no, that was not form him.
nice piece:
A Japanese Tale (continued)
Part 2 – Repatriation and the Dollar-Yen rate
The question to be examined now is the degree to which the US has had to rely on interbank loans to feed the credit spree of the past few years. Japan may well be the prime source of the funds that fed the interbank lending system described in part 1. If they should cease to pump funds into the world's banking system or, even worse, if they begin to call up the interbank loans that provided a substantial portion of the liquidity and easy credit in the rest of the world, a credit squeeze can result, with significant effects on US and other markets.
The answer to the above question would reveal the extent to which the US is vulnerable to a cessation or even a reversal of the flow of funds through the interbank system.
I do not have information of the degree to which US banks have relied of foreign loans to feed demand for easy credit – if that kind of information is even available – but one can begin to make some intelligent guesses. The key to this is essentially two figures: the total amount that has been saved by Americans and the total amount of bank credit extended to individuals and corporations by US banks. From this one could estimate the amount of credit that is supported by actual domestic deposits in the banks. The shortfall between this figure and the total amount of credit to individuals and corporations would provide a guideline to the degree of dependence on foreign interbank loans.
Again, this is a very simplistic approach, but in the absence of any hard information the answer may well be a reasonable ball-park estimate. Unfortunately, a search of the Internet has so far been unsuccessful and the discussion has to continue with a qualitative exploration of the answer and not one based on the actual amounts of savings and debt.
It is known that the American savings rate has been very low during recent years – perhaps 1-2% of GDP is a figure I recall reading somewhere – and the rate is reputed to have gone negative more recently. It would follow that accumulated savings during the past few years are very limited. The other question on the total amount of indebtedness to the banks is less easy to answer.
Many commentators have remarked on a steep increase in private indebtedness over recent years. It has been mentioned that the boom on Wall Street has firstly resulted in substantial borrowing to invest in equities, while many investors have since used their paper profits as collateral for new debt in order to enjoy some of the good things in life that their new-found wealth made possible. I have no information on the extent of corporate indebtedness to the banks – not corporate bonds – but assume that this is not negligible. In a growing economy there is demand for additional working capital and this often comes from bank overdrafts.
It would therefore appear that the US is quite vulnerable to a reverse funds flow in the interbank system that would commence if, for whatever reason, a source of funds at the start of the chain – say, Japan – calls up loans to or deposits in foreign banks. Because few other countries are likely to be in a position to step in and supply new funds on the scale the Japanese have done over the years, the effect on the interbank lending system should be significant and permanent. As a consequence, the US economy will experience a liquidity and credit squeeze that perhaps could turn out to be just as devastating as if the Japanese had repatriated their dollar assets from the US.
Keep in mind that as this process unfolds in the US, there would be a ripple effect that should proceed more like a tsunami. When people are being squeezed by the bank, they will be forced to sell any liquid assets they might have in order to repay their loans. The effect on Wall Street probably will be horrendous. As equity prices fall, banks would realise that even more loans are becoming too risky to tolerate and they will call up these as well. Consumer spending would take dive, interest rates would jump steeply and the sudden credit and liquidity squeeze would snowball quickly, affecting individuals and corporations alike.
At the same time, many investors will seek safety in US Treasuries. The spread between Treasury and other interest rates would balloon and LTCM and the many other hedge funds who have bet heavily on good and sustained growth, financial stability and low inflation to close the spread, would go to the wall in a rush.
The advantage to Japan of following this route to increase the availability of local funds in its financial system is that much of the funding that eventually ended up in the US, where it helped to fuel consumer credit, would have been done through intermediaries, e.g. interbank loans to banks in Switzerland, Great Britain and elsewhere, who then dealt with the US banks. Note that this would have lengthened the chain of interbank loans and thus vastly improved the gearing of whatever funds they pumped into the interbank system. If, for whatever reason, the Japanese have now developed some hidden agenda, this high gearing through intermediaries could assist objectives on that agenda. Further, if a squeeze is put on these intermediaries, Japan's role in what follows would be largely disguised, at least from the popular media and thus from the man on the street.
This long explanation presents another alternative open to Japan to improve cash reserves in their own financial system. This option could be used separately from the alternative solution, i.e. the repatriation of foreign investments, although the amount of Japanese funds in the interbank system may well be too little to offer an independent solution to their problem. It seems more likely that when they eventually are forced to act, this interbank alternative, if employed, would be used in conjunction with other actions.
