22.May.2021 – Japan

Japanese yen is considered a safe asset because of yen carry trade, low inflation rate and a large net foreign asset position


Japanese yen has been traditionally considered a safe asset for a long time. What factors account for its safe haven status?


Yen carry trade


The yen carry trade is one of the most well-known investment strategies. According to an article published in the balance, “the yen carry trade is when investors borrow yen at a low-interest rate then purchase either U.S. dollars or currency in a country that pays a high interest rate on its bonds.”


For example, many investors who would use the yen carry trade strategies would buy riskier assets with funds denominated in Japanese yen borrowed at a low interest rate. During financial market volatility and crisis, however, investors would lower their investment risk by shorting riskier foreign investments and covering their short positions in yen. In other words, they would sell their risky foreign investments to pay back their loans and debt denominated in Japanese yen.


This reversal of yen carry trade would lead to appreciation of Japanese yen, as investors sell foreign assets and buy Japanese yen to pay back their loans. When this happens, other investors who speculate that Japanese yen will appreciate will take long positions in Japanese yen, further inducing appreciation.


Because of this conventional mechanism of yen carry trade, Japanese yen has been an asset to buy during risk-off sentiment in global financial market.


Low inflation (low interest rate)


Japan has experienced a prolonged economic recession since the bubble burst in the 1990s. As a result, Japan has been engulfed in deflation in the following 30 years. This has in turn caused perennially low interest rate in Japan, even leading to implementation of negative interest rate in 2016.


Low inflation is good for the value of a currency because inflation erodes its purchasing power. For example, if a Big Mac burger becomes 10% more expensive from 1,000 yen to 1,100 yen, then 10,000 yen can now only buy 9 Big Mac burgers compared to 10 before the inflation.


Hence, inflation is the biggest threat to stability of a currency. The chart below illustrates the Consumer Price Index (CPI) in Japan from 1994 to 2020.


Japan Consumer Price index

Source: Capital IQ

Note: CPI computed on Y-o-Y %, Monthly basis


As the chart shows, Japan has rarely showed inflation rate above 2%, a target inflation rate by the Bank of Japan, except when Prime Minister Abe initiated Abenomics with quantitative easing in 2014.


On average, Japan’s CPI index only stands at 0.19% in the entire period from January 1994 leading up to June 2020.


Japan’s net foreign asset position


According to IMF Working Paper, The Curious Case of the Yen as a Safe Haven Currency: A Forensic Analysis published in 2013, “safe haven currencies tend to have low interest rates, a strong net foreign asset position, and deep and liquid financial markets. Japan meets all these criteria. After controlling for the carry trade, Habib and Stracca (2012) find that safe haven status is robustly associated with stronger net foreign asset positions (an indicator of external vulnerability), and to a lesser extent with the absolute size of stock market (an indicator of market size and financial development).”


While it is obvious that Japan has liquid financial market and perennially low interest rate, some may question, how large is Japan’s net foreign asset position?


I have written an article on Japan’s secret to maintaining current account surplus, and explained that Japan has been able to maintain current account surplus with its investment income from overseas despite trade deficit.


The below chart shows how large Japan’s net foreign assets are.


Japan's net foreign asset

Source: World Bank

Note: Net foreign assets are the sum of foreign assets held by monetary authorities and deposit money banks, less their foreign liabilities. Data are in current local currency.


With such a large net foreign asset base, Japan is not so much vulnerable to external shocks that may potentially depreciate the value of Japanese yen.


These factors have made Japanese yen a safe asset in the past. Will this continue in the future?


Perhaps with aging population, increasing trade deficit and increasing Japanese government debt which all negatively affect fundamentals of the Japanese economy, it may be possible that one day Japanese yen is no longer a safe asset?


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