Tag: George Soros | Vivek Kaul

13 January, 2016

George Soros Has Got a Backache Again and This Time It’s Because of China

George Soros has got some of the biggest macro calls right over the years. How does he do it? If you were to get around to reading all the books that Soros has written over the years, you will come to realise that he follows something known as the theory of reflexivity to get in and out of financial markets.

Nevertheless, his son Robert, offers another explanation for his success in Michael Kaufman’s Soros: The Life and Times of a Messianic Billionaire. As Robert puts it “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit, I mean, you know the reason he changes his position in the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s his early warning sign.”

Soros himself has had his doubts about how he makes money. As he writes in The New Paradigm for Financial Markets – The Credit Crisis of 2008 and What It Means: “To what extent my financial success was due to my philosophy is a moot question because the salient feature of my theory is that it does not yield any firm predictions. Running a hedge fund involves the constant exercise of judgement in a risky environment, and that can be very stressful. I used to suffer from backaches and other psychosomatic ailments, and I received as many useful signals from my backaches as from my theory. Nevertheless, I attributed great importance to my philosophy and particularly my theory of reflexivity.”

And from the looks of it, seems like George Soros has had a few backaches of late. This time his worries are coming from China. Speaking at an economic forum in Sri Lanka, Soros recently said: “When I look at the financial markets there is a serious challenge which reminds me of the crisis we had in 2008…Unfortunately China has a major adjustment problem and it has a lot of choices and it can actually transfer to the rest of the world its own problems by devaluing its currency and that is what China is doing.”

Over the years, the Chinese yuan has been largely pegged against the American dollar. The People’s Bank of China, the Chinese central bank, has ensured that the value of the yuan has fluctuated in a fixed range around the dollar. This has been primarily done in order to take away the currency risk that the Chinese exporters may have otherwise faced.

In a world where so many things have changed in the aftermath of the financial crisis which started in September 2008, the value of the Chinese yuan against the dollar has been one of the few constants.

Over the last few months, the value of the Chinese yuan against the dollar has gradually been allowed to fall. In August 2015, the People’s Bank of China pushed the value of the dollar against the yuan, from 6.2 to around 6.37. In November 2015, one dollar was worth around 6.31 yuan. By the end of the year, one dollar was worth 6.48 yuan, with the yuan gradually depreciating against the dollar.

In the new year, the yuan has depreciated further against the dollar and one dollar is now worth around 6.58 yuan. So what is happening here? It is first important to understand how the People’s Bank of China has over the years maintained the value of the yuan against the dollar.

When Chinese exporters bring back dollars to China or when investors want to bring dollars into China, the Chinese central bank buys these dollars. They buy these dollars by selling yuan. This ensures that at any given point of time there is no scarcity of yuan and there are enough yuan in the market, in order to ensure that the value of the yuan is largely fixed against the dollar.

Where does the People’s Bank get the yuan from? It can simply create them out of thin air, by printing them or creating them digitally.

The situation has reversed in the recent past. Money is now leaving China. Hence, the total amount of dollars leaving China is now higher than the dollars entering it. And this has created a problem for the Chinese central bank. Between July and September 2015, the net capital outflows reached $221 billion. “[This] occurred for the sixth straight quarter and reached a new record of $221 billion,” wrote Jason Daw and Wei Yao of Societe Generale in a recent research note.

The fact that more dollars are now leaving China than entering it, changes the entire situation. When investors and others, decide to take their money out of China, what do they do? They sell their yuan and buy dollars. This pushes up the demand for dollars. In a normal foreign exchange market this would mean that the dollar would appreciate against the yuan, and the yuan would depreciate against the dollar.

But remember that the Chinese foreign exchange market is rigged. The People’s Bank of China likes to maintain a steady value of the yuan against the dollar. What does the Chinese central bank do when more dollars are leaving China? In order to ensure that there is no scarcity of dollars in the market, it buys yuan and sells dollars. This is exactly the opposite what it has been doing all these years, when more dollars where entering China than leaving it.

