Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Paul Tierno.
And I’m Sean Creehan. We’re analysts in the Country Analysis Unit, and our job is to monitor financial and economic developments in Asia. Today, we continue our series Rethinking Asia, as we consider noteworthy and unusual trends in Asian finance and economics.
We spoke with Jesper Koll, head of Japan at WisdomTree, a global asset manager, about Japan’s notable distinction as a global safe haven during times of market stress. Jesper has been following Japanese markets for over three decades, and brings a wealth of knowledge and experience to the topic.
I was really interested to hear Jesper’s explanation of the history behind Japan’s safe haven status and several of the paradoxes at work. Listeners may be familiar with the topic from media coverage during times of global market turmoil. But Jesper helps us unpack the fundamental causes, and the role of investor sentiment. We asked him, for example, why counterintuitively, Japanese assets rally when global anxiety over the Korean peninsula peaks.
Yeah. It’s not what you might typically assume. If Japan is under threat, why would its markets rally?
Alright, let’s get to the conversation with Jesper.
Jesper, thanks so much for joining us today.
Thank you very much for having me.
So you’ve been covering Japan for more than three decades, during a period when the country’s financial markets have developed a reputation as a safe haven. To begin, could you help us define this concept of safe haven and how Japan gained this status?
Definitely. Empirically, when there’s a shock in the world, and whether it’s a financial shock or whether it’s geo-political shock, the immediate reaction is for the Japanese yen to strengthen. And as a result of that, it’s the safe haven status that Japan has. So if the world goes risk-off, the yen strengthens. And it’s interesting that that’s true, whether it’s international events like Brexit for example, or domestic events like the Japanese banking crisis in ’95, or the Japanese earthquake in 2011. Again, the immediate reaction is for the Japanese currency to strengthen.
I think there are a couple of forces at work here. The most important one is that the yen is one of the predominant funding currencies of global financial markets. So, people are happy to fund in yen, and do international positions. But the moment it becomes risk-off, they rush to take profits on the international positions and pay back their yen creditors. And as a result of that, the yen actually strengthens.
And then the second one is, that you do have at least a market perception that Japanese institutions, like life insurance or pension managers, that in the event of a risk-off trigger, that they actually repatriate their overseas portfolios back to Japan. And that, when you actually look at the data, is much more myth than reality. The dominant force driving yen appreciation during global risk-off events is the fact that global speculators, the global short-term speculative macro hedge fund community is cutting their international positions, and repaying their yen creditors.
In your previous response, you refer to the yen as one of the predominant funding currencies of the global financial system. That sounds like a reference to the carry trade. What’s the role of the carry trade in yen appreciation during risk-off scenarios?
It is interesting because the yen, for many reasons, should naturally be an appreciating currency. The reason I say that is really sort of economics 101, in the sense that Japan, number one, tends to be a low inflation economy. So for example, again, in the United States typically, over time you find that the inflation differential is about two, two and a half percent. Which from a purchasing power parity perspective suggests, that if Japan has two, two and half percent lower inflation than the United States, that means that the dollar relative to the yen should be depreciating by about two, two and a half percent. So that’s the low inflation, the low relative inflation profile that the Japanese economy has, gives it a natural currency for the Japanese yen to actually appreciate.
And then, the second natural appreciation force is, of course, the Japanese current account surplus. Which, for all intents and purposes, tends to be pretty structural. So, as a result of that, when you’ve got this risk-off, when you’ve got this flight to safety, the overlying macro arguments are the yen ought to be an appreciating currency because of the inflation differentials, and because of the current account surplus. That serves as a big rationale as well to close out those carry trade positions.
So I guess one thing that maybe makes it easier to understand is that sometimes people will see this rally and they think, oh, people are flooding into Japan as if it’s like a deliberate decision to up an allocation, when it’s really just a retreat from activity that was taking place overseas in the funding currency of the yen, like you say.
That’s exactly right. And you know an easy way to show this is that of course, during periods of yen appreciation, Japanese risk assets, the equity market tends to go down. So it’s not a flight to quality. ‘Oh my god, the world is buying Japanese yen because they become bullish on the prospects for the Japanese economy, or the Japanese stock market.’ No, it’s exactly the opposite. It is cutting international positions and paying back the Japanese creditor, which was the basis of the carry trade anyways.
