Wednesday, February 07, 2007

Real Money

Today's Financial Times has an interesting editorial calling on the the Bank of Japan to sell off some of its immense holdings of dollars.

(I think that in practice the BOJ and the Ministry of Finance would have to act together to convert BOJ's dollar assets into yen assets. Others know much better than moi about the technicalities. I defer to them.)

Selling dollars to buy up yen is an eminently sensible idea. The BOJ is sitting on an 895.38 billion dollar stack of reserves, most of which are in dollars, a lot of which are in U.S. Treasuries.

Given the generally comatose Japanese consumer, it remains political suicide for the Bank of Japan to raise interest rates (oddly, news of overall weak Japanese consumer spending seems to have failed to reach the desk of the first deputy manager at the IMF--but that is the subject of another post). Raising rates would benefit domestic savers and bondholders. However, it might also wipe out capital investment and urban real estate development, the two drivers of the current recovery (not that one can really say anything for certain about the effects of interest rates below 1%, which are well inside the "pushing on a string" zone of monetary policy).

As nearly everyone points out, BOJ independence is still in its formative years. The Bank's board cannot openly defy politicians, though the declining fortunes of Abe Shinzō must be wearing away at the formerly awesome authority of LDP Secretary General and fierce interest rate hike opponent Nagakawa Hidenao.

Since Japan's ultra low interest rates are essentially fixed, everybody and his/her mother is betting on the yen carry trade.

As a result, the yen is at a 21 year trade-weighted low, or rather a bit more when one considers, as Dr. Brad Setser has, the way prices have moved since the last time the yen was cheap:

...I calculated the cumulative inflation differentials (CPI inflation) between the US and Japan since 1998, and, if I did the math correctly, Japanese prices today are down 3% since 1998, while US prices are up 23%. I think that means that a yen/ dollar of 121 is about equal to a yen/ dollar of 152 in 1998 in real terms. It wasn’t that weak in 98...
This has left some individuals, rather a large number of whom inhabit Europe, feeling rather upset at the BOJ.

Selling a some fraction of the BOJ's foreign currency reserve mountain would at least demonstrate to the Europeans that the BOJ cares--and it would lessen the political pressures on European finance officials to "do something about the value of the yen".

So why do I have my doubts that the BOJ will follow through on the FT's suggestion?

I can think of about 30 billion reasons.

That is at least the amount of money in dollars the BOJ earned last year from the interest on its foreign currency reserves. That is straight, stupid, keep-your-money in-one-place-and-not-even-think-about-it profit. That is not taking into account the valuation increase in the currency reserves from the increased value, as measured in dollars, in the euro fraction of reserves.

Take the interest income and the valuation increase in the euro portion, convert that total in yen and remit that sum to the Ministry of Finance...and man, you're talkin' 'bout earnin' the taxpayers some real money.

It probably too much to ask the BOJ to sell its foreign currency holdings in order just to put on a good show for a European audience.

First, if the BOJ does sells its dollar and euro assets, the market will send those dollar and euro assets right back to Japan in....ta dah...the carry trade.

Remember, the interest rate differential, the 4 percentage point or more difference in between the cost of borrowing money in Japan and the return one can earn overseas--the engine of the carry trade--will remain unaffected by the sale of the reserves.

Second, and I think this is the kicker, selling the reserves would deny the BOJ the opportunity to make money off of the interest rate differential it has created. As Dr. Setser notes in a whiplash-inducing aside:

Of course, the biggest carry trader of them all is the Japanese government. It borrowed a lot of yen to buy something that yielded a bit under 5% a few years back.

The biggest carry trader of them the Japanese government.

What chance is there the BOJ boys and girls--and their counterparts at the MOF--are going to blow up their own deal?

1 comment:

ross said...

Those dollar reserve assets are offset by yen liabilities. I wonder whether the BOJ is more enamored with the carry it is earning than in fear of the fx risk it faces should the dollar fall. I suspect the BOJ wouldn't mind unwinding a bit but, as you mention but few in the media pick up on, that would require that MOF authorize the currency conversion. Could somebody out there get a straight answer from Hiroshi Watanabe on where the MOF stands on this?