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Money Feb 6, 2013

Why Mrs Watanabe can now drive the Sensex higher

By Vivek Kaul

Shinzo Abe, the new Prime Minister of Japan, has promised to end Japan's more than two-decades-old recession through some old-fashioned economics now being dubbed Abenomics by experts.

For lesser mortals, Abenomics is nothing but money printing. Abe plans to go in for 'unlimited' printing on yen which will be used to increase government spending on public works.

So far so good. But what's the idea here? In the process of printing and stuffing the financial system with an unlimited amount of yen, Abe hopes to increase money supply. As an increased amount of money chases the same amount of goods and services, he hopes to create some inflation.

Japanese Prime Minister Shinzo Abe. AFP

Japanese Prime Minister Shinzo Abe. AFP

The target is to create inflation of 2 percent. And how does that help? In December 2012, Japan had an inflation rate of -0.1 percent. For 2012 as a whole inflation was zero, which meant that prices did not rise at all. In fact, for each of the years in the period 2009-2011, prices have fallen in Japan on the whole.

In a scenario where prices are flat or are falling or are expected to fall, consumers generally tend to postpone consumption (i.e. buying goods and services)in the hope that they will get a better deal in the future. This impacts businesses as their earnings either remain flat or fall. This in turn slows down economic growth.

On the flip side, if people see prices going up or expect prices to go up, they generally tend to start purchasing things. Hence, Abe's idea is to flood yen into the financial system in the hope of creating some inflation, or at least get consumers to start thinking that inflation is coming and ensure that they go out and make some purchases.

In case of a scenario where prices are falling, people tend to wait to buy stuff at lower prices. In the reverse case, they are expected to start buying because otherwise they may have to pay more for the same goods. Either way, human beings like a good deal.

When people buy stuff, businesses see an increase in incomes and profits, which in turn spurs economic growth. So that is the theory behind Abenomics.

Now whether this economic theory translates into practice as well with prices rising and the Japanese buying and thus helping create economic growth remains to be seen.

But there is another angle to this. As explained earlier in the article, Abe's plan is to flood the financial system with an unlimited amount of yen. As and when this starts to happen, there will be more yen in the market than before. And this will lead to a fall in the value of the yen against other currencies.

But the market does not wait for things to happen, it starts to react to things it expects to happen. Given this, the Japanese yen has been losing value against the dollar. Three months back, one dollar was worth around 80 yen. Now its worth around 94 yen. What is interesting is that between 29 January 2012 and today, the exchange rate has fallen from 90 yen to a dollar to 94 yen.

The depreciating Japanese yen makes the situation just right for the comeback of the yen carry trade.

So what is the yen carry trade? Let's go back more than 20 years to understand where it all started. In the late 1980s Japan was in the midst of both a real estate and stock market bubble. The Bank of Japan managed to burst the stock market bubble very rapidly and the real estate bubble very slowly, by raising interest rates.

After bursting the bubble, the central bank started cutting interest rates and soon the rates were close to zero. This meant that anyone looking to save money by investing in fixed income investments (i.e. bonds or bank deposits) in Japan would have made next to nothing. This led to the Japanese money looking for returns outside Japan.

Some housewives started staying up at night to trade in the European and North American markets. They borrowed money in yen at very low interest rates, converted it into foreign currencies and invested in bonds and other fixed income instruments giving higher rates of returns than what was available in Japan. Over a period of time these housewives came to be known as Mrs Watanabes, and at their peak accounted for around 30 percent of the foreign exchange market in Tokyo.

The trading strategy of Mrs Watanabes came to be known as the yen-carry trade and was soon being adopted by some of the biggest financial institutions in the world. A lot of the money that came into America during the dotcom bubble came through the yen carry trade. It was called the carry trade because investors made the carry - i.e. the difference between the returns they made on their investment (in bonds or even in stocks for that matter) and the interest they paid on their borrowings in yen.

The strategy worked as long as the yen did not rise in value against other currencies, primarily the US dollar. Let us try and understand this in some detail. In January 1995, one dollar was worth around 100 yen. At this point of time one Mrs Watanabe decided to invest one million yen in a dollar-denominated asset paying a fixed interest rate of 5 percent per year.

She borrowed this money in yen at the rate of 1 percent per year. The first thing she needed to do was convert her yen into dollars. At $1=100 yen, she got $10,000 for her million yen, assuming there were no costs of conversion.

This was invested at the rate of 5 percent interest. At the end of one year, in January 1996, $10,000 had grown to $10,500. Mrs Watanabe decided to convert this money back into yen. At that point, one dollar was worth 106 yen. She got around 1.11 million yen ($10,500 x 106), or a return of 11 percent. She also needed to pay the interest of 1 percent on the borrowed money. Hence her overall return was 10 percent.

Her 5 percent return in dollar terms had been converted into a 10 percent return in yen terms because the yen had lost value against the dollar. So this was a double gain for her. The depreciating yen added to the overall return.

But let us say instead of depreciating against the dollar, as the yen actually did, it had appreciated. And let us further assume that in January 1996, one dollar was worth 95.5 yen. At this rate $10,500 that Mrs Watanabe got at the end of the year would be worth 1 million yen ($10,500 x 95.5) when converted back to yen. Hence Mrs Watanabe would end up with a loss, given that she had to pay an interest of 1 percent on the money she had borrowed in yen.

The point is that for the yen carry trade to be profitable the yen would have to be either stagnant against the dollar or lose value. The moment it started to appreciate against the dollar, the returns in yen terms started to come down.

The yen carry trade worked in most years since it started in the mid-1990s, up to mid-2007. In June 2007, one dollar was worth 122.6 yen on an average. After this the value of the yen against the dollar started to go up, and fell to around 80 yen to a dollar. This has meant the death of the yen carry trade.

But with the yen losing value against the dollar again it makes the idea of the yen carry trade viable again. Between 2004 and 2008, stock markets across the emerging market rose as money through the yen carry trade route came in. This included India as well.

Things now look ideal for the yen carry trade to start again. What helps is the fact that interest rates in Japan are very low, almost close to zero. Hence, money can be borrowed very cheaply.

As the yen carry trade picks up, investors borrow in yen, and sell those yen to buy dollars. This ensures that there is a surfeit of yen in the market, leading to a further fall in its value against the dollar. This in turn makes the yen carry trade even more attractive.

Reports in the international media seem to suggest that it has already started happening. India now remains an ideal candidate for money to come through the yen carry trade route given that the Indian rupee has been gaining value against the dollar, which would make the yen carry trade even more profitable.

While the Indian economy falters, the BSE Sensex, India's premier stock market index, might be getting ready for another rally. This time due to the blessings of Mrs Watanabe(s) from Japan. In fact when I had asked Professor Aswath Damodaran, investment guru, how strong is the link between economic growth and stock markets, in a recent interview, he replied "It's getting weaker and weaker every year."

Reference: Extreme Money: Masters of Universe and the Cult of Risk, by Satyajit Das

Vivek Kaul is a writer. He can be reached at vivek.kaul@gmail.com

by Vivek Kaul

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