So I guess a quick follow up, is whether this is always logical behavior. So, maybe in certain events it might make sense, you’re expecting volatility, you return home. But when we say for example, look at tension on the Korean peninsula, isn’t it a little strange to return money home when the increase in anxiety over the current peninsula, that the implied scenario is that there’s some sort of conflict that would hurt Japan. Any yet, when this happens we see a rally in Japanese assets. It does seem a little bit strange.
I’m just wondering how you view that. How it’s seen in Tokyo amongst market participants. I know the Korean won doesn’t necessarily move in the same direction in these recent scenarios. So I’m just curious to hear what you think of that.
It’s very interesting. And again, these tensions on the North Korean peninsula are a great little current case study. And of course, when there is a tension, when there is a missile that’s being fired, when there’s a test that’s being conducted, you do see the yen strengthening and you do see the Japanese stock market selling off. Which again, just tells you that there is a mismatch here because Japanese risk assets, if it really were a flight to safety, if it really were a safe haven, you would expect for Japanese risk assets to actually be going up. Which is not the case.
But there is a second, in the practical world of modern finance. There’s one additional factor that helps to put the yen into this safe haven status, which is liquidity. If you are a global macro hedge fund, the Japanese yen is the only currency in Asia where you really can put on a two, three, four, five billion dollar position without much problem in a very short period of time. While for example, in the Korean won or in the Taiwan currency, that’s a much, much more difficult undertaking.
So Japan’s asset, the currency in particular but also the Japanese stock market, do have a liquidity premium. So, when there is an international crisis, when something is going on and the Asian time zone is the only time zone that is open in terms of trading, you do find that proportionately the Japanese market always takes it harder on the chin because this is where the liquidity positions can be built very aggressively.
I wanted to follow up on one of the things you said, that in these times of crisis while the yen and Japanese government bonds might appreciate or strengthen, that some risk assets don’t necessarily do so. Partially because they’re risk assets and it’s a period of global volatility. But are there any other factors at play? The reason I bring it up is this is meant to be podcast looking at counterintuitive examples, and it would seem somewhat interesting that assets denominated in yen are falling in value while the yen is appreciating. Is there anything else at play in that sort of dynamic?
I think again, it is the ease of liquidity. Specifically, it’s very easy if you’re a global macro speculator, it’s very easy to short Japanese equities. And within Japanese equities, to short baskets like, for example, the banking baskets. So, I think from that perspective, they slingshot almost. If you look at the Nikkei’s volatility, typically it tends to be about 2x of the volatility of most of the other Asian markets. Ironically, I think it is the ease with which you can actually put on speculative positions here in Japan.
Another question, just from the perspective of Japan as a country, is this a good thing, that Japan serves as a safe haven? What are the benefits and what are the disadvantages? I know, for example, during the 2011 earthquake and tsunami the yen and other assets rallied. On the one hand, that could be good if you’re trying to import certain goods and services. But if you’re looking for your export sector to be more competitive, maybe it’s not helpful in a time of what is otherwise a lot of stress. So I’m wondering if you could talk a little bit about that.
There is no question that the yen’s de facto safe haven status, that when there is a crisis the yen appreciates, that that sort of turbo charges the crisis mentality here in Japan. And that’s true for policy makers, as well as for Japanese individuals. Because again, this counterintuitive move, the yen appreciates but your domestic stock market sells off. So, as a result of that, you do have negative wealth effects that actually do feed into consumer confidence.
It’s a very easy correlation to track, that Japan’s consumer confidence or business confidence is very, very strongly correlated to the Japanese exchange rate. So the yen weakening is good for business sentiment because Japan remains a large net exporter. And conversely, the Japanese stock market going up is great for business and household confidence because again, you do have positive wealth effects that actually do come in to play.
So when all of this reverses, there’s a global event like Brexit, there’s a global event like the Korean crisis, there’s a local event like the Kobe earthquake in 1995, or the big earthquake in 2011, you’ve got a double negative whammy that actually amplifies the negativity of the Japanese business cycle because both yen strengthens and stock market falls are compound as a negative.
