Twenty years ago Japan was in the midst of its notorious bubble economy. That experience ended up plunging the economy into a decade-long spiral of recession and deflation, once the bubble burst.
Today, Japan is at the centre of a new bubble. But this time, its dimensions are global, as investors worldwide have borrowed cheaply in yen to finance an investment binge in currencies, stocks, bonds, real estate and commodities, in both advanced and emerging markets.
The so-called yen carry trades (worth $1 trillion upwards in total according to some estimates) are a legacy of the collapse of Japan’s domestic asset bubble in 1990 and of the liquidity trap into which Japan was plunged after that as the Bank of Japan strove to overcome chronic deflation. Many years of zero interest rates in Japan have rendered the yen an attractive currency for financing speculation – by everyone from global hedge funds to Tokyo office workers.
There is widespread concern over those carry trades in which yen are borrowed and then sold to finance investment in assets denominated in other currencies – anything from US Treasury securities to Indian real estate. If they unwind rapidly, the yen could soar from its current level of near 120 to the dollar to 90 or above, says chief foreign exchange strategist at JP Morgan Chase in Tokyo Tohru Sasaki, a former Bank of Japan official. This could wreak havoc not only on Japan’s economy but on already twitchy global markets.
On watch
Bank of Japan governor Toshihiko Fukui has warned meanwhile that “in the event of a substantial increase in the amount of yen carry trades and drastic changes in the outlook for interest rates, the carry trades could be quickly unwound.” The BoJ is “watching the situation very vigilantly because of the considerable risks”, Fukui told Japan’s parliament recently.
IMF managing director Rodrigo de Rato has also voiced concerns. The build-up of carry trades reflects big interest rate differentials between Japan and elsewhere, he noted on a recent trip to Tokyo. (Japanese short-term interest rates stand at just 0.5%, whereas the US Federal funds rate stands at 5.25%.) De Rato warned those borrowing yen to invest in high-yielding currencies (such as the US, Australian and New Zealand dollars) that “things can change very quickly, and the carry trades may not be here forever.”
Citibank president and CEO William Rhodes argues that “yen carry trades have facilitated the buoyant expansion of investments and leverage evident everywhere today.” The Institute of International Finance (IIF), of which Rhodes is first vice-president, says that capital flows into stocks and bonds, plus bank loans and business investment in 30 emerging markets around the world, reached nearly $502 billion last year, only slightly below the record $509 billion in 2005, and will stay high this year.
The way in which the yen has become caught up in what was once the speculation-financing role of currencies such as the Swiss franc is a tale of almost Byzantine complexity. After being hiked rapidly at the end of the 1980s by the Bank of Japan, which was desperate at that time to rein in a colossal asset boom, Japan’s short-term interest rates were quickly scythed again once the bubble collapsed. They then stayed on the floor for a decade and a half.
Down to zero
In 2000, the BoJ dropped its key overnight call rate effectively to zero and the same time flooded the banking system with liquidity to ward off a threatened systemic financial crisis. This zero interest rate policy was preserved right up until July 2006, except for a brief interval when rates were raised fractionally in 2001, only to be cut again as the Japanese economy fell back into a new trough of recession and deflation.
Even after Japan’s economic recovery began in 2002 (mainly because of booming demand from China and the US), interest rates stayed low. Former prime minister Junichiro Koizumi pressured the BoJ to keep them that way to fend off deflation and to enable the Japanese government to continue servicing its huge debt (equal to 150% of GDP). Koizumi’s successor, Shinzo Abe, stepped up the pressure when he took over last September, because he faced elections and did not want the BoJ taking action that could derail economic recovery.
Investors came to believe that zero interest rates were a permanent feature of the Japanese financial landscape, and that it was safe to use yen for financing carry trades. The yen became the currency of choice for financing international investments, and Japanese savers too began pouring money into foreign stocks and bonds yielding much higher returns than yen assets. All this resulted in huge capital outflows from Japan. Not only were Japanese individuals, as well as investment institutions, pouring money into foreign securities, but hedge funds and all manner of other funds were also borrowing cheap yen, only to sell them again so as to finance investments denominated in other currencies.
Japanese authorities found that they no longer needed to make the heavy interventions in currency markets that they had undertaken to prevent yen appreciation for several years up to 2003, which they argued would worsen Japan’s deflation problems. Markets were doing their work for them, and so official intervention ceased abruptly. The yen went on to fall to a 20-year low in trade-weighted terms, a record low against the euro and a four-year low against the dollar.
