killing a darling: japanese investors don’t sell foreign

14 August 2020

Killing a darling: Japaneseinvestors don’t sell

foreign assets duringturmoil! Is the JPY safehaven status justified?

Andreas Steno Larsen

We have taken a deep dive in to decades of Bank of Japan flow data and findthat Japanese investors almost never sell foreign assets in times of crisis. Theyactually buy! Could this be a future issue for the “safe haven” JPY?

This article is written by Andreas Steno Larsen and Santeri Niemelä.

• The evidence speaks strongly against the widely spread misconceptionthat Japanese investors repatriate their investments during a crisis

• The carry unwinding, which has been shown to strengthen JPY in timesof crisis, has largely lost its meaning due to an abundance of cheap carryfinancing and poor carry opportunities

• Yen failed to perform in the corona crisis which forces portfolio managersall around to explain why they naively trusted yen and to study thefundamentals behind yen’s role as a safe haven

“The yen is a safe haven.” That’s the first thing an FX professional learns about the market. That is long beforelearning about the New Zealand dollar being called the “Kiwi” and the “Aussie” being a China proxy.

Many take that claim at face value but those who seek answers are quickly introduced to a story on Japaneseinvestor behaviour. The story goes something like this: the Japanese have more money invested abroad thanany other nation in the world. When a crisis hits, Japanese investors get scared and want to liquidate theirrisky assets. The yen being their home currency, they prefer having the liquidated money exchanged backto yen [and hiding the money under the mattress as the story about Mrs. Watanabe goes]. This massivedemand for yen causes it to appreciate.

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That is a good story and it sells well when a crisis looms. Let’s have a look at what really happens andwhether there are any grounds for the yen’s safe haven status.

How has the JPY fared historically?

Using a very crude measure of JPY safe haven performance, we calculated how often the yen hasstrengthened against the US dollar when the S&P 500 falls in value. Studying the weekly returns from1997 we find that 70% of the time when the S&P 500 has fallen more than 3% in a week the USDJPY hasgone down. For 4% and 5% thresholds we find that the yen has consistently appreciated 68% and 76%,respectively, of the time when the S&P 500 falls.

Statistically and, to be more specific, historically the JPY has been a trusted partner in times of financialdistress. We don’t deny that. What we are interested in is how the JPY behaves today and in the future.

Net International Investment Position (NIIP)

The Net International Investment Position (NIIP for short) is the dierence between the residents’ financialclaims on non-residents and residents’ financial liabilities to non-residents. In plain English, for Japan it is

Japan has the largest positive NIIP in the world. The latest figure (Q1 2020) stands at USD 3,453 billion. Incomparison, the US has the most negative NIIP, at USD -12,057 billion(2020/Q1) [IMF].

The NIIP is often categorised into Equity, Debt, Direct Investment (FDI), Financial Derivatives, Reserve Assetsand Other Investments. For studying the behavior of Japanese investors, Equity, Debt and FDI are the mostrelevant. Reserves are controlled by the central bank and Other Investments cover, for example, trade creditsand payments to supranational institutions (e.g. IMF). Financial derivatives show the net market value of allopen derivatives. That tells us little about positioning and investor behaviour since only market moves cause aposition to open – not the actions of investors. Therefore, this publication focuses mainly on equity, debt anddirect investment transactions.

The common mistake discussing NIIP

All too often we see analysts mistake changes in a country’s NIIP as evidence of positioning. If you, forexample, study the nominal JPY valued NIIP for Japan and compare it to the USDJPY, you could easily makethe conclusion that a smaller NIIP (i.e. the Japanese selling their investments) leads to a stronger JPY. But thenominal JPY valued NIIP is aected by both exchange rate changes and asset valuation changes. If assets fallin value by 10% then the NIIP contracts by 10%, all else equal – even if no transactions take place. In order toavoid this mistake and study the behavior of investors it is necessary to look at the transaction level.


https://data.imf.org/?sk=7A51304B-6426-40C0-83DD-CA473CA1FD52&sId=1542640325115



Chart 1: Japan's Net International Investment Position and USDJPY

What Japanese investors did in the Global Financial Crisis in 2008

One way of getting to the transaction level (i.e. what the Japanese actually bought and sold) is to study theNIIP balance sheet and clean out the asset valuation and exchange rate eects row by row.