If push comes to shove in Japan and they are forced to act to ensure the survival of the banking system, they may well elect to begin their campaign on the interbank front. If this alternative is used first, its negative effects through a liquidity squeeze on the world's economy – and that of the US in particular – might later be used by the Japanese as one of the 'reasons' why the repatriation of their funds from the US had become unavoidable.
Now we can continue with the original theme of this letter: what should one look for to determine if and when the Japanese are getting so serious about solving their problem that they are marshalling their financial resources from all over the world.
Traditionally, the single most important indicator is the yen-dollar rate. A stronger yen would indicate that funds are flowing from the US dollar into Japan. There is of course already a sustained flow from the dollar towards the yen through the US deficit on the trade balance. However, the effect of this would be minimal if the surplus earned by Japan soon found its way back into the dollar domain as investments in US securities. The inward and outward flows would then be balanced, with negligible effect on the dollar-yen rate as a result of the trade imbalance.
However, should new investment in the US slow down to a trickle when or even before the Japanese begin to repatriate their US investments, the dollar-outflow due to the US trade deficit would suddenly be added to whatever funds are being repatriated and thus contribute significantly to a stronger yen.
Some 6 months ago the dollar-yen rate stood well above ¥140 to the dollar. More recently the dollar traded below ¥115 – a decline in the value of the dollar of almost 20%. Is this a sign that the Japanese have started repatriation?
While some repatriation is most likely taking place, there appears to be another reason for the strong yen. It obviously resulted from increased demand for yen, but this is probably not due to large scale repatriation by the Japanese. The likely origin of this flow out of dollars into yen lies some 3-4 years in the past.
When the US and Japan reached agreement during negotiations in mid-95 that halted the run-up to a full-scale trade war, it was agreed that steps would be implemented to reverse the trend of a very strong yen against the dollar – then trading around just ¥80. As its contribution towards this objective – and not gainsaying that other, less above board objectives may not have featured on a hidden agenda, because by that time the magnitude of the disaster facing the banking system should have been known to top echelon policymakers – the Bank of Japan (BOJ), from the second half of 1995 started to make yen freely available to financial institutions.
Indications are that this occurred on a really massive scale. To do so, the BOJ acted as banks do, creating large amounts of cash out of nothing. Normally this would be inflationary, but in this case the direct effect on the Japanese economy was negligible, as it seems to have been a condition for most of these loans that the cash had to be used to buy dollars to fund investment in the US.
Of course, Japanese financial institutions grabbed at this opportunity. Given their precarious position, the opportunity to borrow almost unlimited funds at 0.5% interest from the BOJ and invest it in the US to earn 6,5% – the then rate on the US 30-year Treasury bond – was just too good to pass up. Not only would they make 6% on the spread, but there would also be a very welcome capital gain if the yen lost ground against the dollar – which was the objective of the BOJ in the first place.
The second objective of the BOJ, apart from a weaker yen, was to help Japanese financial institutions earn good income on large and cheap loans and even to make windfall profits on the capital when the objective of a weaker yen was achieved. After the collapse of the equity and property bubbles these institutions surely needed all the help they could get. The capital base of the banks' took a hard knock as a consequence of the bad resulting from the collapse and this ploy by the BOJ meant that the profits the banks could reap would substantially augment their depleted shareholder's capital. Provided, of course, that not all the paper profits disappear again before they can be banked!
New demand for US Treasuries out of Japan, on top of good fundamentals in the US, saw yields declining substantially since 1995, reaching lows by mid 1998. This increase in the value of the bonds was the third leg in what turned out to be a triple whammy for the Japanese institutions. A massive spread between cost and income; a large exchange rate profit as the dollar strengthened by 50% and more, and thirdly, capital gains as yields on US Treasuries fell sharply. Not even Father Christmas could have been so bountiful!
However, it was not only the Japanese institutions that grabbed this opportunity to gear up their investments. Hedge funds may not have enjoyed as easy a line of credit to the BOJ itself, but they took advantage of the very low interest rates and good liquidity in Japan to obtain cheap funds in quantity which they could invest elsewhere in the world – mostly through the dollar, I assume, on the basis that it offered the greatest perceived stability and could absorb the largest inflow without undue disturbance to the market.
The potential profits for the institutions and hedge funds were immense. If one excludes the extremes of the move, it is found that in November 1995 the dollar was at ¥101 – already 20% up from its low 6 months earlier – while the US 30 bond was at 6,3%. By October 1998 the dollar was at ¥135, having been above this level since May, while the yield on the US 30-year bond had declined to below 5%.
