible for Japan starting to print money. As Casey points out “Together, the U.S. Federal Reserve and the Bank of Japan will print the equivalent of $155 billion every month for an indefinite period.” This will spill over to more countries printing money to hold the value of their currency or even cheapen it.
The currency war which is currently on between countries as they print money to cheapen their currencies will only get worse in the days and months and years to come. Australia is expected to join this war very soon. Countries are also trying to control the flood of foreign money by cutting interest rates. The Australian central bank cut interest rates on Tuesday (i.e. May 7, 2013). The Bank of Korea, the South Korean central bank also cut interest rates on Thursday (i.e. May 9,2013). China has put measures in place to curb foreign inflows.
As Greg Canvan writes in The Daily Reckoning Australia “So as the US dollar moves above 100 yen for the first time in four years…Get ready for an escalation in the currency wars.”
To conclude, it is important to remember what H L Mencken, an American writer, once said “For every complex problem there is an answer that is clear, simple, and wrong.” If only creating economic growth was just about printing more money…
The article originally appeared on www.firstpost.com on May 11, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

6 February, 2013

Why Mrs Watanabe can now drive the Sensex higher

Vivek Kaul
Shinzo Abe, the new prime minister of Japan, has promised to end Japan’s more than two decade old recession, through some old fashioned economics which is being now referred to as Abenomics by the experts.
For the lesser mortals Abenomics is nothing but money printing. Abe plans to go in for an ‘unlimited’ money of money printing and use the newly created ‘yen’ to increase government spending on public works.
So far so good. But what’s the idea here? In the process of printing and stuffing the financial system with an unlimited amount of yen, Abe hopes to increase money supply. As an increased amount of money chases the same amount of goods and services, he hopes to create some inflation.
The target is to create an inflation of 2%. And how does that help? In December 2012, Japan had an inflation rate of -0.1%. For 2012 as a whole inflation was at 0%, which meant that prices did not rise at all. In fact for each of the years in the period 2009-2011, prices have fallen in Japan on the whole.
In a scenario where prices are flat or are falling or are expected to fall, consumers generally tend to postpone consumption(i.e. buying goods and services) in the hope that they will get a better deal in the future. This impacts businesses as their earnings either remain flat or fall. This in turn slows down economic growth.
On the flip side, if people see prices going up or expect prices to go up, they generally tend to start purchasing things. Hence, Abe’s idea is to flood yen into the financial system and in the hope create some inflation or at least get consumers to start thinking that inflation is coming and ensure that they go out and make some purchases.
In case of a scenario where prices are falling people tend to wait to buy stuff at lower prices. In case of a scenario where prices are rising or expected to rise people tend to start buying stuff because otherwise they will have to pay a higher price for it. Either ways, human beings like a good deal.
When people buy stuff businesses see an increase in incomes and profits, which in turn spurs up economic growth. So that is the theory behind Abenomics.
Now whether this economic theory translates into practice as well with prices rising and the Japanese buying and thus helping create economic growth remains to be seen.
But there is another angle to this. As explained earlier in the article, Abe’s plan is to flood the financial system with an unlimited amount of yen. As and when this starts to happen, there will be more yen in the market than before. And this will lead to a fall in the value of the yen against other currencies.
But the market does not wait for things to happen, it starts to react to things it expects to happen. Given this, the Japanese yen has been losing value against the dollar. Three months back one dollar was worth around 80 yen. Now its worth around 94 yen. What is interesting is that between January 29, 2012 and today, the exchange rate has fallen from 90 yen to a dollar to 94 yen to a dollar.
The depreciating Japanese yen makes the situation just right for the comeback of the yen carry trade. So what is the yen carry trade?
Lets go back more than twenty years to understand where it all started. In the late 1980s Japan was in the midst of both a real estate and a stock market bubble. The Bank of Japan managed to burst the stock market bubble very rapidly and the real estate bubble very slowly, by raising interest rates.
