Interview question: As the European crisis intensifies,
fiscal cliff approaches, Chinese growth starts slowing and risk assets take a
dive, in which currency would you park your money?
The consensus answer seems to be the Japanese Yen (JPY). It has appreciated almost 8% from its low against the US dollar in mid-March. Bank of Japan’s refusal to ease further for the time being may account for some of this bounce. However, the Yen’s behaviour is consistent with the Pavlovian market response when the switch is flipped to risk-off.
Apart from renewing headaches for Japanese policymakers, JPY appreciation provides a false sense of security to investors by instantly validating their investment thesis. Investors are falling into the behavioural trap that since buying JPY in moments of crisis has worked before and seems to be working now, it will always work.
To determine whether buying JPY as a safe haven is sound strategy requires some analysis. This requires comparing Japan against the following three main characteristics which define a safe haven currency:
- Political stability and certainty
- Sound fiscal and monetary policy, i.e. policies which are sustainable and do not debase the currency
- Macroeconomic structure and outlook, i.e. resilience to shocks, ability to quickly bounce back from recession and good growth prospects
The first two are necessary to attract short-term safe haven flows. All that investors care about is preservation of capital until a crisis blows over. This desire also explains why government bond yields for countries which face significant long-term challenges have gone negative. The third factor operates over a longer-term and determines whether capital brought in during a crisis will stay and whether more capital will be forthcoming after the crisis is over.
it satisfies only the first condition of political stability and certainty.
Even that is actually a weakness as stability has turned to sclerosis with an
inability to break the deflationary status quo. Fiscal and monetary policies
being pursued are far from what is desirable in a safe haven.
Graph 1: Debt by a thousand deficits
Key: Size of the circle indicates the difference between real interest rates on government debt and real GDP growth. Higher the difference, bigger the circle and more onerous the interest service.
The argument made to defend this gigantic debt burden as sustainable is the fact that it is held largely by the Japanese and is denominated in JPY. Therefore evil speculators and foreigners cannot manipulate a sell-off causing a self-fulfilling debt crisis like the one in
Europe. A large stable base of debt holders may be a
necessary condition for debt sustainability but it certainly is not a
sufficient one. Ultimately debt has to be repaid and this requires growth. Growth
is the one thing that Japan
has desired without much success for the past two decades. At the current level
of debt, it is highly likely that bond holders suffer real losses even if they
get back their nominal investment.
Along with fiscal policy, the soundness of monetary policy is also under question. The Bank of Japan was the first to venture into quantitative easing (QE) in 2001. In April this year, it increased its asset purchase program by 10 trillion Yen to 40 trillion. While Japanese conservatism makes this a relatively small amount as compared to the ammunition deployed by Ben Bernanke, the more popular debaucher of currencies,
stock in relation to its GDP is huge. Japanese M2 money stock (currency in
circulation and deposits) currently stands at 175% of GDP. In contrast, Fed’s
QE has only managed to boost M2 to 68% of GDP. It is also much higher than
other developed countries as Graph 2 shows. Moreover BoJ’s asset purchases
unlike the Fed’s are not confined to government bonds and MBS. The asset
purchase program can also buy corporate bonds and equity enhancing the risk
taken by the central bank. Purely from a monetary perspective, Japan’s situation is closer to the UK,
whose currency is certainly not a safe haven.
Graph 2: Money, money, money, it’s a printing bank’s world
Graph 4: Decidedly less elastic to global growth
In conclusion, JPY does not satisfy the metrics for being a safe haven. The precarious state of its public finances combined with loose monetary policy which cannot be tightened means that the adjustment has to come through currency depreciation. In addition the state of the economy and aging population is unlikely to attract investment. A Chinese slowdown and decline in global demand will worsen the terms of trade putting further pressure on the Yen. Investors rushing blindly into JPY as a safe haven may find out too late that they have instead put their money into a Ponzi scheme.
Post-script for short-term traders:
Even if short-term trading horizons justify buying JPY against USD or other currencies (except EUR) to play momentum, a contrarian position is likely to be much more profitable at this juncture. This is in light of the fact that the downside to being short JPY (especially against USD) is substantially lowered by expected intervention. And the probability of intervention increases with JPY strength.