Weak yen conundrum: why Japanese households love foreign financial assets

International Economy, The, Wntr, 2007 by Tadashi Nakamae

Did it fall or was it pushed? The recent decline of the yen has led to speculation among non-Japanese observers that the Japanese government is orchestrating the currency's fall. However, yen depreciation is not a specific policy target. Rather, it is an inadvertent and inevitable result of a series of snowballing factors that can be traced back to the Bank of Japan's post-bubble monetary easing. The Ministry of Finance completely stopped its currency intervention practices in the spring of 2004.

In February 1985, just before the Plaza Accord was agreed, it cost 260 yen to buy one U.S. dollar. By April 1995, the Japanese currency had strengthened to 84 yen to the dollar--a gain of 211 percent. The currency has since reversed course, sliding back to 117 yen to the dollar as of November 2006. At face value, the yen depreciated by 29 percent over the past eleven-and-a-half years. However, during the same period, U.S. consumer prices increased by 33 percent, while Japan's consumer price index declined by 0.3 percent. In other words, relative prices in Japan came down by 25 percent compared to the United States. When the diverging inflationary trends are taken into account, the yen's real depreciation vis-a-vis the dollar between April 1995 and November 2006 was 46 percent. (In terms of the real trade-weighted exchange rate, the depreciation was 39 percent.)

Why has the yen weakened since 1995? The biggest drag on the currency was the Bank of Japan's monetary easing. Ten-year Japanese government bond (JGB) yields peaked at 7.5 percent in 1990--the height of the nation's real estate and stock market bubble. The yield fell below 1 percent at the end of 1998 and has hovered around 1.5 percent during the following eight years.

Similarly, the Bank of Japan's target overnight call rate, which peaked at 6 percent in 1990, had collapsed to zero by 1998. The target rate remained at zero until mid-2006, except for a brief period in 2000 when then Bank of Japan Governor Hayami tried unsuccessfully to raise rates. Japanese interest rates have been held close to zero--an unprecedented low--for nearly a decade.

The Bank of Japan undertook drastic steps to lower interest rates to save domestic banks and non-financial companies after Japan's bubble burst. Easing the interest-payment burdens of those entities was the most effective measure to rescue them.

The victim of this policy was the household sector. Their interest income was wiped out. After peaking in 1991 at 39 trillion yen in returns from 600 trillion yen in interest-bearing financial assets (mostly bank deposits), households' interest income has nose-dived to less than 5 trillion yen from 860 trillion yen in interest-bearing assets.

The redirection of households' interest income supported Japan's corporate restructuring and helped banks to write down and write off their glut of bad loans. Companies and banks were nursed back to health at the household sector's expense. Not only was their interest income erased, corporate restructuring also kept a lid on wage increases. (Globalization, which opened the door to abundant cheap labor in countries such as China, also constrained wage growth). Consumers' purchasing power has weakened as wages remained flat, interest income was lost, and the yen weakened. Thus, despite the fall in the household savings ratio from 15 percent in 1991 to 2.5 percent in 2006, Japanese consumption has been stagnant for more than a decade.

Zero interest rates also triggered a significant change among Japanese savers. An increasing number, who had traditionally favored domestic bank deposits, are now looking abroad for better returns.

Japanese individual investors first sought higher yields by making foreign-currency deposits. Yet these instruments failed to take off because of their high commissions and fees.

Foreign bond funds came next. These funds were attractive not only for their higher yields, but also for their unique monthly dividend-payment schedule. This ingenious payout structure is particularly attractive to retail investors, who often require supplemental monthly income. In addition, deregulation made foreign bond funds--originally sold only by stockbrokers--easier to buy. Sales increased rapidly after banks were allowed to offer the funds.

Individual investors' latest foray into overseas markets is through foreign-exchange margin trading. Retail investors are now able to easily profit from global interest-rate differentials thanks to evolution in the foreign-exchange market. Take the yen-dollar rate spread of 5 percentage points. With 10 times leverage, retail investors can realize at least 50 percent annualized returns, assuming the exchange rate remains stable or the yen weakens. Such transactions are all the more attractive because of cheap trading costs.

In Japan's currency market, retail investors are believed to originate more than half of daily transactions. This shift of household savings from domestic bank deposits to overseas assets (foreign currency deposits, bond funds, leveraged currency trades, etc.) is now the biggest factor weighing down the yen.