Along those lines, one of the other stats that belies Japan’s status as a safe haven, is high level of debt to GDP. Typically, when we talk about highly indebted countries there’s an assumption that the debt makes capital flows volatile. And for other countries with high debt to GDP, they experience outflows in times of turmoil. Can you talk about why that’s different for Japan?
You put your finger on the second great myth that we’ve got in Japan. This is an enormous home currency bias. You can look at it, whether you’ve got zero interest rates, whether you’ve got negative real interest rates, there’s not been over last 30 years serious incidences of any sign of capital flight. Quite the opposite. You do have sometimes during periods of home blown crisis, like the Kobe earthquake in ’95, or the tsunami earthquake in 2011, you do have a little bit of net portfolio repatriation here. But the reality is that the home currency preference of the end saver, of the asset owners, is very, very high.
And you are aware that throughout the 1990s there was a lot of attempts to deregulate the retail foreign exchange market, to make it easier for Mr. and Mrs. Watanabe to access international currency. But that did not change the home currency bias of the Japanese people, of the Japanese asset holders very, very significantly. So foreign asset ownership, a non-yen denominated asset still make a very, very small portion of households as well as pension assets in Japan outside of the GPIF.
So to that extent that that behavior maybe slowly changes a lot of efforts ongoing in Japan to increase that risk appetite, to the extent that maybe the next generation does increase the foreign allocation—will that change the dynamic of the safe haven? Will there be less of an investor sentiment during a time of global volatility to return back to Tokyo, to the home market?
Yeah. This is where it gets very interesting. I think right now, I think if you wanted to explain why is there such a high home currency bias in Japan, one of the possible explanations is the age structure of Japan. The older you get, the more conservative you become. The more liquid you want to be. Your ultimate liability is of course, death duties and taking care of your health care needs in old age. The Japanese people, basically they all want to retire. They all want to stay in Japan.
As a result of that, the age profile of Japan given the demographics, makes the asset owners in Japan more conservative. And as a result of that, they’ve got not only a high liquidity preference, but they also have got a very high domestic liquidity preference.
So the stars are really aligned for the safe haven status to continue.
Yeah. Again, you look at the safe haven status there and you’ve got the overlying macro arguments. Look, Japan is a relative to the world, low inflation economy. So the yen ought to be appreciating. It’s got a balance of payment surplus. So again, the yen ought to be appreciating.
On top of that, you’ve got this position of the yen being a funding currency for global speculators. As a result of that, in any period of risk-off, those yen short-term loans are being paid back, which leads to yen appreciation.
Over the past several years, we’ve seen the emergence of a widening cost of hedging Japanese yen. Swapping it into foreign currencies, like the US dollar, for investment purposes. I’m wondering if you could talk about the role of the yen in funding for global investors. How this impacts short-term capital flows and hedging costs? And how it all connects back to Japan’s safe haven status?
Yeah. The market, in that respect, is actually very efficient in the sense of, fine, if you’re a Japanese investor and you do engage in the global carry trade. So you increase your international positions. To hedge those positions, basically that’s where the currency basis, the basis swap comes in to play. And you’re paying slightly more than the interest rate differential that there is. So basically, you’re relying on the underlying asset needs to actually appreciate rather than…because the interest rate differential is more than absorbed by the basis swap there.
It’s quite interesting that the market’s bias is one of always looking for yen appreciation as the default, that’s the way the forwards are being priced.
And Jesper, while we’re on the topic, or going back to the safe haven status-are there any times when the yen and other Japanese assets that you would expect to appreciate didn’t necessarily act as they might have, or act as you might have expected them to?
Well, as any forecaster will testify, there have been many, many times when asset prices don’t behave the way that you expected it to be. But I think that probably a couple of periods stand out. The biggest one, probably is the period after political events happen in the United States of America. The volatility that came through, for example, with the election of the new president. As a result of that, you did have fairly dramatic yen depreciation.
Another period was in Japan more recently, when in the autumn of last year, we got this snap election. Prime Minister Abe, a little bit surprisingly perhaps, won another two-thirds majority. And again, that led to risk-on, and it led to yen depreciation. It’s quite interesting, sometimes where there is a little bit of a disconnect—it’s the other way around. When you do have global political events as a trigger point, or domestic political events as a trigger point to actually increase the global risk appetite. That can certainly catch you off guard quite significantly here in Japan.