The trouble is that China cannot create dollars out of thin air, only the Federal Reserve of the United States can do that. China does not have an endless supply of dollars. The foreign exchange reserves of China as of December 2015 stood at $3.33 trillion. In December 2015, the foreign exchange reserves fell by $107.9 billion. They had fallen by $87.2 billion in November. In fact, between December 2014 and December 2015, the Chinese foreign exchange reserves have fallen by a huge $557 billion, in the process of defending the value of the yuan against the dollar.

While, China has the largest foreign exchange reserves in the world, it is worth asking what portion of these reserves are liquid? The Chinese central bank has invested these reserves in financial securities all over the world. As of October 2015, $1.25 trillion was invested in US government treasuries.

The question is how quickly can these investments be sold in order to defend the value of the yuan against the dollar? As economist Ajay Shah wrote in a recent column in the Business Standard: “For a few months, reserves have declined by a bit less than $100 billion a month. We may think that, with $3 trillion of reserves, the authorities can handle this scale of outflow for 30 months. Things might be a bit worse. Questions are being raised about the liquidity of the reserves portfolio. There are only a few global asset classes where the Chinese government can easily dispose of $100 billion of assets per month. A lot of the reserves portfolio might not be in these liquid asset classes.”

Given this, China does not have an endless supply of dollars and cannot constantly keep defending the yuan against the dollar. This explains why it has gone slow in defending the yuan against the dollar, in the recent past, and allowed its currency to depreciate against the dollar.

The question is why is all this worrying the world at large, Soros included? A weaker Chinese yuan will make Chinese exports more competitive. This will mean a headache for other export oriented economies like Japan, Taiwan, South Korea, Germany, and so on. They will also have to push the value of their currencies down against the dollar. Hence, the global currency war which has been on a for a while, will continue. Further, a weaker yuan might lead to China exporting further deflation (lower prices) all over the world.

But what is more worrying is the fact that residents and non-residents are primarily the ones withdrawing their money out of China. The non-residents withdrew $82 billion during the period July to September 2015. The residents withdrew $67 billion, after having withdrawn $102 billion between March and June 2015.

When any economy is in trouble it is the locals who start to withdraw money first. This is clearly happening in China. And that has got the world worried. Also, China is a major consumer of commodities and any economic slowdown in China, will lead to a fall in commodity demand. This isn’t good news for many commodity exporting countries in particular and global economic growth in general.