Looking at equity investments in 2008 from the beautifully coloured NIIP balance sheet from the Ministryof Finance, Japan, we can see that Equity Securities investments fell from JPY 65,376 billion to JPY 35,817billion from the end of 2007 to the end of 2008. At first glance this might suggest that the Japanese dumpedforeign equities during the crisis year of 2008. But when equity re-valuations (approx. -40%) and exchangerate changes (approx. +20%) are taken into account, it becomes apparent that the Japanese actually investedheavily in foreign equities in 2008.

The exact figures published by the Ministry of Finance reveal that exchange rate changes and equity re-valuations reduced the JPY valued NIIP together by 55% and the Japanese in fact bought JPY 6.4tr in foreignequities during 2008 when – according to the widespread market story – they should have been sellingthem. A study of more granular monthly transaction data reveals that the equity buying frenzy – the largestever seen from Japanese investors up to that point – is concentrated in the months following the Lehmanbankruptcy.




Table 1: Japan’s NIIP end of 2007 and end of 2008. Assets are what the Japanese have investedabroad and Liabilities are what foreign investors have invested in Japan.

The Bank of Japan comments on the changes in the balance of payments and, more particularly, thetransactions that cross the Japanese border in the publication Japan’s International Investment Position atYear-End 2008. While discussing changes in equity investments they find that the Japanese bought moreequities than ever recorded:

"Equity securities assets (foreign equity securities held by residents) amounted to 35.8 trillion yen, falling by29.6 trillion yen or 45.2 percent from year-end 2007. This marked the first decrease in six years. Althoughinvestment in foreign equity securities by residents marked a record high in 2008, equity securitiesassets registered the largest decrease on record due to the appreciation of the yen and the worldwidedecline in equity prices. As for factors responsible for changes in equity securities assets, the transactionfactor accounted for an increase of 6.4 trillion yen, the largest such increase on record."

The transaction factor for debt securities is even larger, but that partly follows from the fact that the stock ofdebt investments is larger (JPY 65,376tr vs JPY 222,311tr in 2007). The Bank of Japan comments on it brieflyas follows:

"As for factors responsible for changes in assets in bonds and notes, the transaction factor accountedfor an increase of 7.3 trillion yen. This reflects active acquisitions by "other sectors" resulting from thecontinued purchases of foreign bonds and notes by pension funds, individual investors, and businessenterprises through investment trusts."

Why did the yen appreciate in 2008?

Carry trading – the act of selling a low yielding currency and buying a high yielding currency – experienced aboom in the early 2000s. It was often advertised as “arbitrage” and “low risk alpha” before it became widelyknown in 2008 how tail-heavy carry trading actually tends to be.

Back then the JPY was the only major currency with near-zero interest rates. In fact, the JPY has had near-zero interest rates since 1995 (ICE Libor 3M). Because of this, it became the most popular funding currency in




carry trading after the more liquid market standard, the US dollar. From 2000 to 2005 the US 3M Libor brieflytouched 1.0% and the 3M Euribor was hovering at 2.0% and above, while the JPY Libor was practically zero.

Charts 2 & 3: 3M JPY Libor, 3M USD Libor and 3M Euribor

The Bank for International Settlements (BIS) provides the best evidence of this behaviour because data on FXpositioning is largely unavailable. BIS reports their FX market findings every three years in an unimaginativelynamed BIS Triennial Survey.

