Tag: yen carry trade

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

18 January, 2014

Sensex reclaims 21k: Why yen carry trade will ensure ‘easy money’ continues

Vivek Kaul
The Federal Reserve of United States, the American central bank, plans to go slow on money printing starting this month i.e. January 2014. Until the last month the Federal Reserve printed $85 billion every month. It pumped this money into the financial system by buying government bonds and mortgage backed securities.
The idea was to ensure that there is enough money going around in the financial system and, thus, help keep long term interest rates low. This would hopefully encourage people to borrow and spend and, thus, help the American economy to start growing again.
The risk was that all the money being printed would lead to inflation. While the money printing hasn’t led to consumer price inflation, it has led to a rapid rise in the stock market as well as real estate prices in the United States. This is primarily because people (which includes investors) could borrow at very low interest rates and invest that money in stocks as well as buy homes.
“Since the turnaround began on March 9th, 2009, the S&P-500 index has chalked up gains of +175%, – ranking it as the fourth longest bull market of all-time. In cash terms, the US-stock market has generated $13.5-trillion in paper wealth,” writes Gary Dorsch, Editor, Global Money Trends, in his recent column.
The 20 City S&P/ Case- Shiller Home Price Index, the leading measure of U.S. home prices,rose by 13.6% in October 2013, in comparison to a year earlier. This is the highest gain in prices since February 2006, when prices had risen by 13.9% in comparison to the year earlier. Real estate prices in the United States, as measured by the 20 City S&P/Case- Shiller Home Price Index had peaked in April 2006.
So the markets in the United States as well as other parts of the world have done very well over the last few years as the Federal Reserve of United States has printed truck loads of money. The interesting thing is that even with the Federal Reserve deciding to go slow on money printing, the markets haven’t fallen.
It is worth pointing out here that when the Federal Reserve Chairman Ben Bernanke had first talked about going slow on money printing (or tapering as he called it) in May-June 2013, financial markets (stock, bond and foreign exchange) had reacted very badly to the news.
But when the Federal Reserve has actually gone ahead with “tapering” and decided to print $75 billion per month (instead of the earlier $85 billion) the markets haven’t reacted violently at all. Why is that the case?
One reason is the fact that the Federal Reserve has managed to communicate to the investors that tapering isn’t really tightening. What that means is that even though the Federal Reserve will go slow on money printing and not print as many dollars as it was in the past, it will ensure that short term interest rates will continue to remain low. As Jon Hilsenrath writes in the Wall Street Journal “Most notably, the Fed’s message is sinking in that a wind down of the program won’t mean it’s in a hurry to raise short-term interest rates.”
This means at some level the dollar carry trade can continue. Hence, big institutional investors can continue to borrow in dollars at low interest rates and invest that money in different financial markets all over the world.
It needs to be pointed out that whether the Federal Reserve decides to further cut down on money printing depends on the overall state of the American economy. One particular number that the Federal Reserve likes to look at is the number of jobs created every month. In December 2013, the US economy saw a net increase of 74,000 jobs. As Andre Damon writes onwww.globalresearch.ca “The US economy generated a net increase of only 74,000 jobs in December, about one third the number predicted by economists and less than half the amount needed to keep pace with population growth. The increase in non-farm payrolls was the lowest since January 1, 2011, when the economy added 69,000 jobs. Friday’s number followed two months in which payrolls grew by 200,000 or more, leading to claims that the economy was shifting into high gear.” This implies that it will be difficult for the Federal Reserve to cut down from the $75 billion that it is currently printing in a month. Hence, it is unlikely that the Federal Reserve will stop money printing any time soon.
What has further energised the financial markets is the fact that the Bank of Japan, the Japanese central bank, is also printing money big time. As Dorsch writes “The Bank of Japan(BoJ) has taken a page out of the Fed’s quantitative easing playbook, – but multiplied by 3-times. The BoJ is buying ¥7.5-trillion of government bonds (JGB’s) per month, and intervening directly in the equity market, by purchasing ¥1 trillion of exchange-traded funds linked to the Nikkei-225 each year. The BoJ aims to inject $1.4-trillion into the Tokyo money markets by April ‘15, equal to a third of the size of Japan’s $5-trillion economy.”
The Federal Reserve until last month was printing $85 billion every month. This works out to a around $1.02 trillion every year. The amount of money being printed by the Bank of Japan is more than that. What this means is that interest rates in Japan will remain low. This will encourage the yen carry trade, where an investor can borrow in yen and invest the money in different financial markets around the world.
What will also help is the fact as the Japanese central bank keeps printing money, the yen will depreciate against the dollar and thus spruce up returns. In the last one year the yen has gone from around 89 to a dollar to almost 103-104 to the dollar currently. “With liquidity injections of ¥7-trillion per month, Tokyo has engineered the yen’s -18% devaluation against the US$, -23% against the Euro, -15% against the Korean won, and a -12% slide against the Chinese yuan,” writes Dorsch.
How does this help yen carry trade? Let us understand this through an example. Let’s say an investor borrows 100 million yen and converts them into dollars. Currently one dollar is worth around 104 yen.
Hence, 100 million yen can be converted into around $961,538 (100 million yen/104). This money is invested in financial markets around the world and let’s say at the end of one year has grown by around 8% and is now worth $1.04 million. One dollar by then let us assume is worth 110 yen.
When $1.04 million is converted into yen, the investor gets 114 million yen. This means a return of 14%. Hence, the depreciating yen adds to the overall return for anyone who borrows in dollars.
It also means that financial markets around the world will see foreign investors continuing to bring in more money. India should also benefit from the same over the next one year. Given this, the BSE Sensex should continue to go up till December 2014. CLSA expects the Sensex to touch 23,500 by December 2014. Deutsche Bank Markets Research expects the Sensex to do even better and touch 24,000 by the end of this year. It does not matter that the real economy will continue to be in doldrums.