The column originally appeared on the Vivek Kaul’s Diary on January 13, 2016

15 April, 2015

George Soros’ theory of reflexivity explains the rut in public sector banks

Public sector banks continue to remain in a big mess. In a recent research note Crisil Research points out: “ Asset quality remained under pressure with gross non performing assets rising by 45 bps[basis points] to 5% of advances because of continuing stress across sectors such as infrastructure, construction and iron and steel. Also, restructured assets for public sector banks as a proportion of advances increased by 70-100 bps to around 7-8% as of December 2014.” One basis point is one hundredth of a percentage.
What this means in simple English is that for every Rs 100 given by Indian public sector banks as a loan(a loan is an asset for a bank) nearly Rs 12- 13(Rs 5 worth of non performing assets plus Rs 7-8 worth of restructured loans) is in shaky territory.
The borrower has either stopped repaying the loan or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank) by increasing the tenure of the loan or lowering the interest rate. Crisil Research expects gross non-performing assets to remain at the current high levels, during the period January to March 2015, results for which will soon start coming out.
The question is how did the Indian public sector banks end up in this state? The simple answer as explained above is that they gave loans to borrowers who are no longer repaying them. The next question is whether the due diligence carried out by banks was adequate? This is where things get interesting.
A major portion of the loans which are now not being repaid were given out during the period 2002 and 2008. This was the period when the stock market in India was in the midst of a huge rally. The economy was also doing well.
This had created a massive “feel good” factor which ensured that corporates where willing to borrow and banks were willing to lend. Between end December 2001 and end December 2007, the lending by banks went up at a rapid rate of 26.8% per year. To give a sense of comparison, the lending by banks between December 2007 and December 2014 went up at the rate of 16.8% per year, which is significantly lower. If we consider a much shorter period between December 2011 and December 2014, the lending by banks went up by just 13.4% per year.
What this clearly tells us is that the growth in bank lending between December 2001 and December 2007 happened at a very rapid rate. This rapid rise was a reflection of the era of “easy money” that existed during that period due to the stock market and the Indian economy both going from strength to strength.
And this is where things started to get messy. Before we go any further it is important to understand, the theory of reflexivity proposed by hedge fund manager George Soros.
As Soros writes in The New Paradigm for Financial Markets: “The crux of the theory of reflexivity is not so obvious, it asserts that market prices can influence the fundamentals. The illusion that markets manage to be always right is caused by their ability to affect the fundamentals that they are supposed to reflect.” Reflexivity refers to circular relationships between cause and effect
Typically, the price of a stock is expected to reflect the underlying earnings potential of a company (or the kind of money that the company is expected to make in the days to come) or what analysts like to refer to as fundamentals of a company. What Soros implies through the theory of reflexivity is that the stock price of a company also impacts its earnings potential. Or to put it simply stock prices can have an impact on the fundamentals of a company.
In the feel good and easy money era that prevailed between 2001 and 2007, the stock prices of companies rallied at a rapid rate. This gave the companies the confidence to borrow a lot of money from banks, in the hope of expanding and earning much more money. But they bit more than they could chew and a few years down the line the interest that they paid on their outstanding debt was a major part of their total expenses. This had an impact on their profits. Hence, the stock price of a company ended up having an impact on its earnings.
As companies started defaulting on their interest payments and loan repayments, banks started becoming a part of this mess as well. They had to write off loans as well as restructure them. This has now led to a situation where the stressed assets of public sector banks are now close to 12-13%. In this way, a rapidly rising stock market ended up having an impact on the performance of banks. Also, in many cases the public sector banks were forced to lend to crony capitalists by politicians.
“High GNPAs will restrict growth in net interest income to 5-7% year on year, in spite of lowering of deposit rates by some of the banks,” points out Crisil.
To conclude, the bad habits are usually picked up during good times. And that is precisely what happened to public sector banks in India.