Do you see that as well with movements related to China? I’m wondering, you mentioned the liquidity of the yen in various Japanese assets, and just the general use of the yen to react to a lot incidents that maybe may not directly involve Japan. But I’m wondering—you talked a bit about reaction to US presidential election—but I’m wondering, with China, of course massive amounts of investment in China, but still a closed capital account and some limits to renminbi trading. I’m wondering, do you see more and more movements in Tokyo, and adversely against the yen, or appreciation when we see changes in investor sentiment with regard to China.
Yeah. Very, very important. And I think you’ve put your finger on what, looking forward, is going to become more and more important, which is exactly that we are moving from, dare I say, a bilateral relationship where you focus predominantly on dollar-yen, moving towards a trilateral relationship where you’re looking at the relationship between the yen and the dollar, as well as the yen and the renminbi. This is the key going forward.
Like you mentioned, obviously China does not have an open capital account, has a managed exchange rate. And the changes in the fixing, in the daily fixing of the Chinese renminbi do already have a significant impact on the trading here in the Japanese stock market, for example. The fixing happens at 11:30 here in Tokyo time, and this does have a very, very important signaling impact for the Japanese equity market.
And of course, people remember very clearly August 2015 when the People’s Bank of China did devalue its currency in August 2015, and that had a significantly negative impact on Japanese risk assets.
Going forward, I think you’re right, China is incredibly important. And the willingness of the People’s Bank of China to use the currency as an active policy management tool, that comes with a lot of non-transparency. Here in Tokyo, I have a lot of discussions with institutional investors that say, look, the Federal Reserve in America, the ECB in Europe, the Bank of Japan. These are relatively transparent institutions with a very transparent schedule. How and why and when decisions are going to be made is very transparent. While in contrast, the People’s Bank of China has basically no transparency on how, when and why, monetary policy in general, but currency policy in particular is going to be changed. That’s going to be one of the big uncertainties going forward.
So from the perspective of Japan as a safe haven, would the takeaway be that that status will likely continue far into the future? Particularly, to the extent China’s capital controls remain pretty well in place?
That’s exactly right. The volatility exposure of yen assets to global events would only be reduced if and when you actually do get a more liquid renminbi market. When you do get a significant loosening of capital controls in the People’s Bank of China. Between now and then, it is this policy uncertainty in the People’s Bank of China over their monetary and exchange rate policy that actually will amplify further the risk-on, risk-off safe haven status of Japan.
Just as we close out the conversation, I was wondering if you could talk about some other assets, or some other global assets or currencies that may operate along the same lines as the Japanese yen as a safe haven currency—perhaps for some of our listeners who aren’t necessarily as familiar with those currencies. And whether or not those countries share any of the same traits as Japan, and if so, what they are.
As you know, the comparison is always between the Japanese yen and the Swiss franc. In many ways, some similarities in the sense that you do have both monetary regimes very, very aggressive continuing to grow their balance sheets to counter against this underlying trait of currency appreciation. The Swiss franc is also used as a funding currency, given the negative interest rate structure there.
As well as, if you go back over time, again, Switzerland being a relatively low inflation economy with relativity to the rest of the world, having lower inflation, being a funding currency of choice. As a result of that, as global speculative capital, global short-term capital has grown, the slingshot’s developed from taking out loans in Swiss francs or in Japanese yen to fund international positions. Closing out those positions when there is a risk-off event. That sort of led to similar volatility profiles between the Swiss franc and the Japanese yen.
Well, Jesper, thank you so much for talking with us today. This has been a really interesting discussion and hopefully our listeners have learned a lot. I know that we have.
Thank you very much. And thank you much for your work, and I hope we can continue this conversation.
We hope you enjoyed today’s conversation with Jesper. For more episodes like this, you can find us on iTunes, Google Play and Stitcher. If you like what you hear, please leave a review. Feedback from listeners like you will help more people find us. And for even more content, look up the Pacific Exchange blog available at frbsf.org. Thanks for joining us.