Japanese Yen

Thesis

At 120 per dollar, the Japanese Yen is undervalued by about 28% vis-[CH1] à-vis the U.S. dollar and over 50% vis-[CH2] à-vis the Euro. While the Yen has been depressed for years, economic conditions in Japan and policies undertaken in Japan and elsewhere are likely to change this situation e.g., 1) Japan’s economy is growing 2) the Bank of Japan is tightening monetary policy 3) Japan’s largest import is oil which is traded in dollars 4) the U.S is a less important export market for Japan than it was 15 years ago. Accordingly, we plan to purchase yen in the near future.

 

 

Purchasing power parity

The data in the following table compare the exchange rate of the dollar to a collection of currencies from other developed nations as of 5/7/07. It also compares the price of purchasing a Big Mac in those same countries. From this data, we can infer the purchasing power parity exchange rate of the dollar vis-à-vis the other currencies and compare it to the actual exchange rate. 

 

The data indicate that the yen is undervalued by 28% vis-[CH3] à-vis the U.S. dollar and over 50% vis-[CH4] à-vis the Euro, i.e., as of this writing, a Big Mac is 28% cheaper in Tokyo than in New York. While this analysis is not precise, the yen is so undervalued on a purchasing power parity basis (at least considering the cost of a Big Mac) compared to the currencies of other developed nations that we conclude that the yen is likely to be significantly undervalued.

 

The yen appreciated from 358 per dollar in 1971 to about 82 per dollar in 1995. The yen depreciated over the last 12 years, hitting an intermittent  low of about 146 to the dollar in August of 1998, and  current trades at about 120 yen per dollar.

 

Where does the yen go from here?  While there are many factors which determine a currency’s value, four factors recently changed and are likely to contribute to the yen’s appreciation vis-à-vis the dollar:

 

1)     Japan’s economy is growing. Japan’s economy recently recovered from the long malaise it experienced since 1990.

 

2)     Japanese officials are tightening monetary policy while fiscal conditions are improving. 

 

3)     Japan’s largest import is oil. Oil is denominated in dollars; a stronger yen means that Japan pays less for fuel.

 

4)     The U.S. is a less important export market for Japan than it was 10 years ago. This being the case, a higher yen vis-à-vis the dollar has less negative impact on Japan’s economy than it would have had 10 years ago.

 

We will briefly review the evidence underlying these statements and then offer some closing comments.

 

1) Japan’s economy is growing.

 

Japan’s economy is growing; in the quarter ending 12/31/06, Japan’s economy grew at an annual rate of 4.8%. This is a considerable improvement over Japan’s poor economic performance during the previous 15 years.         

 

After several years of deflation, prices in Japan have stopped falling and are starting to rise. Japan’s unemployment figures also confirm that their economy is improving. During 2006, Japan had 4.1% unemployment; not only is this low, but it is expected to fall lower.   For instance, the Economist Intelligence Unit forecasts Japan’s unemployment rate to fall to 3.8% during 2007 and 2.5% during 2008.  One would expect such a tight labor market to exert upward pressure on wages, thus contributing to inflation and giving the Bank of Japan (BOJ, Japan’s central bank) reason to continue raising interest rates.

 

 

2) Japanese officials are tightening monetary policy and fiscal conditions are improving.

 

After many years of loose monetary policies, the BOJ is tightening the money supply, which is likely to put upward pressure on the value of the yen. This is very different than the BOJ’s policies over the last decade. For instance, during the spring of 1999, in an effort to stimulate their economy, the BOJ lowered short-term interest rates to 1/10th of a percent (0.001%) per year; this was called the Zero Interest Rate Policy. Frustrated by the ineffectiveness of the Zero Interest Rate Policy, the BOJ embarked on its Quantitative Easing Policy beginning in March 2001.   Quantitative easing consisted of conducting open market operations to increase the money supply and reduce long-term interest rates. (Spiegel, Mark, FRBSF Economic Letter Number 2001-31, published by the Federal Reserve Bank of San Francisco, 11/2/01, p.1.)   These easy money policies had a number of consequences including:

 

a)     Boosting the Japanese economy (eventually).

b)    Depressing the yen.

c)     Stimulating the so-called carry trade where people borrow yen and invest in higher yielding currencies and assets.    