The column originally appeared on The Daily Reckoning on April 15, 2015

30 August, 2013

What George Soros must be thinking about the rupee

Vivek Kaul
George Soros likes to believe that he has managed to make all the money that he has, by following what he calls the theory of reflexivity. Not everyone believes this though.
His son Robert, offers another explanation for his success in Michael Kaufman’s Soros: The Life and Times of a Messianic Billionaire. As Robert puts it “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit, I mean, you know the reason he changes his position in the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s his early warning sign.”
Soros himself has some doubts. As he writes in The New Paradigm for Financial Markets – The Credit Crisis of 2008 and What It Means “To what extent my financial success was due to my philosophy is a moot question because the salient feature of my theory is that it does not yield any firm predictions. Running a hedge fund involves the constant exercise of judgement in a risky environment, and that can be very stressful. I used to suffer from backaches and other psychosomatic ailments, and I received as many useful signals from my backaches as from my theory. Nevertheless, I attributed great importance to my philosophy and particularly my theory of reflexivity.”
So what is the theory of reflexivity? As Soros writes “The crux of the theory of reflexivity is not so obvious, it asserts that market prices can influence the fundamentals. The illusion that markets manage to be always right is caused by their ability to affect the fundamentals that they are supposed to reflect…Buy and sell decisions are based on expectation about future prices, and future prices, in turn, are contingent on present buy and sell decisions.”
Now what does that mean in simple English? Let’s understand this in the context of the rupee which has depreciated rapidly against the dollar in the last few months.
The rupee largely fell because of our high current account deficit. The current account deficit is the difference between total value of imports and the sum of the total value of its exports and net foreign remittances. Simply put, our demand for dollars was more than their supply. The rupee was also adjusting for the high consumer price inflation that we have had for a long time now.
So the rupee falling against the dollar was a given. The fall in the value of the rupee was reflecting the economic fundamentals of India. Or as conventional economic theory goes, market prices reflect the fundamentals on most occasions.
The trouble is that rupee has had a free fall and this has led some economists to believe that it has fallen more than it should have to reflect India’s economic fundamentals. As Rohini Malkani, Prachi Mishra and Aman Mohunta write in The Economic Times “ However, with the rupee around 65-66 to a dollar, it has overshot its equilibrium value and is undervalued at current levels.”
Simply put, the value of the rupee against the dollar has fallen more than it should have to reflect India’s economic fundamentals. The trouble with this argument, like most arguments made by theoretical economists is that it tends towards ‘equilibrium’.
While the fall in the value of the rupee reflects India’s economic fundamentals, at the same time the fall in the value of the rupee also impacts India’s economic fundamentals. Malkani, Mishra and Mohuna do not take the second factor into account.
As the rupee falls, Indian oil companies need to pay more for the oil that they import. If the government chooses not to pass on the higher cost onto the end consumers ( as it has done in the past) this means that the oil companies need to be compensated for the “under-recoveries”.
This means a higher expenditure for the government. A higher expenditure in turn means a higher fiscal deficit. Fiscal deficit is defined as the difference between what a government earns and what it spends. This will lead to more borrowing by the government and will crowd out private sector borrowing (for banks as well as corporates) leading to higher interest rates. Higher interest rates will have slowdown economic growth further.
If the government chooses to pass on the increase in the cost of importing oil to the end consumer, it will lead to higher inflation. A higher inflation can’t be good for economic growth either. A weaker rupee will also make other important imports like fertilizer, coal, palm oil etc, costlier. This will have its own impact on economic growth as people will cut down on consumption to meet higher expenses.
India’s external debt as on March 31, 2013, stood at at $ 390 billion. Of this nearly 79% debt is non government debt. External commercial borrowings(ECBs) made by corporates form nearly 31% of the external debt. This is not surprising given that the Credit Suisse analysts point out that 40-70% of the loans of 10 big corporate groups that they studied for a recent research report, are foreign currency denominated.
With a weaker rupee, as these loans mature, corporates will need more rupees to buy dollars. And this will have a huge impact on their profit and loss accounts. Lower profits or losses are obviously not good news.
A weaker rupee also has an impact on Indian exports, given that India’s top exports like gems and jewellery, organic chemicals, vehicles, machinery and petroleum products, are all heavily import dependent. Hence, people in this business will have to pay more in rupee terms to import raw materials that they need to make their finished products. This will have an impact on the pricing of exports and explains to a large extent why a weaker rupee doesn’t necessarily always lead to higher exports.
What this means is that a fall in the value of the rupee will soon start impacting India’s economic fundamentals or perhaps it already has. And this in turn will mean a further fall in the value of the rupee. Swaminathan Aiyar explained it best in a recent column in The Economic Times “Many experts say the rupee has overshot and will come back. Really? Remember the same thing was said about the Indonesian rupiah when it depreciated from 2,500 to 3,000 to the dollar in 1997, but it eventually went all the way to 18,000. Estimates based on fundamentals quickly become meaningless because a crisis changes fundamentals hugely. The crashing rupee has already changed the economy’s fundamentals.”
Disclosure: The idea for this article came from Swaminathan Aiyar’s column Get ready for another Asian Financial Crisis in The Economic Times
The article originally appeared on www.firstpost.com on August 30, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

19 April, 2013

Reuters bumps off George Soros, turns out he is alive and supposedly shorting gold

