YEN STRENGH IS LIKELY TO PROVE SHORT-LIVED / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Yen strength is likely to prove short-lived

By Mansoor Mohi-uddin

Published: March 16 2011 13:38

Visiting clients in Tokyo on Friday I saw the impressive reaction of Japan’s citizens to the country’s earthquake. There was no panic in the streets. People, though clearly fearful of the swaying skyscrapers around them, were orderly and dignified and still ready to help others. The admirable response showed Japan at her best.


The country now faces grave challenges as it deals with the aftermath of the earthquake and the tsunami. In the financial markets, the authorities also need to maintain the trust of investors in Japanese government bonds, restore confidence to the equity markets and prevent the yen from becoming highly volatile.

Foreign exchange participants have been reviewing the experience of exchange rates following the Kobe earthquake in 1995. At the time the dollar fell sharply from around 100 yen to 80 yen as Japanese insurance companies repatriated foreign assets to finance the pay-out of claims at home. This time the reaction in the currency markets has been similar. After an initial knee jerk response higher in the dollar above 83 yen on Friday as news of the earthquake hit the wires, Japan’s currency has again begun to strengthen, testing the 80 yen level this week.


But currency market investors should be aware that the risks of a weaker yen too have also risen in the wake of Friday’s events. First, there are some key differences between 1995 and 2011. The yen is weaker now in trade-weighted terms even though it is trading around the same nominal levels against the dollar as it was in 1995. That helps Japan’s exports.


But the authorities’ room for manoeuvre is limited. The Bank of Japan has already kept interest rates at almost zero for years. The Ministry of Finance has to manage a gross government debt position of more than 200 per cent of gross domestic product.


As a result, investors should expect policymakers to be more proactive in dealing with sudden yen strength. In 1995, the authorities did intervene in the currency markets. But their yen selling was insufficient to prevent a large-scale appreciation. The Bank of Japan was only able to reverse the yen’s rally by massively increasing its ‘Rinban’ purchases of government bonds, a measure of quantitative easing. The central bank’s decision on Monday to flood the markets with liquidity shows policymakers remember the lessons of 1995. Furthermore, Japan’s G7 partners are unlikely to object if the authorities in Tokyo again enter the currency markets to stop the yen from appreciating given the magnitude of Friday’s shocks.


Second, foreign investors in 1995, especially macro hedge funds, held short positions on the yen. As the currency started to strengthen they were forced to close out their positions, adding upward pressure to the exchange rate.


But in the run-up to this year’s earthquake, overseas fund managers have been significant buyers of Japanese equities. Their selling of local stocks and the repatriation of funds abroad now is acting as a check on yen strength.


Third, the impact from Friday’s tragic news is likely to weigh on consumer sentiment and retail sales. Coupled with the inevitable lags in reconstruction, economic activity is likely to flag for the next few months. That is not a recipe for currency strength. Retail investors may also respond to Japan’s shocks by diversifying their portfolios further into foreign assets.


Fourth, a debate may ensue about Japan’s willingness to use nuclear power to meet a significant share of the country’s energy needs. If that results in Japan becoming more reliant on supplies of imported oil, the trade surplus will be affected.


Last, and most importantly, investors are likely to question the long-term health of the country’s public finances.


The rating agencies have so far indicated Japan’s sovereign ratings are not at risk. But the cost of reconstruction will worsen the government’s budget deficit. If growth also slows for the next couple of quarters, Japan’s debt -to-GDP ratio will become more extreme – this is the key risk to the yen.


Before the earthquake struck, the currency was already set to weaken as the European Central Bank signalled it was ready to raise interest rates, the Bank of England considered early rate hikes and the Federal Reserve gets closer to ending quantitative easing.


In contrast, the Bank of Japan is unlikely to raise interest rates this year or next. If domestic investors – who hold around 95 per cent of Japan’s government bonds – start to shift abroad, the yen may depreciate sharply as it did in the late 1990s. The ability of Prime Minister Kan’s administration to pass supplementary budgets through the Diet while retaining the trust of the bond markets will be a key factor in Japan recovering from last week’s events.


Mansoor Mohi-uddin is managing director of foreign exchange strategy at UBS


Copyright The Financial Times Limited 2011