Those who see the Japanese yen weakness of recent years as a permanent market feature argue that it reflects a structural shift, driven by the belated diversification of Japanese household financial assets into overseas markets.
Households are perceived as moving savings into higher yielding overseas assets, and in the process keeping the yen under persistent downward pressure. If this is true, and there is certainly anecdotal evidence of heightened Japanese retail investor interest in emerging market assets, then there is little prospect of yen recovery until this diversification is complete, or until returns on Japanese assets move back closer to international levels.
However, if yen weakness is being driven primarily by yen borrowing designed to facilitate a variety of carry trades, the yen weakness could unwind rapidly if risk appetite declines. Using the Bank of Japan's flow of funds data, it is possible to see if there is any hard evidence one way or the other.
From this analysis, one finds that although Japanese household savings are very large, direct flows into overseas assets have been very small. There have been much larger outflows through financial intermediaries, which may reflect some Japanese household diversification. However, bond flows seem to be small relative to both equity and short-term loan flows. This suggests that yen weakness has, in part, been a reflection of global equity market strength rather than carry. It also suggests that a significant proportion of yen carry trade is expressed through short-term loans which could be rapidly reversed.
The Bank of Japan produces flow of funds data on a quarterly basis that measure the financial flows between various sectors of the economy and the types of assets involved. It also produces data on the stocks of outstanding financial assets and liabilities by sector. The latest data refer to Q1 2007.
Looking at this data, total net financial assets were enormous, at around JPY1,100tr (US$9.3tr) at that time. The major asset holding was in currency and deposits, followed by insurance and pensions' assets, shares, and other securities. The major liability was in housing loans. The striking feature of this is that currency and deposits make up more than two-thirds of net financial assets, which suggests that Japanese households are very conservative asset managers.
Direct holdings of overseas assets were small at JPY13.1tr (1.1%) of net assets. It is clear then that Japanese households are not very active direct players in overseas asset markets. However, households certainly have been acquiring overseas assets through financial intermediaries (banks, insurance companies, and investment trusts). By far the largest acquisition has been made by financial institutions, with around JPY 110tr (US$900bn) flowing overseas over the period.
Within the financial institutions, the strongest flow has been from stock investment trusts that have acquired a cumulative JPY43tr in overseas assets since 1998. Bond investment as a category has actually been negative during the period, but much of the insurance company overseas investment has probably been in bonds, so there has undoubtedly been an increase in Japanese household indirect holdings of overseas bonds. However, it has been investment in overseas equity that has been the dominant flow, and this probably has more to do with the strength of the international equity markets since 2003 than with carry trade considerations.
If equity outflows have been important in yen weakness then there should be a relationship between equity market performance and the yen. Since the beginning of 2006, the yen has had an increasingly close inverse relationship with the equity market. The equity market reversals of May 2006 and February 2007 were both associated with yen strength, and the recent setback has also seen the yen recover.
The strength of this relationship in recent months has been unusually strong. The average correlation between mid-1999 and mid-2006 was close to zero, but it is currently about 70 per cent (stronger equities mean a weaker yen), which may well reflect the importance of Japanese outflows into the equity markets.
Another significant feature of the Japanese capital export in recent times is the proportion that has been in the form of short-term loans. These have been running at about JPY3tr per month recently and account for the vast majority of all Japanese capital exports.
To some extent the build-up of short-term overseas loans may be a reflection of the size of the carry trade, though it is impossible to identify from this whether Japanese or non-residents have been the major players. However, given the nature of the flows, they are likely to be unwound at some stage, suggesting upward pressure on the yen at that time.
Looking at the interest rate, at the policy board meeting in January of this year, three members opposed the continuation of support for an overnight call rate of 0.25%, and in February, this rate was raised to 0.50%. It was expected that the interest rate will be raised again in August. However against a backdrop of turbulent financial markets the Bank of Japan acted on the side of caution and did not raise interest rates.
However, a hike later on in the year to 0.75% is still expected. Should the Bank of Japan increase rates, then this should see the yen recover further in the way it did last February.
This report was compiled by Peter Calleya, manager Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.