Vivek Kaul
George Soros rest in peace. That’s what the news agency Thomson Reuters wanted us to believe when it released a 1,122 word long pre-written obituary of the famed hedge fund manager at 5.41pm eastern standard time in the United States, yesterday evening (or a little after 4 am Indian Standard Time (IST) today morning).
What gave away the mistake was the following paragraph: “George Soros, who died XXX at age XXX, was a predatory and hugely successful financier and investor, who argued paradoxically for years against the same sort of free-wheeling capitalism that made him billions.”
The dummy triple X’s made it clear that Thomson Reuters had put out the obituary by mistake. It is normal for news agencies to keep obituaries prepared in advance, but on the rarest occasions like this one they get released before the death of the person.
The obituary as can be made out from the paragraph reproduced above wasn’t kind to Soros. Someone like Soros, who has made the kind of money that he has, doing what he does best i.e. bet against countries and big bubbles, as and when he does die, isn’t going to inspire obituary writers to write nostalgia infused pieces, anyway.
The pre-written obituary did manage to list out some of Soros’ big achievements. “He was known as ‘the man who broke the Bank of England’ for selling short the British pound in 1992,” the second paragraph of the obituary read.
In fact this was the trade that made Soros famous. The story behind the trade is very interesting. On October 24, 1992, Soros was in London and was leaving his house to play tennis. As soon as he got out of his house, he was besieged by a slew of journalists and photographs. All they wanted to know was whether he had made a billion by betting against a pound. Earlier in the day The Daily Mail had carried a story on Soros with the headline “I Made a Billion as the Pound Crashed.” Soros soon found out about the newspaper report.
What is not very well known is the fact that the idea of betting against the pound wasn’t Soros’. Though once he came to know of it and was convinced about it, he went full tilt with the trade. The idea for the trade essentially came from Stanley Druckenmiller who was the chief trader and strategist of George Soros’ Quantum Fund.
As Michael Kaufman writes in Soros – The Life and Times of a Messianic Billionaire “In 1992 Druckenmiller calculated that, despite public assurances to the contrary, the Bank of England would not be able to avoid devaluating the pound. He called Soros to discuss his thinking. “I told him why I thought the pound could collapse and the reasons I had and I told him the amount I was going to do. I did not get a scolding, but I got something close to a scolding, which was, well, if you believe all that, why are you betting only two or three billion.” With Soros’ encouragement, Druckenmiller more than tripled his original stake.”
So Soros bet big on the pound being devalued and had a position of $10 billion on the British pound. The trade essentially involved short selling the British pound and later buying it back once it was devalued. And that is what happened. He eventually ended up making $1 billion on the entire trade. Soros later stated that he wanted to execute an even bigger trade and borrow and sell British pounds worth around $15 billion.
Kaufman made a very important conclusion about Soros on the basis of this trade. “There are thousands of people who are good at analysis and hundreds who re good at predicting trends, but when you get down to using that information, pulling the trigger, putting it on the line to make what you are supposed to make, you are down less than a handful…You know, the ugly way to describe it would be ‘balls.’ To be willing at the right moment in time put it all on the line. That is not something, in my opinion, that can be learned. It is totally intuitive, and it is an art, not in any way a science,” he writes. So while everyone might do the right analysis, it takes a man with balls like Soros to get up and trade big on it.
Soros is great at making big macro-economic calls. Other than betting against the British pound, he also is said to have short sold the Thai baht and the Malaysian ringitt in 1997, and made a killing in the process. Both the baht and the ringitt were then pegged against the dollar. The baht was fixed at 25 to a dollar and 2.5 ringitt made a dollar.
Soros is said to have successfully bet against these currencies by short selling them. Short selling essentially involves borrowing a particular asset, selling it in the hope that its price falls, buying it at a lower price and thus making a profit out of the whole trade.
When Soros supposedly short sold the baht, the Thai baht central bank would have initially bought the baht by selling dollars. This helped maintain the peg between the dollar and the baht. The trouble was that the Thai central bank had only a limited number of dollars to sell. And once they ran out of dollars they had to let the baht fall in value against the dollar, which is what Soros wanted, and thus he made a killing. The same logic would have worked in case of the Malaysian Ringitt as well.