The article originally appeared on www.firstpost.com on January 13, 2014
(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)

5 April, 2013

Japan is getting into money printing party too

Vivek Kaul
In India we have been dealing with very high rates of consumer price inflation in excess of 10%. On the other hand Japan has been dealing with exactly the opposite thing. The country has no inflation. During 2013, the average inflation has stood at -0.45%. This scenario where prices are falling is specifically referred to as deflation.
And this is not a recent phenomenon. In 2012, the average inflation for the year 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 had a huge impact on the economic growth in Japan. 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.
To get over this Japanese politicians have been wanting to create some inflation so that people will start spending again. The Bank of Japan, the Japanese central bank, in a statement released on April 4, 2013, said “The Bank will achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years. It will double the monetary base.”
In simple English what the statement means is that the Bank of Japan will try and create an inflation of 2% in the earliest possible time with an overall limit of two years.
The question is how will this inflation be created? The Bank of Japan plans to print yen and double the money supply in the country. This money will be pumped into the financial system by the Bank of Japan buying various kinds of bonds including government bonds and exchange traded funds from Japanese banks and other financial institutions.
When the Bank of Japan buys bonds from banks it will pay for it in the newly printed yen. Thus newly printed yen will land up with banks. Banks can then go ahead and lend this money. As an increased amount of money chases the same amount of goods and services, the hope is that prices will rise and some inflation will be created. And this will put an end to the deflationary scenario that has prevailed over the last few years.
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 to avoid paying more for them in the days to come. This helps businesses as well as the overall economy. So by trying to create some inflationary expectations in Japan the idea is to get consumption going again and help the country come out of a more than two decade old recession. With prices of things going up people are more likely to buy now than later and thus economic growth can be revived.
There is another angle to this entire idea of doubling money supply and that is to cheapen the yen against the dollar. The Japanese refer to a strong yen as Endaka. Hans Redeker, from Morgan Stanley told Ambrose Evans-Pritchard of The Daily Telegraph that the package was dramatic enough to break “Endaka” – strong yen – once and for all.
On April 3, 2013, one dollar was worth around 93 yen. As I write this piece on April 4, 2013, one dollar is now worth 95.5 yen. Hence for anyone looking to convert dollars into yen would have got more yen if he had converted on April 4 rather than April 3.
As the Bank of Japan starts printing yen to create inflation, 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. That’s the theory behind the yen cheapening against the dollar.
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.
In early November 2012, one dollar was worth 79.4 yen and now it is worth around 95.5 yen. A cheaper yen will help Japanese exporters as it makes them more competitive in the international market.
Let us say a Japanese exporter sells a product at a price of $1million. Earlier when he converted dollars into yen he would have got 79.4 million yen. Now with the yen losing value against the dollar he will get 95.5 million yen. Since the exporter’s cost in yen remains the same, he makes a higher profit.
The exporter can also cut prices in dollar terms and thus make his product more competitive against competitors from other countries. If he cuts prices by 15% to $850,000 in the international market, he still makes around 81.2 million yen ($850,000 x 95.5 yen), which is better than the 79.4 million yen he was making when one dollar was worth 79.4 yen and the product cost $1 million. A greater price competitiveness will ensure that exports pick up and that in turn will help revive economic growth. At least that’s how things are supposed to work in theory.
In fact Germany, one of the world’s biggest exporters is already feeling the heat. One euro was worth around 101 yen in the second week of November. As I write this one euro is worth around 125 yen. This has made Japanese exports more competitive against that of Germany.
