THE ART OF YEN: and how New Zealand’s economy may disappear down a Japanese black hole
Financial commentators like Investigate’s own Peter Hensley have been warning for months we’ve been living on borrowed time. Now, as SELWYN PARKER discovers, a ten billion dollar chicken might be coming home to roost and it will hit homeowners and workers alike with eggs that are anything but golden
Mr. Watanabe is a well-paid, middle-ranking executive in a foodstuffs distribution business in Nagoya with a lot of disposable income. Like most of his compatriots and unlike most New Zealanders, he’s a saver who likes to invest some of his money in liquid assets such as bank deposits, Bank of Japan bonds and other conventional instruments. Trouble is, for the last four years, it’s hardly been worth Mr. Watanabe’s while to put his spare cash into his own country’s banks. Interest rates on deposit accounts are low and the Bank of Japan, alone among the big central banks, has paid practically nothing on its bonds. Its governors have their reasons, as we see later, but the Bank of Japan’s zero-rate policy left Mr. Watanabe and millions of other thrifty Japanese with a problem. Namely, how to get a decent return.
A big part of their solution, as NZ finance minister Michael Cullen knows only too well, was to buy New Zealand dollars in what we call uridashi – or ‘bargain basement’– bonds. It’s known as the yen carry trade. By borrowing yen at a paltry rate of around 0.30 per cent and buying kiwis paying around seven per cent, Mr. Watanabe and his fellow retail investors are clocking up a handsome 6.7 per cent return before transaction costs.
Until three years ago, nobody worried too much about uridashi kiwis. Indeed Mr. Cullen and the Reserve Bank welcomed these torrents of yen; all small countries need as much foreign investment as they can get. But as the uridashi flows grew bigger and faster, they prompted well-publicised panic visits to Tokyo to try and stem the torrent. But still it’s kept on coming, like the overflowing water in The Sorcerer’s Apprentice. At November, about NZ$40bn was held in uridashis. It’s nearly all short-term money with a life of one to three years. Over NZ$10bn worth of uridashi bonds are due to be redeemed – effectively cashed in – during 2007.
THESE are uncharted waters. New Zealand has never been in this situation before, and nor has the rest of the world. Reading between the conscientiously objective lines of a central banker, Reserve Bank governor Dr. Alan Bollard and other senior staff are worried. Citing the “high level of ‘cyclical’ liquidity” in our foreign exchange markets, Dr. Bollard explains how delicately balanced is the situation. “Given the reliance on foreign capital [i.e. uridashi kiwis and the related but longer-term eurokiwis], any rapid change in global perceptions of New Zealand’s credit-worthiness would dramatically alter the cost of capital” he warned in November’s financial stability report.
That’s central bank-speak for “there’s a problem out there”.
In short, uridashi bonds are hot money and, when or if they turn, they will likely turn fast with dramatic consequences for New Zealand. As the Reserve Bank points out, just one consequence would be higher interest rates all around on everything from mortgages and credit cards to farm loans and hire purchase. Another would be a sharp fall in the equity markets.
Beyond New Zealand, some even forecast a melt-down as the yen carry trade runs out. “It’s going to be ugly” predicted David Bloom, a currency expert with HSBC bank not normally noted for his gloomy views, earlier this year. Political economist Lyndon LaRouche, who is known for a degree of pessimism, fears the worst, foreseeing “a hit with a magnitude far beyond any individual nation or currency”.
Even sober pundits like Morgan Stanley chief economist Steven Roach see bubbles resulting everywhere from the global, carry-trade borrowing that has blown out prices for assets – that’s, everything from kiwi dollars to commercial property in central London. In the City of London, where many billions of cheap yen have been converted into sterling and other currencies and re-invested in these assets, you can sense the growing nervousness. “Yen carry trades are a risky game”, warns currency market expert John Authers of the Financial Times.
Another small nation has already been through it. Iceland had run short-term rates even higher than New Zealand, up to 10.75 per cent, and been flooded with yen-based speculation on its krona. When credit-rating service Fitch down-graded Iceland’s sovereign debt in March, in part because of concerns about the carry-trade, the money promptly fled. As a result the stock market plunged 20 per cent in a day and the krona collapsed eight per cent in 48 hours.