As the third paragraph of the Reuters obituary pointed out “His Soros Fund Management was widely blamed for helping trigger the Asian financial crisis of 1997.”
Soros has the ability to make big macro-economic calls. But he never a good stock picker. As Aswath Damodaran professor of finance at the New York University’s Stern School of Business,told me in an interview sometime back “Soros has never been a great micro investor. He has made his money on macro bets. He has never been a great stock picker. For him it has got to be massive macro bubbles, an asset class that gets overpriced or underpriced.”
In that sense Soros is different from the class of investors who believe in buying financial assets which are supposedly underpriced and then holding onto it in the time to come. Soros works in the opposite way. He either likes entering a bubble early or shorting them once they have got on for too long. As he writes in The New Paradigm for Financial Markets “Nothing is quite as profitable as investing in an early-stage bubble.” In fact one his favourite quips is “when I see a bubble, I invest”.
What works in Soros’ case is that he is able to exit just before the tide turns. As he has honestly admitted to in the past: “I don’t have a particular style of investing, or, more exactly, I try to change my style to fit the conditions…I assume that markets are always wrong…Most of the time we are punished if we go against the trend. Only at inflection point are we rewarded.”
And his ability to exit just before the tide turns or what he calls an inflection point, was most recently at play in case of gold. Soros is said to have made a lot of money by betting correctly on gold in the last ten years. He is recently said to have cut his gold holdings before the price of the yellow metal started to fall and now there are even rumors that he is shorting gold big-time and making a killing doing the same.
In his latest interview he was very vague on gold as any good trader would expected to be. As he told South China Morning Post when asked what was his view on gold “That’s a complicated question. It has disappointed the public, because it is meant to be the ultimate safe haven. But when the euro was close to collapsing in the last year, actually gold went down, because if people needed to sell something, they could sell gold. Therefore they sold gold. So gold went down together with everything else. Gold was destroyed as a safe haven, proved to be unsafe. Because of the disappointment, most people are reducing their holdings of gold. But the central banks will continue to buy them, so I don’t expect gold to go down. If you have the prospect of a crisis, you will have occasional flurries or jumps. So gold is very volatile on a day-to-day basis, no trend on a longer-term basis.”
In recent times Soros has tried to set his legacy right by projecting himself as not just a ‘greedy’ hedge fund manager who has made tonnes of money but as a thought leader. As he told the US Congress a few years back: “The main difference between me and other people who have amassed this kind of money is that I am primarily interested in ideas, and I don’t have much personal use for money. But I hate to think what would have happened if I hadn’t made money: My ideas would not have gotten much play. I wish I could write a book that will be read as long as our civilization lasts…I would value it much more highly than business success.”
Soros has written several books in which he has fancied himself as a philosopher who is a firm believer in the Theory of Reflexivity, originally proposed by Karl Popper. Soros has explained this theory in great detail in some of his books and has even gone into some detail on how it helps him make investment decisions.
As he writes in The New Paradigm for Financial Markets “People are participants, not just observers, and the knowledge they can acquire is not sufficient to guide their actions. They cannot base their decisions on knowledge alone…People’s understanding is inherently imperfect because they are a part of reality and a part cannot fully comprehend the whole…One must put oneself in the position of a detached observer. The human mind has worked wonders in trying to reach that position, but in the end it cannot fully comprehend the fact that it is part of the situation it seeks to comprehend.”
And this understanding Soros feels helps him make the investment decisions that he does. But that is something that his eldest son Robert, doesn’t agree with. As he puts it “My father will sit down and give you theories to explain why he does this or that. But I remember seeing it as a kid and thinking, Jesus Christ, at least half of this is bullshit, I mean, you know the reason he changes his position in the market or whatever is because his back starts killing him. It has nothing to do with reason. He literally goes into a spasm, and it’s his early warning sign.”
So much for all the philosophy of investing. It’s the back pain which gets Soros going.
The article originally appeared on www.firstpost.com on April 19,2013.
(Vivek Kaul is a writer. He tweets @kaul_vivek)