The currency had provided a gain of about 30% over this period while the bond had appreciated by about 25% in value. The combined gain over this period of 3 years – which excludes the extremes of the moves! – turns out to have been well in excess of 60%. Not bad at all on a loan that costs only 0.5%! Japanese institutions who bought early enough saw a combined gain that reached well above 125% at its peak.
The problem is that the gains have in fact peaked. The firmer yen of recent months and the jump in the US bond rate to above 5% has already taken more than 15% off the exchange and bond market profits that could have been realised by yen investors just after mid 1998.
Two questions arise from this decline in the value of the dollar and US bonds, namely what exactly has been responsible for these recent trends and, secondly, are the declines in the dollar and in the bond market perhaps connected. It would appear from analysis of the timing of recent trends that the stronger yen is probably not so much due to Japanese repatriation as to the hedge funds having unwound at least some of their positions in the US – most likely their investments on Wall Street, as explained below.
Many of these funds must have been nervous in the aftermath of the Asian Flu and its effect on spreads in US interest rates, which almost sank LTCM, and probably hurt many of the funds as well. In terms of the timing of these events, it is important to note that from late July to the end of August – just at the time the dollar began to fall steeply against the yen - Wall Street lost almost 20% in a steep fall. To the already nervous hedge funds, this drop must have looked as if it might become a repeat of the 1987 nightmare.
These were not the only matters of concern the funds had on their minds. Many of the funds are reputed to be quite short in the physical gold market through sales of borrowed gold. When the gold price bottomed out at about $280 and then practically refused to go any lower – in fact, it was tending to rise above $300, which required further short sales and even maneuvers by other interested parties – the funds were caught in a bind. They could not afford to buy back the gold; the amount of gold that has been sold short is too vast to obtain through normal market channels once hedge funds change from net sellers to net buyers. If the funds changed from net sellers into net buyers of gold, the price would already be through the roof before they had really started to accumulate what they need to cover their short positions.
By second half 1998 hedge funds who had some idea of how large the total short position had grown probably were anticipating a roasting in the gold market – unless something really unforeseen happened to flood the market with supply, which must have seemed highly unlikely even to the optimists among them. From whose hoard would 8000 tons and more of cheap gold suddenly appear to get the funds out of their bind?
Given this precarious situation, the prospect of also being hammered on their 'yen carry' deals – as the practice of borrowing cheap yen became known – either through a collapse of US equity prices or a stronger yen, or both, must have been distinctly distasteful to the hedge fund administrators. Luckily, from the perspective of the hedge funds, Wall Street and the yen are much less demand or supply-sensitive than gold, which meant they could close positions in equities and export funds without a total collapse of either market.
One golden rule states that if there is a panic, it is best to panic first. By mid August it was evident that some new market force was pushing the dollar lower against the yen – and doing so despite the poor economic prospects for Japan. It was therefore not so much that the yen had become attractive as that the dollar holding had become distinctly unattractive. Now the funds were going home.
Soon after, push became shove and the dollar declined from its peak at ¥147 on 11 August to ¥130 in early September – a fall in the value of the dollar of 10% in one month, which is large even for a third rate currency. By mid October, when Wall Street had just started its rally that would take it to new all-time highs, the dollar was down to ¥114 for a decline of 22% since August. The combined effect of the weaker dollar and weakness in the Dow meant that yen-investors on Wall Street were down by 28% between 30 July and 8 October. Surely the hedge funds had more than enough reason to panic, sell out and to unwind their positions in US equities in order to repay their yen loans.
One piece of evidence to support this deduction is that from the time when Wall Street confirmed its new bull run in mid October, the yen has remained relatively stable in the range ¥112-114, as if the strong selling pressure on the dollar has suddenly been relieved and may perhaps have been partly offset by new yen-carry funds – anticipating a weaker yen again? – starting to flow from Japan into a stronger Wall Street.
In yen terms, Wall Street peaked in mid July and the US bond market, despite the weaker yen, only reached its high in early October. A steep fall in the yen value of Treasuries since October is largely due to the weaker bond market and relatively little so to a weaker yen. This fact shows the weaker bond market was more the result of a switch in asset allocation from bonds to equities and not primarily the result of a currency play or the repatriation of investments in the US Treasuries – even though one can guess that the more nervous hedge funds and some Japanese unwound at least some of their US bond market positions when yields began to rise steeply in October.
Yet the pressure on the Japanese banks to turn the paper profits of their US investments into hard yen before they lose too much, must also be mounting.
If the Japanese have not yet made any significant repatriations of their US investments nor, by available evidence on interest rates, have they placed a squeeze on interbank loans, under what conditions are they likely to start doing so? If at all. This question is examined in the next installment.
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