Commentary / Japan

Why global speculators love the yen

by Jesper Koll

The Japanese yen is the sweetheart of global speculators. Speculators loath uncertainty but thrive on calculated risk, and the yen offers unparalleled favorable odds for fast-paced global money managers.

Incredible but true, it is with almost 100 percent certainty that any new crisis or sudden bad news in global markets will force a sharp yen appreciation. This was true for the Brexit shock, the recent trade war fears, North Korean missile tests, Japanese earthquakes — you cannot find a global shock that did not result in an immediate surge in the yen. There is no other asset class in the world that offers as much predictability, which is why the yen is loved by speculators around the world.

For Japan, the extraordinarily high sensitivity of its currency to global events is a serious problem. As a de facto lightning rod for global thunderstorms, the yen’s rise brings local disaster. In fact, every economic downturn over the past five decades was preceded by the yen’s appreciation.

There is a clear cause and effect: Almost two-thirds of Japanese companies’ profits come from exports or global sales (through offshore production). So when the yen gets stronger, those overseas earnings translate into less yen.

Clear speak: Corporate Japan’s profits take a big hit when the yen goes up; a ¥1 appreciation cuts profits by almost a full percentage point. This is where the vicious cycle starts that leads from yen appreciation to recession. Lower profits quickly translate into lower bonus payments for Japanese employees, which depresses consumer spending.

In addition, lower profitability for large exporters quickly forces them to demand price cuts from local suppliers and merchandisers. In Japan, the link between large multinationals and local small and medium-size companies is very close. A negative and deflationary feedback loop is quickly started if the yen’s appreciation is sustained.

The negative impact of yen appreciation on corporate profitability is why there is such a strong negative correlation between Japanese stocks and the currency. Almost 90 percent of the time, the yen’s appreciation forces Tokyo stocks to drop. Again, investors and speculators love this sort of high probability and steadfast causality. Yes, it is good investment advise: On any signs of global troubles, go long on the yen and short-sell Japanese stocks.

This is why it is wrong to describe the yen as a “safe haven.” A safe haven has positive connotations. It implies that you bring your money back home and park your assets in local securities that will appreciate or at least hold their value. Yet exactly the opposite happens: The yen’s strength pushes Japanese stocks down, triggers an economic downturn and forces deflation. Nobody in Japan wins, unless you can short-sell Japanese stocks.

Unfortunately, to break out of the vicious circle from yen appreciation to domestic asset deflation will not be easy. To cut the first link — the link between global crisis-induced “risk off” and yen strength — would require the imposition of capital controls, i.e., cutting off yen-funding for short-term speculators. Given the yen’s role as a global funding currency — Japan is back at being the single largest holder of U.S. treasury debt — capital controls as a means to enforce currency stability are not an option for Japan (unless you want to trigger a global financial crisis).

In contrast, cutting the second link — the one between the yen and the stock market and the economy — is possible. Two counter forces can be mobilized: domestic corporate strategic restructuring away from industry toward services, and household asset portfolio rebalancing.

Corporate strategic restructuring away from industry to services could break the link between currency appreciation and profitability by raising domestic market-generated profits. Profit margins at home in Japan are well below global standards because of dismal capital efficiencies at services sectors and a shortage of listed service sector companies. Japan is ripe for a service sector revolution, with the combination of new technologies and new customer needs forced by demographic change poised to deliver an entrepreneurial and investment boom in services around Japan. The more profitable the domestic service sector gets, the more service companies list on exchanges and grow, the lower the overall dependency on old-economy exporters’ profits will get.

To get there, special economic zone initiatives for health care, finance, tourism, hospitality and integrated resorts, sports, design and entertainment, etc., should be encouraged more aggressively. Any entrepreneurial endeavor that focuses on postindustrial services should be promoted with tax incentives and seed capital from public-private investment partnerships.

Second, to counter the short-selling of the stock market triggered by the yen’s appreciation, Japan needs to mobilize another buyer. Here, the obvious source of purchasing power is retail money, the vast savings pool of Mr. and Mrs. Watanabe. Again, tax incentives encouraging equity investments could be used, as well as the removal of certain disincentives like, for example, the current unfavorable death-tax treatment of equity portfolios passed from one generation to the next.

However, the biggest change required comes from Japan’s financial services industry. Current practices and product offerings are not only limited in choice but come at a very high cost: For the average retail investment fund sold in Japan, the all-in cost for the consumer is almost four times what it is for an American retail investor. So a big reason why Mr. and Mrs. Watanabe prefer bank deposits over investment trusts comes down to the rational price consciousness of consumers. Make no mistake — Japan’s financial institutions will have to offer more cost-effective investment products to mobilize household savings away from deposits.

Without new products and better sales practices, Japan won’t be able to break the vicious circle that leads from the yen going up to the stock market going down. For Japan to de-couple from global speculators’ whims, Japanese assets must become more loved by Japanese investors.

Jesper Koll is WisdomTree’s head of Japan. Researching and investing in Japan since 1986, he’s been consistently ranked as a top Japan strategist/economist. He publishes blogs at www.wisdomtree.com/blog .