Tuesday, 25 June 2019

Currency Wars

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Japan’s massive money injection has raised fears of a global currency war that could threaten Asia’s economic stability, but there are signs that the market may be overestimating the spill-over effect.

A Japanese flag flutters atop the Bank of Japan building in Tokyo.

Source: Reuters/Toru Hanai

A Japanese flag flutters atop the Bank of Japan building in Tokyo.

It was the sheer size involved in the Bank of Japan’s April 4 announcement that shocked the world. At 18.4% of GDP, the BoJ’s asset purchases under its massive quantitative-easing programme are almost twice those of the Bank of England, and around five times greater than those of the US Federal Reserve, according to Nomura.

Although the jury is still out whether or not a doubling of Japan’s monetary base will lift Japanese growth and reflate prices, the impact of the move on global sentiment is clearly evident.

An immediate consensus has emerged that the BoJ will force large holders out of the Japanese Government bond market and into higher-yielding assets that can only be attained outside of Japan.

There are signs, however, that the speculative investment community has been overly aggressive in pricing in the impact of Japanese offshore investment, and there is even a greater risk that investors are buying up currencies and assets that may not be heavily included in the Japanese shopping list – if and when they do come to the market in a meaningful way.

According to analysts and data from Japan’s Ministry of Finance, the heavy selling that has driven the yen down more than 23% against the US dollar has mostly been from speculative funds outside of Japan. In other words, the global markets are front-running massive Japanese outflows that have not taken place yet.

Japanese institutions, too, have been selectively selling yen and buying risk assets outside of Japan, but not on a net/net basis. In fact, the MOF flow data showed Japanese investors were net sellers of ¥1.14trn (US$11.4bn) of foreign bonds and notes in the week to April 6 – the biggest outflow in 11 months.

Nor has there has been much evidence of higher foreign asset purchases since November 2012, according to Bank of America Merrill Lynch foreign exchange strategist Adarsh Sinha, with Japanese investors, instead, reducing their exposure to foreign stocks (likely in favour of domestic equities) and investment in foreign bonds virtually flat relative to the historical average four-month flow of over ¥4trn.

Anticipation of the BoJ’s bond purchases has crowded out Japanese investors, including life insurers and pension funds, but most of the flow out of the JGB market has been heading into local equities, according to Richard Yetsenga, head of global markets research at ANZ. The Nikkei rose close to 50% from November 16 to April 12.

The global markets are front-running massive Japanese outflows that have not taken place yet

Yetsenga states that the BoJ easing will generate some capital outflows from Japan, as domestic investors flee lower Japanese yields and a depreciating currency, but cautions the trend “will not be anything as powerful as the yen carry trade of years gone by”.

Part of this reflects the relatively low foreign holdings of Japanese assets and the absence of rate differential incentives. However, the biggest reason for this, according to Yetsenga, is the fact that Japan has gone from running a huge current account surplus during the height of the yen carry trade in 2001–07 to current-account neutral.

BofA Merrill’s Sinha puts the heavy buying of emerging-market currencies in the days after the April 4 announcement down to “foreign investor pre-positioning ahead of anticipated Japanese outflows”.

However, will Japanese investors really shift to offshore investments – and if so, where?

The spill-over impact from the BoJ’s aggressive policy is likely to have a substantial impact on the G4 bond markets as investors search for high-rated alternatives. However, Nomura, ANZ and BofA Merrill agree that some emerging Asian countries will also become beneficiaries of Japanese outflows at some stage.

Nomura says the search for carry is likely to push Japanese institutional and retail investors into emerging-market bonds in large and liquid markets covered by sovereign bond indices, with the potential for a significant impact on forex markets in these countries.

ANZ sees strong fundamentals underpinning the Philippines peso and Thai baht, while other beneficiaries include the Indonesian rupiah and Indian rupee. BofA Merrill also sees the rupiah as a standout, while noting that Japanese flows into China are likely to be gradual and drawn out. Even with limited Japanese participation, however, there has been a large speculative move into the renminbi; since November 16, it has risen 25% against the yen and around 0.80% against the US dollar.

China’s central bank has shocked many in the market by fixing the currency at higher rates than bank models predict on an almost daily basis, reaching record highs against the dollar since the landmark revaluation in 2005 even after first-quarter data showed that GDP growth slowed unexpectedly by 7.7% year on year.

As such, there is little sign of a brewing “currency war” between the two major players in Asia, despite lingering political tensions.

China may even silently welcome a weaker yen. Nomura economist Zhiwei Zhang notes that there is limited direct competition between manufacturing industries in China and Japan, while cheaper imports from the latter could actually benefit the former due to the vertical integration of industries, such as electronics.

A stronger renminbi could also help dilute inflationary pressures in China, especially amid signs of speculative inflows after the country’s forex reserves posted their largest quarterly gain since mid 2011 in the March quarter, rising US$128bn to US$3.44trn. Amid a growing number of warnings of the dangers of China’s credit and investment binge, Beijing has signalled a willingness to sacrifice growth for now to pursue a more balanced, consumption-led path, part of which will require a stronger currency.

While Japanese outflows to other markets appear all, but guaranteed, the timing, size and destinations of the investment, as well as the international policy response to the move, are far from clear.

The BoJ’s easing experiment has already created unprecedented volatility in the JGB market, as Japanese investors try to assess how to manage their portfolios following the tectonic shift in policy. Given the enormous, speculative front-running by foreign hedge funds, volatility in other asset markets is also likely to rise, potentially to extreme levels, in the months ahead.

To see the digital version of this report, please click here.

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