Yen-Carry Trade -- Japan's Other Bubble?: William Pesek Jr.
By William Pesek Jr.
quote.bloomberg.com
11/11 22:36
Tokyo, Nov. 12 (Bloomberg) -- If there's anything Japan Inc. fears more than a global recession, it's a stronger yen. It could slam profits at Honda Motor Co., Sony Corp. and Toyota Motor Corp. -- basically, the nation's strongest companies at the moment.
These days, it's not just exporters worrying about a less competitive yen, but investors too. That's especially true of those who've borrowed cheaply in low-interest-rate yen and re- invested the funds elsewhere. A jump in the yen could again put them on the losing side of the so-called ``yen-carry trade.''
The strategy exploits the huge gap between U.S. and Japanese interest rates. Portfolio managers, banks and companies borrow in low-cost yen -- at rates of 1 percent or less -- and reinvest the funds in higher-yielding markets such as U.S. Treasuries. The payoff is twofold: the almost 3 percent yield premium and the dollar's rise versus the yen. The latter dynamic boosts profits further by the time they're converted back to yen.
Trouble is, it has a spotty track record. In October 1998, for example, the trade went spectacularly wrong. As Russia's default and the implosion of Long-Term Capital Management Co. sent shockwaves through global markets, the yen, which had been weakening for years, surged 25 percent in a matter of days.
The phenomenon left little doubt that the rush to borrow cheaply in yen can cause financial bubbles. When they burst, markets can get broad sided. In 1998, investors scrambled to dump the higher-yielding assets in which they'd parked their yen borrowings. For many, it was the only way to repay their debts. A similar dynamic occurred in 1994 when aggressive Federal Reserve rate increases slammed U.S. bonds.
Rude Awakening
The question now is whether the yen is about to jump higher. If so, many who rediscovered the yen-carry trade could be in for a rude awakening. As Japan's economic problems deepened and Tokyo pursued a weak-yen policy, many banks and investors from Dublin to Bangkok felt it was safe to load up on cheap yen financing.
They may wish they hadn't. Given the dire state of Japan's economy, fundamentals hardly support a firmer currency. The Bank of Japan's policy of boosting the money supply also would appear to give yen-carry aficionados comfort. Yet a weakening dollar may leave Japan powerless to stop the yen from surging.
The yen reached a two-month high of 119.11 versus the dollar in trading today and has risen almost every day since Oct. 22. After years of stubborn strength in the face of falling growth, terrorist attacks, accounting standards, and a gaping current account deficit, the dollar may be about to slide.
Few currency analysts expect a dollar freefall, but with the Fed still cutting rates and the U.S. downturn proving deeper than thought, the dollar may have a hard time holding its ground.
Manipulation
No country with a free-floating currency manipulates theirs more than Japan. Finance Minister Masajuro Shiokawa today said ``we will consider steps'' if the yen keeps rising. A falling dollar, however, would be beyond Tokyo's control. Once a dollar sell-off gets going, it may take on a life of its own, causing violent swings in foreign-exchange markets.
That's decidedly bad news for Japan's fragile economy. Its mild recovery this year is a purely exchange-rate-driven one -- take away a weaker currency and the world's second-largest economy is back in recession. At a time when Tokyo hopes to tackle its decade-in-the-making banking crisis, a stronger yen is the last thing policy makers want.
Investors, too. The yen-carry trade has been a lucrative one and many are reluctant to abandon it. As the yen drifts higher -- and chances are it will continue to -- sticking with the position may be too expensive and risky for many investors.
Weak Dollar Policy?
Adding to the uncertainty is Washington's currency policy. For the first time in years, U.S. officials may have a valid reason to rethink the ``strong dollar'' policy. As the U.S. economy weakens further, President George W. Bush's team may figure a lower dollar would help. A formal U.S. policy shift would be among Tokyo's worst nightmares.
What's more, there's reason to think the yen-carry trade bubble is bigger now then it was in 1998. Admittedly, there's no way to quantify this statistically -- it's a purely connecting-the- dots exercise. Yet anecdotal reports suggest a broadening of the trading strategy in recent years to smaller banks and businesses.
South Korean commercial banks, for example, have aggressively marketed yen-denominated loans to self-employed individuals and small- and mid-size businesses. The ministry of finance has expressed concern about the surge in yen-denominated loans amassed at some local financial institutions. Korean borrowers could be in for a rough time if the yen jumped in value.
The yen-borrowing binge poses a different challenge to Tokyo: financial uncertainty. In 1998, when emerging markets were reeling from Russia's economic meltdown, global policy makers learned the yen-carry trade was a bubble to be reckoned with. It suddenly became apparent how many hedge funds and leveraged traders had borrowed cheaply in Japan and taken risky bets in other markets.
When those positions turned against them, investors quickly rushed to repay yen loans, boosting the currency. The lesson for Tokyo was that the yen-carry trade had left the economy vulnerable to the whims of market speculators. That could happen again. |