In 2004 BIS reports “… a surge in traditional foreign exchange trading. This seems to have been driven bymomentum trading and carry trades in a global search for yield on the part of institutional investors andleveraged players […] Reportedly, the three main funding currencies were the US dollar, the yen and theSwiss franc. The main recipients of the borrowed funds included sterling and the [high-yielding] Australianand New Zealand dollars, as well as a number of emerging market currencies. This is consistent with astrong increase in turnover in the Australian and New Zealand dollars: by 98% and 152%, respectively. “

Three years later, in 2007, BIS reports an unprecedented 69% increase in average daily turnover. “Thetransactions between reporting dealers and non-reporting financial institutions, such as hedge funds,mutual funds, pension funds and insurance companies, more than doubled during three years and in April2007 contributed to more than a half of the increase in aggregate volume.”

New Zealand dollar, “which attracted attention from investors as a highyielding [sic] currency” is namedas one of the most notable increases in share. “More broadly, the share of emerging market currencies intotal turnover has increased, to almost 20% in April 2007”. All this suggests that carry trading was a widelypopular strategy and that JPY was used to fund it (together with USD and CHF).

The 2010 survey, which already contains the Global Financial Crisis, reports further changes in investorbehaviour: “Trading by households and small non-bank institutions has grown enormously, […] Japaneseretail investors are the most active, with market estimates suggesting this segment represents 30% ormore of spot Japanese yen trading (ie more than $20 billion per day).”

When the financial crisis started to roil the markets in 2008, investors wanted to close risky positions,including carry trades. This meant selling the high yielding currency and buying back the funding currency– in many cases the JPY. At the same time, the briefly elevated JPY rates made the JPY less tempting touse for funding new carry positions. The wave of JPY buying that was caused by unwinding carry tradesstrengthened the JPY.


https://www.bis.org/publ/qtrpdf/r_qt0412f.htm

https://www.bis.org/publ/rpfxf07t.htm

https://www.bis.org/publ/qtrpdf/r_qt1012e.htm



Similar findings are reported by BIS in 2010: “The rise in FX volatility and increased risk aversion of investorsled to a rapid unwind of currency carry trade positions, with funding currencies appreciating sharplyand many investors experiencing large losses. The Japanese yen, for example, appreciated by 7.7% againstthe Australian dollar on 16 August 2008.”

Because this carry positioning in the JPY was widely known in the market, investors started to buy the JPYin order to ride the wave of “mechanical” JPY buying. This, obviously, exacerbated the situation and JPYappreciation snowballed. The fastest JPY appreciation followed the bankruptcy of Lehman Brothers inSeptember 2008 and, more particularly, during the massive risk-o seen in the market afterwards.

BIS reports US asset hedging via JPY and Emerging Market (EM) hedges via EM FX: “With limited marketliquidity in various asset classes, many investors reportedly turned to spot FX markets to hedge riskexposures (“proxy hedging”). For example, downside risk in US equities was reportedly hedged by buyingJapanese yen, in European equities by selling the euro, and in emerging market equities using emergingmarket currencies.”

Chart 4: EURJPY and USDJPY spot

Can the JPY appreciate again due to carry trade unwinding?

Should the markets get as excited again about carry trading as they were in the early 2000s and these carrytrades were unwound in a risk-o scenario, the JPY would no longer be the “only” funding currency that facesa wave of buy-backs. Namely, in addition to revealing the tail-riskiness of carry trades, the 2008 crisis alsoforced several major central banks to slash their interest rates to near-zero or negative. This in turn made ite-markets.nordea.com/article/59357/killing-a-darling-japanese-investors-dont-sell-foreign-assets-during-turmoil-is-the-jpy-safe-haven-status-justified



possible for investors to fund their carry trades in various currencies more cheaply than in the JPY. After 2008,the EUR, the CHF and even the SEK have been popular funding currencies. Very recently, even the dollarfunding cost had dropped to 0.25% (3M Libor). The cheap rates combined with the dollar’s superior liquiditywill surely increase the proportion of dollar funded carry. Therefore, should carry unwinding occur again, theflow of money would be distributed among other major currencies – not just to the JPY as it did in 2008.

Chart 5: Funding costs have come down in most major currencies. The JPY has “competition” for therole of funding currency.

What about the recent coronavirus crisis?