There’s hardly a single respected authority in The City or in the central banks who doesn’t think the yen carry trade will unwind sometime next year. The question is when, and how violently. The big worry is that nobody knows the size of the yen carry trade and therefore the effects of a collapse are unpredictable. Measured in US dollars, it’s certainly billions and possibly trillions. Most authorities hope for an orderly phase-out but some fear the worst. “The entire global financial system is on the verge of disintegration, as a result of the imminent collapse of the yen carry trade”, predicted the Daily Telegraph, not normally a doom-saying newspaper, back in February.
But let’s get back to Mr. Watanabe and New Zealand.
IT ALL started soon after the millennium, almost imperceptibly. To fire up a chronically flat economy after nearly a decade of deflation, the Bank of Japan, the main culprit, started handing out what was effectively free money. The intention was benign but nobody expected the result. Quick to spot an opportunity in the currency markets, the relatively new breed of investors, the hedge funds or “hedgies” in the trade’s parlance, started borrowing yen at give-away rates and buying up higher-return assets elsewhere. In effect, the Bank of Japan became unofficial lender of first choice to the world.
The hedgies and other big borrowers weren’t however just buying toll-roads, commercial property, ports, airports, commodities such as gold and silver and other normal assets with this cheap money. They also began to purchase and hold as assets great swathes of higher-rate currencies. Foreign-exchange traders, the reef fish of the banking sector, have done this on a daily basis for years, but the actual holding of currencies as an asset class was an alarming new phenomenon for many central bankers.
At first the currency of choice was the greenback in the form of US treasuries – T-bills in the trade. But the “spread”, or margin, on T-bills was only a few basis points and, ever opportunistic, the hedgies looked elsewhere and started gobbling up bonds in high cash-rate countries such as Iceland, Brazil, Australia and New Zealand. The carry trade had reared its head.
About the same time, uridashi investors like Mr. Watanabe entered the scene, often holding only a few thousand dollars individually but collectively adding up to billions.
THE kiwi soon acquired the doubtful accolade of one of the carry-trade currencies of choice, largely because of its high official rate. This is largely driven by New Zealand households’ insatiable appetite for debt but uridashi investors don’t really care about the factors that create high official rates. They are just looking for high-yielding assets in a world of low inflation. By late 2004, about NZ$4bn worth of uridashis had been issued. In general the Reserve Bank still welcomed the foreign investment. After all, Japanese investors had been here before with the samurai bonds of the mid-nineties. And it’s generally good for debt markets to be liquid.
But in 2005 it all started going through the roof. By the middle of the year, the value of uridashis was approaching NZ$8bn. By the end of 2005, it was NZ$10bn. Over August, October and November, more uridashi bonds were issued in kiwis than in any other currency, more even than the mighty greenback and the much more stable Aussie dollar. In October alone, an incredible NZ$2.5bn of uridashis were snapped up, the highest monthly amount on record. Clearly, something was going on; foreigners were hardly buying the kiwi dollar for its long-term prospects and underlying strengths.
It was about now that the Reserve Bank began to worry about the de-stabilizing effect of all this short-term money. By the end of 2005, nearly NZ$45bn of uridashis were outstanding. And half of that was in the hands of Japanese retail investors like Mr. Watanabe, a class of investor prone to sudden changes of mood.
As the Reserve Bank noted with typical understatement: “Given the small size of the New Zealand government securities markets relative to those of the major economies, flows of these magnitudes stand out”. The problem was that all this attention is driving up the kiwi to abnormal levels relative to other currencies.
ACROSS the Tasman, the Reserve Bank of Australia has been tracking a phenomenon that, technically speaking, isn’t meant to happen. As Guy Debelle, head of the RBA’s international department, remarked in November, the carry trade flies in the face of accepted theory. This says that any positive interest differential between two currencies is generally negated by the risk of the currencies moving against each other over the life of the investment. Remember, the carry trade is built around holding the currency, not flicking it on overnight. As Debelle said: “In contrast, those who undertake carry trades do not expect the exchange rate to wipe out the interest differential [and] sometimes they even expect the converse, namely that any exchange rate move will increase the value of the investment”.
The Aussie dollar has survived four years of exposure to the yen carry trade without suffering in general the degree of volatility that has characterized the kiwi. This is partly because uridashis represent a much smaller proportion of the Australian economy than they do in New Zealand. However between April and June of 2006, even Australia got a glimpse of what can happen. That occurred when the Aussie depreciated against the yen. Almost immediately, there was a sharp sell-off of uridashis by nervous Japanese investors.
