The Economist on Japan 3

The Economist on Japan 3

Out with a whimper

Apr 26th 2007 | TOKYO
From The Economist print edition
Japanese individuals take up where the foreign carry traders left off

TWO months ago, when a sudden burst of volatility broke over the world's financial markets, concern focused on the “carry trade”—the apparently widespread practice of borrowing yen at dirt-cheap interest rates in order to buy higher-yielding assets in America, Australia or even Iceland. The carry trade, analysts and policymakers complained, had driven the yen to unnaturally low levels. Conversely, an all-too-sudden unwinding of carry-trade positions risked destabilising global markets, as everyone rushed for the exits and the yen spiked. At the end of February, such predictions appeared to be coming true: between February 23rd and March 5th, the yen shot up from ¥121 to the dollar to ¥116.

Since then, however—not very much. Most of the world's stockmarkets have gone back to floating happily upwards. Volatility in financial markets has declined. Meanwhile, the yen has drifted back towards ¥119. Curiously, though, the currency's recent slide has taken place without any help from carry traders, whose positions, if anything, are being unwound. It is worth wondering whether the carry trade has been exaggerated.

Admittedly, the size of the market is fiendishly hard to gauge. Earlier this year Hiroshi Watanabe, Japan's deputy finance minister for international affairs, put the trade at $80 billion-160 billion. That the carry trade exists at all is gleaned only indirectly. One clue comes from financing trends among foreign banks in Japan. Whereas loans last year barely grew for Japan's banking sector as a whole, yen financing by foreign banks shot up by ¥7.4 trillion ($64 billion); foreigners are reckoned to be mainly responsible for the carry trade.

Another clue comes from dollar/yen positions in international money markets. As recently as last May these positions, on balance, were long yen, but that changed and in February net short positions reached a record $17.8 billion. Economists at Goldman Sachs in Tokyo reckon that the total size of the yen carry trade is perhaps two to five times the size of money-market transactions, since much of the business is unrecorded, conducted over-the-counter. Assuming the trade's total size to be at the top of the Goldman Sachs range puts the February peak towards the bottom end of Mr Watanabe's estimate.

Since then, however, short yen positions have fallen sharply, to just two-fifths of their peak levels. A great unwinding of the carry trade, in other words, has taken place, but with very little of the predicted turbulence. What is more, a powerful resurgence in the carry trade seems unlikely. For the trade to be tempting to speculators, there must be low levels of volatility and large differentials in short-term interest rates to offset the risk of adverse currency moves. Yet Japanese rates, of 0.5%, look as if they are ineluctably heading up. On April 27th the Bank of Japan (BoJ) will publish its half-yearly outlook, which is expected to be upbeat. The BoJ is eager to “normalise” interest rates, which until a year ago were set at zero to counter deflation. Eisuke Sakakibara, a predecessor of Mr Watanabe's who is now out of government, predicts that the central bank will raise rates to 0.75% as soon as May. Most economists expect a move in the autumn, with another quarter-point rise early next year. Either way, the trend is towards a narrowing of interest-rate differentials, making the carry trade less profitable.

Slowly, attention is likely to shift to a potentially more powerful bunch of market participants: individual Japanese investors. Japanese households have plenty of savings, but for years they have been averse to risk, keeping their savings in low-yielding yen. Now that is changing. These investors are more concerned about long-term yields, and in Japan low long-term rates are unlikely to be much affected by rising short-term ones—ten-year government bonds yield just 1.65% compared with 4.64% for equivalent American treasuries and 5.83% for Australian ones.

This helps to explain a surge in the purchase of foreign securities by individuals, chiefly through investment trusts. Investment-trust buying was ¥12.9 trillion in 2006 (in 2002 there was net selling), bringing their total holdings of foreign securities to ¥45.4 trillion. In addition, retail investors' direct share of Japan's foreign-currency market may be 20-30%, whereas individuals' holdings of foreign currency exceed foreigners' holdings of Japanese securities. The clue to the yen's future, in other words, lies with the little man.