It can be easily argued that the yen, strengthened by the carry unwinding, encouraged Japanese investorsto head abroad because, in terms of foreign currency, they were 20% wealthier. It is therefore important tosee how they behaved in the coronavirus crisis where the JPY– to many investor’s disappointment – did notappreciate.

The year-end data provided by Japan’s Ministry of Finance is obviously not available yet. Luckily though, itprovides a monthly proxy dataset that covers Equity, Short-term and Long-term debt instruments. The datasetcovers transactions made by “Designated Major Investors” who make up approximately 80–90% of theyearly volume. It is therefore a highly accurate proxy for the more detailed year-end data. Below we study themonthly Financial Account sum for net Equity, Debt and FDI flow, and that data strongly supports the findingsin the International Transactions in Securities data used here.




Interestingly, the coronavirus crisis is a near perfect repetition of 2008 in terms of investor behaviour. Just as2008 witnessed the largest foreign equity investments made by Japanese investors, March 2020 was themonth when the Japanese, once again, bought more foreign equities than ever before in a single month. Itmay well be a coincidence that each crisis brings a new record in investment flow from Japan, but it certainlyspeaks volumes against the age-old story of scared Japanese investors who repatriate their risky investments!

Chart 6: Japanese net equity purchases from abroad. The purchases starting from October 2008 werethe highest ever witnessed. A new record was made in March 2020 when the Japanese again investedmassively abroad.

While the focus always seems to be on Japanese investors, it is equally important to look at the other side ofthe coin – foreign investors in Japan. Again, be it a coincidence or not, the GFC and the coronavirus crisis arevery similar in terms of investor behaviour. Foreign investors sold a record amount of Japanese equities anddebt in 2008 and again in March 2020.

The appreciation of the yen was suggested as a reason behind the heavy Japanese asset sell-o in 2008.For example, the Bank of Japan argued in Japan's International Investment Position at Year-End 2008 that inforeign currency terms the Japanese assets oered tempting selling opportunities because – in relative terms– the yen denominated assets were still at decent foreign currency valuations following the global downturn.This, however cannot be the case in the coronavirus crisis as the yen did not appreciate in the same way it didin the Financial Crisis.




Chart 7: Foreign net Long-Term Debt purchases from Japan. The single-month records of dumpingJapanese debt have occurred in the month after the Lehman bankruptcy (October 2008) and again inthe gloomiest month of the coronavirus crisis (March 2020).

Studying the monthly Financial Account data, which only specifies the flow in net terms, we see howmassively the FDI, Equity and Debt investments flowed from Japan towards international markets. TheFinancial Account data – unlike the monthly International Transactions in Securities data used in other chartsof this chapter – is based on the whole flow and not only the Designated Major Investors. The less granularFinancial Account data supports the findings in the International Transactions in Securities data.




Chart 8: Monthly Financial Account (sum of net figures) for FDI, Equity and Debt.

What happened with the JPY in this crisis?

It is quite clear the JPY did not perform in its perceived safe haven role in the coronavirus crisis. We arguethat the movements seen for example in the USDJPY were merely driven by USD weakness followed by USDstrength and then weakness again.

In early March, the USD 3M Libor fell drastically to 0.77% (9 March). This opened up the possibility forEuropean and Japanese investors to increase their record-low hedge ratios in the EURUSD and USDJPY tomore normal levels. The unbearable, above 3%, cost of carry had previously forced investors outside of the USto hedge as little as possible to avoid it. When the cost of hedging dropped, there was no longer any reason tokeep hedging so low. Furthermore, since it was known that hedge ratios will potentially be increased and theUSD will face “mechanical” selling, there was a risk of a weaker USD – which in turn added fuel to the fire.




Chart 9: March 9: 3M USD Libor fell far below 1% and hedging cost was no longer an issue in EURUSD,USDJPY and USDCHF to name a few important pairs

The low USD rates and potential USD selling caused it to quickly lose value against the EUR, JPY and CHF, toname a few currencies. The move in the USDJPY was thus not JPY safe haven demand but simply the weakdollar.