8 April, 2013

As yen nears 100 to a dollar, Mrs Watanabe is back in business

Vivek Kaul
The Japanese yen has gone on a free fall against the dollar. As I write this one dollar is worth around 98.5 yen. Five days back on April 5, 2013, one dollar was worth around 93 yen. In between the Japanese central bank announced that it is going to double money supply by simply printing more yen.
The hope is that more yen in the financial system will chase the same amount of goods and services, and thus manage to create some inflation. Japan has been facing a scenario of falling prices for a while now. During 2013, the average inflation has stood at -0.45%.
And this is not a recent phenomenon. In 2012, the average inflation for the year was 0%. In fact, in each of the three years for the period between 2009 and 2011, prices fell on the whole.
When prices fall, people tend to postpone consumption, in the hope that they will get a better deal in the days to come. This impacts businesses and thus slows down the overall economy. Business tackle this scenario by further cutting down prices of goods and services they are trying to sell, so that people are encouraged to buy. But the trouble is that people see prices cuts as an evidence of further price cuts in the offing. This impacts sales.
Businesses also cut salaries or keep them stagnant in order to maintain profits. As The Economist reports “A survey by Reuters in February found that 85% of companies planned to keep wages static or cut them this year. Bonuses, a crucial part of take-home pay, are at the lowest since records began in 1990.”
In this scenario where salaries are being cut and bonuses are at an all time low, people will stay away from spending. And this slows down the overall economy.
For the period of three months ending December 2012, the Japanese economy grew by a minuscule 0.5%. In three out of the four years for the period between 2008 and 2011, the Japanese economy has contracted.
The hope is to break this economic contraction by printing money and creating inflation. When people see prices going up or expect prices to go up, they generally tend to start purchasing things to avoid paying more for them in the days to come. This spending helps businesses and in turn the overall economy. So the idea is to create inflationary expectations to get people to start spending money and help Japan come out of a more than two decade old recession.
The other impact of the prospective increase in the total number of yen is that the currency has been rapidly falling in value against other international currencies. It has fallen by 5.9% against the dollar since April 4, 2013. And by around 26.5% since the beginning of October, 2012. The yen has fallen faster against the euro. As I write this one euro is worth 128.5 yen. The yen has fallen 7.5% against the euro since April 4, 2013, and nearly 28% since the beginning of October, 2012.
As the yen gets ready to touch 100 to a dollar and 130 to a euro, this makes the situation a mouthwatering investment prospect for a certain Mrs Watanabe. Allow me to explain.
In the late 1980s, Japan had a huge bubble in real estate as well a stock market bubble. The Bank of Japan managed to burst the stock market bubble by rapidly raising interest rates. The real estate bubble also popped gradually over a period of time.
After the bubbles burst, the Bank of Japan, started cutting interest rates. And soon they were close to 0%. This meant that Japanese investors had to start looking for returns outside Japan. This led to a certain section of Tokyo housewives staying awake at night to invest in the American and the European markets. They used to borrow money in yen at close to zero percent interest rates and invest it abroad with the hope of making a higher return than what was available in Japan.
Over a period of time these housewives came to be known as Mrs Watanabes (Watanabe is the fifth most common Japanese surname) and at their peak accounted for around 30 percent 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.
Other than low interest rates at which Mrs Watanabes could borrow the other important part of the equation was the depreciating yen. Japan has had low interest rates for a while now, but the yen has been broadly been appreciating against the dollar over the period of last five years. This is primarily because the Federal Reserve of United States has been printing money big time, something that Japan has also done, but not on a similar scale.
Now the situation has been reversed and the yen has been rapidly losing value against the dollar since October 2012. And this makes the yen carry trade a viable proposition for Mrs Watanabes. In early October a dollar was worth around 78 yen. Lets say at this price a certain Mrs Watanabe decided to invest 780,000 yen in a debt security internationally which guaranteed a return of 3% in dollar terms over a period of six months.