After bursting the bubble by raising interest rates the Bank of Japan started cutting interest rates and soon the rates were close to 0%. This meant that anyone looking to save money by investing in fixed income investments(i.e. bonds or bank deposits) in Japan would have made next to nothing. This led to the Japanese money looking for returns outside Japan.
Some housewife traders started staying up at night to trade in the European and the North American markets. They borrowed money in yen at very low interest rates, converted it into foreign currencies and invested in bonds and other fixed income instruments giving higher rates of returns than what was available in Japan. Over a period of time these housewives came to be known as Mrs Watanabes and at their peak accounted for around 30% of the foreign exchange market in Tokyo.
The trading strategy of Mrs Watanabes came to be known as the yen-carry trade and was soon being adopted by some of the biggest financial institutions in the world. A lot of the money that came into America during the dotcom bubble came through the yen-carry trade. It was called the carry trade because investors made the carry i.e. the difference between the returns they made on their investment (in bonds or even in stocks for that matter) and the interest they paid on their borrowings in yen.
The strategy worked as long as the yen did not rise in value against other currencies, primarily the US dollar. Let us try and understand this in some detail. In January 1995, one dollar was worth around 100 yen. At this point of time one Mrs Watanabe decided to invest one million yen in a dollar denominated asset paying a fixed interest rate of 5% per year.
She borrowed this money in yen at the rate of 1% per year. The first thing she needed to do was to convert her yen into dollars. At $1=100 yen, she got $10,000 for her million yen, assuming there were no costs of conversion.
This was invested at the rate of 5% interest. At the end of one year in January 1996, $10,000 had grown to $10,500. Mrs Watanabe decided to convert this money back into yen. At that point, one dollar was worth 106 yen. She got around 1.11 million yen ($10,500 x 106) or a return of 11%. She also needed to pay the interest of 1% on the borrowed money. Hence her overall return was 10%.
Her 5% return in dollar terms had been converted into a 10% return in yen terms because the yen had lost value against the dollar. So this was a double gain for her. The depreciating yen added to the overall return.
But let us say instead of depreciating against the dollar, as the yen actually did, it had appreciated. And let us further assume that in January 1996, one dollar was worth 95.5 yen. At this rate $10,500 that Mrs Watanabe got at the end of the year would be worth 1 million yen ($10,500 x 95.5) when converted back to yen. Hence Mrs Watanabe would end up with a loss, given that she had to pay an interest of 1% on the money she had borrowed in yen.
The point is that for the yen carry trade to be profitable the yen would have to be either stagnant against the dollar or lose value. The moment it started to appreciate against the dollar, the returns in yen terms started to come down.
The yen carry trade worked in most years up since it started in the mid 1990s, to mid 2007. In June 2007, one dollar was worth 122.6 yen on an average. After this the value of the yen against the dollar started to go up, and fell to around 80 yen to a dollar. This had meant the death of the yen carry trade.
But with the yen losing value against the dollar again it makes the idea of the yen carry trade viable again. Between 2004 and 2008, stock markets across the emerging market rose as money through the yen carry trade route came in. This included India as well.
Things as they are now look ideal for the yen carry trade to start again. What helps is the fact that interest rates in Japan are very low almost close to 0%. Hence, money can be borrowed very cheaply.
As the yen carry trade picks up, investors borrow in yen, and sell those yen to buy dollars. This ensures that there is a surfeit of yen in the market leading to a further fall in its value against the dollar. This in turn makes the yen carry trade even more attractive.
Reports in the international media seem to suggest that it has already started happening. India now remains an ideal candidate for money to come through the yen carry trade route given that the Indian rupee has been gaining value against the dollar, which would make the yen carry trade even more profitable.
While the Indian economy falters, BSE Sensex, India’s premier stock market index might be getting ready for another rally. This time due to the blessings of Mrs Watanabe(s) from Japan. In fact when I had asked Professor Aswath Damodaran, how strong is the link between economic growth and stock markets, in a recent interview, he replied “It’s getting weaker and weaker every year.”
Reference: Extreme Money: Masters of Universe and the Cult of Risk by Satyajit Das
The article originally appeared on www.firstpost.com on February 6, 2013
(Vivek Kaul is a writer. He can be reached at [email protected])