Chart 10: March 9: USD weakened against EUR, CHF and JPY

This all changed quickly in the latter part of March when asset valuations suddenly dropped. Investorsoutside the US no longer had low hedge ratios because hedging nominals were unaected by thedeterioration of the underlying asset. Furthermore, cash markets started to face serious trouble and the USDexperienced a sudden and deep squeeze before the Fed promised swap lines through a number of foreigncentral banks.




Chart 11: March 21: US assets (here S&P 500) fell so much that there was no longer a need to increasehedges. The asset revaluations took care of the under hedging

The USD weakness thus reversed as quickly as it had appeared. Notably, during the worst days of the crisis(e.g. 23 March) when equities found their bottom, the JPY weakened massively against the USD.




Chart 12: March 21: USD strengthened against EUR, CHF and JPY. And more notably, USDJPY fellduring the worst days of the crisis!

What about earlier crises?

The latest global crisis before 2008 is the burst of the so-called dot-com bubble from March 2000 to October2002. The dot-com bubble was caused by an internet craze where investors and the public thought thatanything related to the internet would be a financial success. The pins that possibly popped the bubble werethe Fed announcing plans to aggressively hike rates and news of Japan entering into a recession. The crisis hittech companies disproportionately (e.g. Nasdaq Composite fell 77% from top to bottom) but it was a seriouscrisis for all equities. The S&P 500 lost 48% and the Nikkei shed 62% (top to bottom).

The yen’s behaviour during the crisis is inconclusive. Initially the JPY strengthened against the EUR andthe GBP but not against the USD. The trends ended in autumn 2000 and after that the JPY weakenedsignificantly for years against other major currencies despite the fact that the crisis was still raging.

The more interesting part of the crisis is again the behaviour of Japanese investors. The data from 20 yearsago is not as detailed as today, so we can only study the net amounts in the Financial Account (i.e. Balance ofPayments transactions). We are therefore unable to determine whether flows from Japan are local or foreigninvestor driven. The flow, however, is clearly from Japan towards international investments. The years 2000–2002 see steady growth in flow.




Chart 13: Financial account for Direct Investment (DI), Equity and short and long-term debt (Debt).The flow is towards international investments during times of crisis (2000–2002 and 2008–2009).

The dot-com crisis adds to the list of market shocks where investors have done the opposite of marketexpectations. During the 20-year-period there have been three dierent types of crisis (tech, financial andwell, let’s call it consumption crisis) where Japanese investor behaviour has not supported the market story ofinvestment repatriation.

How will the JPY behave going forward?

If the investment repatriation story is unfounded and the carry unwinding mechanism has lost power, itdoesn’t leave much for the JPY’s safe haven role. It is true that conventions, beliefs and traditions play animportant role in the financial markets – just try explaining the value of gold!

But if the yen has enjoyed the role of “safe haven” for only a couple of decades then a failure to perform mightdamage its status severely. If portfolio managers got burned in the coronavirus crisis because the JPY failedthem, they may face dicult questions from their superiors. When they are forced to explain why they reliedon the JPY they will investigate it and perhaps find that it was not based on much else than hopes and habits.And since the JPY has enjoyed the role of safe haven for such a short period of time (compared to gold withits 2,600-year history) it is more likely to lose it.

There is, however, an important fundamental question we failed to answer in the beginning. How do youdefine a safe haven? If the definition is relaxed and safe haven is something that doesn’t depreciate, then theJPY might still work. After all, it is a highly liquid currency. The liquidity ensures that the JPY will not face thee-markets.nordea.com/article/59357/killing-a-darling-japanese-investors-dont-sell-foreign-assets-during-turmoil-is-the-jpy-safe-haven-status-justified



same kind of situation we saw in the NOK in this crisis, where the currency weakened massively every timesomeone tried to sell it. But liquidity alone doesn’t make a safe haven. We would say it is a necessary but nota sucient condition.

Japan’s economy poses some problems for the JPY in a crisis. Japan’s export heavy, open economy makesit vulnerable to a global crisis and it has a higher than average “beta”. A global crisis might then hit the JPYthrough Japan’s economy if the yen’s safe haven role is not there to support it.