 

Japanese easy money policies also likely contributed to asset inflation in other parts of the world, e.g., the United States. Over the last 12 months, however, Japanese officials have started to reverse these policies. For instance, on March 9, 2006 the BOJ announced that they ended their policy of quantitative easing. In July 2006, they increased short-term interest rates from zero percent to 0.25%. On February 21, 2007, the BOJ raised short-term interest rates to 0.5%. We conclude that the BOJ is serious about returning to a more normal monetary policy. Interestingly, as interest rates have risen, so has borrowing by small and medium-sized firms;  this corroborates Japan’s positive GDP growth figures over the last several quarters.

 

Japan’s fiscal policy has historically been weak; their debt currently stands at 160% of GDP.   This situation, however, is improving. For instance, the Japanese Ministry of Finance (MOF) released a draft of its 2007 budget in December 2006 which shows that it expects tax revenue to rise 17% in 2007 as a result of the economic upturn. Consequently, the MOF budgeted issuance of Yen25.4 trillion of bonds during 2007, down 15% year-on-year. (Japan at a Glance: 2007-2008, The Economist Intelligence Unit, February 2007, pp.2-3.) As a result, Moody’s recently upgraded its outlook on Japan’s Government Bonds (rated A2) from stable to positive.

 

3) Japan’s largest import is oil.

 

The following table shows Japan’s main imports during 2005 by dollar value.

 

According to the Economist Intelligence Unit, Japan’s Main Imports by Value are oil, coal, natural gas($132 billion), machiney ($118 billion) food ($50 billion) and chemicals ($39 billion). Note that Japan’s largest import is fuel, primarily oil, which is quoted in dollars. To the extent the yen gains value against the dollar, Japan’s fuel bill will decrease. In this way, Japan benefits from a strengthening yen. 

4) The U.S. is becoming a less important market for Japan.

The classic reason arguing against the appreciation of the yen is that Japan is an export-led economy dependent on a cheap currency to subsidize its exports to the U.S. While we are aware of no evidence that Japan is likely to abandon its drive to export goods, there is strong evidence that Japan is becoming less dependent on selling goods to the U.S. The U.S. share of Japanese exports peaked in 1986 at 38.5% and was 23% in 2005.

 

Data published by the Economist Intelligence Unit indicate that in 2005 Japan exported 23% of its goods to the U.S. while exporting 35% of its goods to three countries: China (including Hong Kong), South Korea, and Taiwan. While some of the goods exported to other Asian countries may ultimately end up in the U.S., a look at the data indicate that about 21% of China’s exports are shipped to the U.S. and 15% of Koreas.

 

While the U.S. is an important market for Japan and other Asian exporters, its role is diminishing. Also note that there is pressure for other Asian currencies to appreciate vis-à-vis the dollar. The Korean won and the Chinese yuan have appreciated about 5% in the last 18 months. The inference we draw from this is that Japan’s monetary authorities will have greater flexibility to let the yen appreciate vis-à-vis the dollar in the future than in the past.

 

Closing comments

What initially attracted us to the yen as a potential investment was our observation that it appreciated at times when most other assets depreciated. This is illustrated by the data presented in the chart on page one of this report: each time the BOJ has tightened monetary policy in the last year, the yen has appreciated and market volatility, as measured by the VIX, has increased. What we then noticed is that the yen is undervalued, probably significantly undervalued, compared to the dollar and other major currencies. Finally, as we studied events in Japan, we found evidence that conditions in Japan are significantly different than they have been since the early 1990s and, as a result, the yen is more likely to be allowed to appreciate against the dollar than at any time in the last 15 years.

 

Two other qualities we think are compelling about the yen: the yen is an excellent medium of exchange and store of value. For instance, as a medium of exchange consider that approximately 20% of all foreign exchange transactions involve the yen. As a store of value, Japan’s low inflation, improving fiscal conditions and strong economy bode well for the yen.  Given these qualities, it is no surprise that a number of central banks, including the Peoples Bank of China and the Bank of Russia have recently stated that they have begun buying yen for their currency reserves. 

 

 

 

 

Catalysts

 

Continued strong performance of Japan’s economy leading to further interest rate increases in Japan.

 

Europeans continue to push Japan to allow the yen to appreciate.

 

Increased volatility in the markets causing an unwinding of the yen carry trade.

 

Increasing yen demand from central banks diversifying their foreign currency holdings away from the dollar.