While all this pleased a Japanese government that could look virtuous compared to China (which continued to intervene heavily to keep the yuan within prescribed limits), it worried Fukui and some other BoJ policy-makers. Even though consumer price inflation in Japan remained very modest, asset inflation began to take off, in the form of rising land prices (by increments of 30-40% annually on prime sites in Tokyo), and there were corresponding rises in property prices.
Daring move
Braving a political storm, the BoJ’s policy board finally abandoned its “quantitative easing” policy last July, under which it had flooded the Japanese banking system with excess liquidity for five years. Taking an even bolder step, the policy board abandoned the zero interest rate policy last September and raised the overnight call rate to 0.25%. Leaders of Abe’s ruling Liberal Democratic Party threatened all kinds of reprisals against the BoJ, but Fukui held firm and raised the rate by a further 25 basis points, to 0.5%, in March this year.
A sharp setback in global stock markets followed a few weeks later, and while some blamed this on a sudden drop in the Shanghai stock market, others detected an unwinding of the yen carry trades. Their reasoning was that Fukui had challenged market perceptions about the permanence of zero interest rates in Japan, and at the same time US Federal Reserve chairman Ben Bernanke had begun to move toward a dovish stance, with the next Fed move on interest rates likely to be on the downward side. The gaping interest rate differentials that had given birth to the carry trades appeared to be eroding.
Asian Development Bank president Haruhiko Kuroda, a former Japanese vice-finance minister for international affairs, notes that “there has been some unwinding of yen carry trades but a real unwinding is yet to come.” He adds that the carry trades will not easily unwind, but changes in economic fundamentals could prompt a reversal. The carry trades “cannot go on for ever. The US economy might slow further, or Japan, where inflation is near zero, could see interest rate changes. In these cases, carry trades could unwind.”
Many people stand to get their fingers burned if they do unwind. JP Morgan’s Sasaki says that part (several trillion yen) of what he estimates is the 40 trillion yen ($335 billion) of carry trades outstanding is accounted for by Tokyo “office ladies” and others taking short-term positions in foreign exchange via Japanese brokers. The bulk of the carry trades, however, are represented by longer-term positions by Japanese investors in foreign currency bonds and in real estate lending overseas.
Sasaki’s estimates do not include the many derivative transactions linked to yen carry trades, and some economists argue that when these are factored in, the true size of speculative transactions involving the yen is probably anything between $500 billion or even $1 trillion and over. No one knows for certain the true size of the carry trades, but there is a growing consensus that they are large enough to spell trouble at some point. An earlier unwinding of yen carry trades in 1998 caused the yen to surge by 15% against the dollar within a matter of days, and some say this was a major factor behind the Russian financial crisis at that time.
Pivotal questions
The critical questions are, where do Japanese interest rates go from here, and will rising rates in Japan meet US rates on their way down? JP Morgan’s Sasaki believes that the yield differential between the yen and dollar would need to fall below 3 percentage points (instead of 4.75 at present) in order to precipitate a collapse of yen carry trades. But analysts agree that the BoJ is going to have a tough time justifying further rate rises from here on, in the light of recent economic data.
BoJ governor Fukui has made it clear that he wants to raise rates “proactively” and in small but regular increments in order to stave off various perceived threats to monetary stability in Japan. Apart from fears of another real estate bubble developing in Japan’s major cities (there are currently more than 90 skyscraper developments under way in Tokyo alone as developers take advantage of cheap borrowing), Fukui worries about a bubble in corporate capital investment developing on the back of ultra low interest rates.
But on the consumer price inflation front, things hardly favour further rate increases. After crawling at an agonizingly slow rate back into positive territory in 2005, following several years of continuous decline, consumer prices in Japan were back in negative territory by March of this year (minus 0.2% compared to February). “Consumer price inflation is clearly back in negative territory and could remain there for much of the coming year,” says chief economist Richard Jerram at Macquarie Securities in Tokyo.
“We have been looking for two more rate hikes by the end of fiscal year 2007, but that looks more difficult now,” he adds. Even if the BoJ does not hike rates again soon, the danger of an unwinding of yen carry trades remains. Market volatility has returned after several years of relative stability that favoured a build-up of carry trades. “This may be changing the picture for the market where carry trades have dominated,” says Minoru Shioiri, senior foreign exchange trader at Mitsubishi UFJ Securities in Tokyo. There is a bubble in foreign exchange markets and it could burst eventually, adds Sasaki.