Previous studies

There is one research paper we know of which studies the yen’s safe haven status in particular. The CuriousCase of the Yen as a Safe Haven Currency: A Forensic Analysis from Botman, Filho and Lam finds that capitalinflows cannot explain the yen’s safe haven status. They “find evidence that changes in market participants’risk perceptions trigger derivatives trading, which in turn lead to changes in the spot exchange rate withoutcapital flows”. They quote both portfolio rebalancing through derivative transactions [in yen] and self-fulfillingexpectations causing the currency appreciation. While the paper has some diculty in pinpointing the truecause behind yen appreciation in crises, the authors argue strongly that capital inflows (e.g. repatriation ofinvestments) are not the culprit.

Brunnermeier, Nagel and Pedersen find in their study Carry Trades and Currency Crashes that high-interest-rate currencies tend to perform poorly in crises and low-interest-rate currencies perform well. They arguethat this eect is caused by unwinding of carry trades and is subject to the act of carry trading. This supportsour argument that if the popularity of carry trading has declined since the early 2000s and carry trades arefunded in many other currencies than the yen, then the carry unwinding eect would be subdued. The samefinding is shared in Habib Stracca [2011]. They find that “the interest rate dierential is not a fundamentaldriver of safe haven status, and it depends on carry trade strategies being pursued”.

What currencies should you rely on if the JPY is not to be trusted anymore?

The US dollar is the reserve and system currency of the world (FX weekly: Geopolitics… Who cares? Followthe flows). The reserve currency status is discussed in this article. The system currency role, on the other hand,once again became very concrete in March 2020 when the global FX swap market threatened to shut downbecause of a dollar deficit in the market. Only when the Fed promised practically an unlimited amount dollarsthrough other central banks did the swap market calm down. Therefore, we argue that in a deep crisis, suchas the one seen in March this year, the dollar’s system currency role will dominate and dollars will be in highdemand.

In the medium term, though, we dislike the dollar’s prospects. The US is dangerously divided politically, thecoronavirus has devastated the country more than any other and the current administration has severelydebilitated US relations with China, Russia and Europe. On top of that, dollar has lost its most important edgefrom the past few years, the high interest rates. When the dollar oered a 2–3% carry on top of other majorcurrencies it was clearly more tempting than now, when the carry is far below 1%.


https://e-markets.nordea.com/article/59255/fx-weekly-geopolitics-who-cares-follow-the-money

https://e-markets.nordea.com/article/59255/fx-weekly-geopolitics-who-cares-follow-the-money

https://e-markets.nordea.com/article/59193/fx-weekly-the-usd-will-remain-the-no-1-reserve-currency



Because of the negative medium-term prospects of the dollar we only recommend far out-of-the-money calloptions in the dollar. For example EURUSD puts with 3–10% delta. They oer a cheap catastrophe hedge thatwe believe is mispriced by the market.

A higher delta alternative is the euro. With its recovery package agreement the EU moved towards a strongerunion that doesn’t have to be questioned every time a crisis hits. Until now it has been far too easy to play theItaly-exit or the doomed-euro card, which has kept the euro from strengthening in times of crisis.

The Swiss National Bank (SNB) has made it very clear it doesn’t want a strong CHF. And as discussed inthis publication, the SNB has the ability (and willingness) to keep printing francs for export for as long asnecessary. For the SNB it is a money making machine. Therefore we would steer clear from the CHF even ifmarkets like it as a safe haven and continuously test the nerves of the SNB.

Why are you hearing this now?

We don’t know.

We believe the status of the JPY is so widely accepted and the stories behind it so intuitive that no one hasactually bothered to check it.

Andreas Steno LarsenChief Global FX/FI [email protected]+45 55 46 72 29


https://pankki.nordea.fi/Images/58-367424/Nordea_FX_Quants_2020_05_28_uk.pdf



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killing a darling: japanese investors don’t sell foreign

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