There are many explanations behind the curious strengths and weaknesses of various currencies in the forex markets right now.
As far as sterling goes, the logic behind its relentless dive is reasonably clear (just ask Jim “the-UK-is-finished” Rogers) although, as the FT notes on Wednesday, its banking crisis is “no more serious” than that of the US. However, as a smaller economy, the UK is far more vulnerable to capital flight. Also, sterling has been trading with particularly strong correlation with bank stocks –- and we all know where they’ve been heading.
For currency market watchers, however, one trend that seems to defy economic gravity is the robust performance of the yen – even as Japan falls deeper into recession.
The year 2008 “will be remembered as the year of extraordinary JPY appreciation”, says Tohru Sasaki, global forex strategist at JP Morgan in Tokyo. Part of it is seasonal, he says in a note issued this week, as the currency tends to appreciate between mid-February and March 31, the end of Japan’s financial year. Corporates tend to repatriate their overseas funds or, at least, substantially reduce their foreign securities holdings, in this period. And this year in particular they have been liquidating their foreign assets towards fiscal year-end amid growing recession concerns.
Various new factors suggest that upward pressure on the yen will continue in the second quarter – not least a concerted slow-down in yen sales by domestics in 2009 amid the relentless unwinding of yen carry trades, according to Sasaki. A few quick numbers:
Indeed, in 2008, the yen’s nominal effective exchange rate appreciated by 32.4 per cent – the largest increase in the floating currency regime that began in 1971. USD/JPY declined 18.9% in 2008, which is the largest decline since 1987, and GBP/JPY declined 40.2%, which is the largest fall since 1958. However, the net outflow (portfolio + FDI – trade balance) from Japan reached ¥14.2 trillion in 2008, which is the largest outflow since data is available from 1989.
Obviously, there was strong downward pressure coming from yen sales by domestic players last year. The fact that the yen appreciated significantly even under such circumstances suggests that foreign investors’ unwind of carry trades dominated yen sales by the Japanese. Considering the historic appreciation of the yen over the period, it may be no exaggeration to say that the magnitude of unwinding of carry trades by foreigners exceeded ¥20 trillion last year.
Although there was a substantial outflow from Japan in 2008, this was driven largely by massive flows from pension funds, which alone bought a net ¥4.8 trillion of foreign equities last year. Most of these purchases were for the purpose of portfolio rebalancing, notes Sasaki. But after the big increase in their foreign equities purchases last year, and a substantial decline in global stock markets, Japanese pension funds have only limited room for additional purchases in 2009.
Another key driver of outflows were Japanese corporates, which sent a record ¥8.6 trillion out of Japan in foreign direct investment between January and November (December data is not yet available). A certain portion of the FDI outflow was due to big injections by Japanese financial institutions into US banks – among them, SMFG spent £500m ($815m) shoring up Barclays, Mizuho pumped $1.2bn into Merrill Lynch and MUFG splurged $9bn for a 21 per cent stake in Morgan Stanley.
But common sense and some risk aversion are setting in (our words, not Sasaki’s), alongside the concerted slowdown in the Japanese economy, and such outflows are likely to be subdued in the first half of 2009 at the very least.
Similarly, foreign bond investment by retail investors (through investment trusts and uridashi bonds – foreign bonds sold to Japanese investors) and life insurance companies have tailed off in the past few months – not least because “Japanese are now seriously feeling the economic downturn and are hesitant to take risks”, in Sasaki’s view. This comes after exceptionally large net purchases of foreign securities by Japanese investors in Q1 last year, mainly due to foreign stock purchases by pension funds and uridashi bond investment by retail investors.
On top of all this are also some special factors which could generate upward pressure on the yen beyond March, he adds: First, is the prospect of tax law changes that would promote the repatriation of Japanese companies’ overseas retained earnings – possibly from the beginning of next fiscal year, in April. Sasaki estimates that Japanese companies’ overseas retained earnings may have hit JPY20 trillion by the end of fiscal year 2007 in March 2008, and that ¥4-7 trillion of this could be repatriated.
Second is the Japanese government’s move to scrap capital gains taxes for foreigners who hold stakes in Japanese companies through investment funds.
In a move to end corporate and income taxes on foreign investments from April, the government reportedly plans to submit a bill in the current Diet session. If passed into law, the change may provide an incentive for foreign investors to boost their investment in Japanese stocks, which in turn would increase capital inflows and support the yen. The amount of Japanese stock investment by foreigners differs significantly in each year, and it’s difficult to estimate the potential impact of this change, notes Sasaki:
We do not think that a proposed tax change will automatically boost Japanese stock investment by foreign investors. However, if foreign investors think the bottom of the stock market is near and decide to buy back what they net-sold last year, a lower tax rate may become one of the supportive factors for their decision.
One final point: it has been assumed that Japanese stock investment by foreign investors have been FX hedged since 2004, notes Sasaki. However, if they start investing in Japanese stocks in this year, it is unlikely that FX-hedging will be required, because there is no longer significant yield differentials between Japan and other major countries.
Even if outflows from Japan resume in Q2 as seen in the past, which is not our main scenario, these flows could be more than offset by inflows stemming from factors mentioned above.
Related links:
Summary of Sasaki’s yen note – Long Room
Yen gains to record versus pound on concern bank losses to rise - Bloomberg
Pound falls to record low against the dollar – Bloomberg
Rogers: The UK is finished -FT Alphaville