WHAT makes the kiwi more vulnerable than its big brother across the Tasman is New Zealand’s massive current account deficit, standing at 9.5 per cent of gross domestic product. Even the Reserve Bank calls it “very substantial”. Some of the worst savers in the western world, New Zealand residents have spent – and, admittedly, in some cases invested — more than they have saved in every single one of the last 33 years. Like any household that has overspent and faces a “funding gap” in finance talk, this hole has to be filled somehow and it’s foreign debt that has done it. By November, New Zealand’s net foreign liabilities stood at around 80 per cent of gdp, a truly alarming number by the standards of conventional economics. And the percentage continues to rise.
As the Reserve Bank and everybody else acknowledges, this puts New Zealand in a precarious position from what is known as “rollover risk”. What if all those uridashis are not refinanced at more or less current rates? An added danger is that a lot of our foreign debt is short-term. “Around half of all New Zealand’s debt liabilities have maturities of less than one year”, noted the Reserve Bank’s financial stability report in November. Right now, there’s an overhang of uridashis looming over the market, with about NZ$10.2bn of uridashis coming due over 2007.
It’s not all bad. About 40 per cent of all that foreign debt is held in New Zealand dollars, which protects the kiwi somewhat against the vagaries of international currency movements. Also, some of the debt has been raised by the overseas-based parent banks of our local institutions and they are skilled at managing down interest rates to competitive levels.
But the important point is we’re in the hands of foreigners. If in the coming months, they take a view that lending to New Zealand is a riskier proposition, we have to expect an abrupt, possibly crippling, rise in domestic interest rates as uridashi investors take fright.
BUT just what factors would conspire to scare Mr. Watanabe? The most important one by far is a change in the policy of the Bank of Japan that would make yen more expensive to borrow, threatening the interest-rate gap between the yen and the kiwi. And it’s already happening. The Bank of Japan has started tightening money, draining out of the system the liquidity that has sustained the carry trade. By some estimates the central bank has sucked up 20 per cent of domestic money supply since March 06 when it first signaled an end to the weak yen. The last thing a yen carry-trader wants is a stronger yen, but ominously the Japanese economy is growing again.
Interest rates are also rising, albeit slowly. In July, the Bank of Japan hiked base rates to 0.25 per cent, the first increase in six years. However as currency market expert John Authers points out, “only a brief pick-up in the yen can inflict nasty losses”.
But there’s a bigger and more menacing picture and it’s called leverage. The yen carry trade is based on it. Mr. Watanabe may be quite happy with his six per cent margin between the yen and the kiwi, but the hedgies aren’t. They “gear up” massive yen borrowings to multiply the interest-rate margin in the search for “alpha” – vastly superior – returns. Assume a hedge fund has US$100m in capital to invest and it borrows US$1bn, giving it a ten-fold increase in available funds. The financial scientists now buy their US$1bn worth of yen at, say, 0.35 per cent and buy kiwis at 7 per cent for a return before charges on swaps and other instruments of 6.65 per cent. Multiply that by ten and you get 66.5 per cent. That’s leverage.
But of course, leverage applies in reverse. When the worm turns, massive gains turn into massive losses. And that also could already be happening, as the relationship between the yen and the greenback shows. This link is a big factor in the carry trade, even for uridashis, simply because so much of it is based on the US dollar.
Since the beginning of 2006, the yen is up 1.9 per cent against the dollar, which erodes much of the carry-trade profit. That makes it hard for hedge fund managers to sleep, especially after the Amaranth hedge fund dropped US$5bn in October by betting wrong against natural gas futures prices.
Similarly, a drop of a percentage point or two in the value of the kiwi would make Mr. Watanabe nervous.
The picture will become clearer for New Zealand from early 2007 when the NZ$10.2bn worth of uridashis are due. That’s when we confront the rollover-risk that so concerns the Reserve Bank. Meantime there are tremors in this increasingly nervous market.
That creaking and grinding sound you hear could be the breaking up of the world’s financial ice floe, with important consequences for over-borrowed, big-spending New Zealanders.
FOOTNOTE: Selwyn Parker is a former senior writer for Metro magazine, now based in London. His last piece for Investigate was on John Hood, the Oxford Vice-Chancellor