Forbes.com - Say Yes to the Yen - Shawn Baldwin


Say Yes To The Yen
Shawn Baldwin 08.17.10, 4:55 AM ET

The Japanese yen recently rallied to 15-year highs against the U.S. dollar along with hitting highs against other major currencies. Throughout the economic crisis, the yen has continued to display strength; while other currencies have seen their gains reduced significantly, the yen has gained over 40% since the economic crisis began--almost 8% of that has been over the last 2 months.

Why does the yen continue to rise?

Because of narrowing interest rate differentials, concerns about the world economic outlook and the possibility of intervention.

Japan's finance minister has allayed those fears, stating that the yen's rise continues to be set by the markets. It is easy to understand why some feel that the Minister would want to intervene. The rising yen against the dollar makes Japanese goods considerably more expensive for American consumers--Japan Inc.’s largest export customer.

The continued strengthening of the yen makes the revenue earned from Japanese companies' U.S. subsidiaries worth less when the repatriated revenues are converted from dollars into yen. This has already caused Japan's business groups to cry out for a reduction in tax rates--but surprisingly, to be steadfast in supporting no intervention.

The currency’s strength certainly isn’t due to Japanese domestic economic strength. Instead, the yen's strength is a by-product of private sector recycling of the current account surplus and international purchases of Japanese assets. U.S. dollar weakness is a strong factor, and that suggests that intervention on the bilateral pair may not be successful.

This makes it highly unlikely that the Bank of Japan will intervene. The last time that the BOJ intervened to weaken the yen was in 2003, when over the course of 126 days the Ministry of Finance sold yen in the open market to purchase $315 billion. These measures eventually sent the yen 11% lower.

However, overall success of interventions in changing the long-term path of a currency is less certain--and they only seem to work when nations coordinate their efforts--highly unlikely in this environment. From a historical basis, the G-8 industrialized countries have not intervened in the foreign exchange markets throughout the economic crisis, making intervention impractical and not politically feasible.

So do not expect Japan's Minister of Finance to intervene--unless the yen strengthens beyond 84.8, the multiyear high set last November after the Dubai sovereign debt shock.

Because the yen's strength may aggravate existing disinflationary forces, the prudent course of action would be to increase Japanese government bond purchases in combination with an expansion of policies to accelerate international buying of the instruments.

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One more reason the yen may continue to appreciate: China's activity. Recent data from Japan shows that China has increased its holdings of Japanese Government Bonds (JGBs) by $6.2 billion in the first trimester of 2010, more than double its previous record in 2005. China bought more JGBs than it sold for the first half of the year, the biggest annual increase since 2005. China then purchased a net 456.4 billion yen ($5.3 billion) of JGB’s in June, following record net buying of 735.2 billion yen in May, according to the Japanese Ministry of Finance.

Japan has also reported large purchases of yen money-market accounts by nonresidents--a total of $10.7 billion from July 11to 17. It would be prudent to assume that a number of these purchases are being made by the Chinese. Because China now says that it pegs its currency to a basket of currencies and not the U.S. dollar, this could tactically be an ideal time for China to readjust its $2.5 trillion dollar reserve portfolio away from the greenback.

China isn’t the largest holder of yen--the U.K. is, and London bought over 26.3 trillion yen last year and have invested another 18.3 trillion yen this year, further powering the currency. Given the weakening U.S. dollar in a soft economy, this creates an opportunity for traders. Expect investors to fuel the yen’s rally and continue to propel the currency to record highs.

Shawn Baldwin is chairman of Capital Management Group, an investment advisory and research firm based in Chicago. Neither he nor his family nor CMG own Japanese government bonds.

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