The first thing she would have had to do is to convert her yen to dollars. She would get $10,000 (780,000 yen/78) in return. A 3% return on it would mean that the investment would grow to $10,300 at the end of six months.
This money now when converted back to yen now when one dollar is worth 98.5 yen, would amount to around 10,14,550 yen ($10,300 x 98.5). This means an absolute gain of 234,550 yen (10,14,550 yen minus 780,000 yen) or 30% (234,550 expressed as a percentage of 780,000 yen). So a gain of 3% in dollar terms would be converted into a gain of 30% in yen terms, as the yen has depreciated against the dollar.
This depreciation is now expected to continue and hence expected to revive the prospects of the yen carry trade. As Ambrose Evans-Pritchard writes in The Daily Telegraph “The blast of money is expected to reignite the yen “carry trade” and flood global markets with up to $2 trillion (£1.3 trillion) of pent-up savings, giving the entire world a shot in the arm.”
This money is expected to go into all kinds of investment avenues including stock markets. As Garsh Dorsh, an investment letter writer, writes in his latest column “Most recently, the key driver that’s lifting stock markets higher around the world is the massive flow of liquidity via the infamous Japanese “Yen Carry” trade.”
Over a period of time the yen carry trade feeds on itself further driving down the value of yen against the dollar. As one set of investors make money from the carry trade it influences more people to get into it. These people sell yen to buy dollars leading to a situation where there is a surfeit of yen in the market in comparison to dollars. This further drives down the price of yen against the dollar. The more the yen falls against the dollar, the higher the return that a carry trade investor makes. This in turn would mean even more money entering the yen carry trade. And so the cycle, which tends to get vicious, works.
As George Soros, the hedge fund manager, told CNBC: “If what they’re doing gets something started, they may not be able to stop it. If the yen starts to fall, which it has done, and people in Japan realise that it’s liable to continue and want to put their money abroad, then the fall may become like an avalanche.” And this can only mean more and more yen chasing various investment avenues around the world and leading to more bubbles.
But that’s just one part of the story. The Japanese yen has been depreciating against the euro as well. This has made Japanese exports more competitive. A Japanese exporter selling a product for $10,000 per unit would have made 780,000 yen ($10,000 x 78 yen) in early October. Now he would make 10,14,550 yen ($10,300 x 98.5) for the same product. In October one dollar was worth 78 yen. Now it is worth 98.5 yen.
A depreciating yen means higher profits for Japanese exporters. It also means that the exporter can cut price in dollar terms and make his product more competitive. A 20% cut would mean the Japanese 788,000 yen ($8000 x 98.5 yen), which is as good as the 780,000 yen he was making in October 2012.
This increased price competitiveness has already started to reflect in numbers. Japan reported a current account surplus of 637.4 billion yen ($6.5 billion), for the month of February 2013. This was the first surplus in four months and was primarily driven by increased export earnings.
The trouble of course as Japanese exports get more competitive on the price front it hurts other export oriented countries. The yen has lost nearly 28% against the euro since October. This has had a negative impact on countries in the euro zone countries which use euro as their currency. For January 2013, seventeen countries which use the euro as their currency, in total logged a trade deficit (the difference between exports and imports) of 3.9 billion euros.
Japan also competes with South Korea primarily in the area automobile and electronics exports. Hyun Oh Seok, the finance minister of South Korea, said last month that the yen was “flashing a red light” for his nation’s exports.
Of course if Japan can resort to money printing, so can other nations in-order to devalue their currency and ensure that their exports do not fall. It could lead to a race to the bottom. As James Rickards author of Currency Wars: The Making of the Next Global Crisisputs it “we are well into the third currency war of the past 100 years….I am certain that we are closer to the critical state than we ever have been before ”
The article originally appeared on www.firstpost.com on April 8,2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)