And by wanting to double money supply by printing yen, the Bank of Japan is only doing what various other central banks around the world have already been up to. The Federal Reserve of United States has expanded its balance sheet by 220% since early 2008. The Bank of England has done even better at 350%. The European Central Bank came to the party a little late and has expanded its balance sheet by around 98%. The Bank of Japan has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the last four years. But since late December 2012, Bank of Japan has also been getting ready to enter the money printing party. This was after Shinzo Abe took over as the Prime Minister of the country on December 26, 2012. He promised to end Japan’s more than two decade old recession by creating inflation and reviving economic growth. The new Bank of Japan governor Haruhiko Kuroda is only following the path that has already been laid up by Prime Minister Abe and other central banks all around the world.
The trouble is that central banks which have tried this path have managed to create very little inflation and economic growth The reason for it is simple. The western world is still feeling the negative effects of the borrowing binge it went into between the turn of the century and 2008. So people don’t want to borrow. The money that central banks have been printing is being borrowed by large institutional investors at close to zero percent interest rates and being invested in all kinds of assets all over the world.
With the Bank of Japan expected to buy all kinds of bonds from banks and other financial institutions, it means that the financial system will be flush with money. This along with a depreciating yen is expected to unleash a massive yen carry trade. “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,” writes Ambrose Evans-Pritchard.
Investors will borrow in yen at very low interest rates and invest it in various kinds of financial assets all over the world. This is called the carry trade because investors make the carry – i.e. the difference between the returns they make on their investment (in bonds or even in stocks for that matter) and the interest they pay on their borrowings in yen. This money will be invested in all kinds of financial assets around the world. Whether it will come to India, remains to be seen. (For a more detailed argument on the yen carry trade read Why Mrs Watanabe can now drive the Sensex higher.)
As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracles:
“What is apparent that central banks can print all the money they want, they can’t dictate where it goes. This time around, much of that money has flown into speculative oil futures, luxury real estate in major financial capitals, and other non productive investments…The hype has created a new industry that turns commodities into financial products that can be traded like stocks. Oil, wheat, and platinum used to be sold primarily as raw materials, and now they are sold largely as speculative investments.”
So the question is what stops all the money that will be printed in Japan from meeting the same fate, as the money that was printed by other central banks? Nothing.
The other thing that central bank governors haven’t been able to answer is what will they do once inflation does start to appear, which it eventually will. How will Haruhiko Kuroda ensure that all the money that he plans to print creates just 2% inflation and not more?
Also money printing is an idea which every country can implement. And with Japan betting big on it, other export oriented countries(like South Korea with which Japan primarily competes in automobiles and electronic exports) will also have to resort to it to protect their exports.
Central bank governors have used the excuse of money printing not leading to much inflation as an excuse for printing more and more money. Mervyn King, the Governor of the Bank of England, has said in the past that“those people who said that asset purchases would lead us down the path of Weimar Republic and Zimbabwe I think have been proved wrong ,” he has said. King implies that excess money printing will not lead to the kind of high inflation that it did in Germany in the early 1920s and Zimbabwe a few years back.
Just because money printing hasn’t led to inflation now, doesn’t mean that can be totally ruled out in the days to come. As Albert Edwards of Societe Generale writes in a report titled Is Mark Carney the next Alan Greenspan “King’s assertion that because the quantitative easing(another term for money printing) to date has not yet produced rapid inflation must mean that it will never produce rapid inflation is just plain wrong. He simply cannot know.”
And that is something that every central bank governor who chooses to print money is ignoring right now. They really can’t know what the future holds.
The article originally appeared on www.firstpost.com on April 5, 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])