Now The Blame Game’s on the Yen

``Three financial postures for firms, households, and government units can be differentiated by the relation between the contractual payment commitments due to their liabilities and their primary cash flows. These financial postures are hedge, speculative, and ‘Ponzi.’ The stability of an economy’s financial structure depends upon the mix of financial postures. For any given regime of financial institutions and government interventions the greater the weight of hedge financing in the economy the greater the stability of the economy whereas an increasing weight of speculative and Ponzi financing indicates an increasing susceptibility of the economy to financial instability.”-Hyman Minsky, Finance and Profits: The Changing Nature of American Business Cycles, 1980

Last week also tackled on the unwinding of the YEN carry trade as a possible risk to the present bullish momentum of the global markets.

The Economist magazine recently argued that the in spite of the lack of intervention, the present record low levels of the Japanese YEN against the Euro and the real trade weighted value which is now at its lowest level since 1970s according to an index tracked by JP Morgan, see figure 5, the Japanese Yen is “misaligned” and has contributed to the distortion of the global economy, through the exacerbation of the “asset-price bubbles” around the world.

Figure 5: Economist: Living Dangerously?

The preeminent magazine castigated US Secretary of Treasury Hank Paulson for being short-sighted, who had earlier said that the YEN has been market driven and reflects economic fundamentals.

Their gripe is that even with one of the world’s largest current-account surpluses and low levels of inflation, ``the abnormally low rates”, wrote the Economist, ``could be viewed as a form of intervention to hold down the yen.”

Therefore together with the Financial Times editorial both have recommended the use of its excess US dollar ($875 billion) foreign exchange reserves to intervene and shore up the Yen.

I recall Japan spent something like ¥ 35 trillion, about US $320 billion from 2003 until March 2004, representing about 7% of its GDP to depress the Yen’s value on the account of the faltering US Dollar. Unfortunately despite such intervention, the Yen failed to depreciate and instead appreciated, until in 2005 where the US dollar mounted a fierce across-the-board rally. In other words, Japan’s intervention had been essentially a failure and a waste of taxpayer’s money. Today, in the absence of official intervention, the market itself drove the Yen where it is today.

As we have pointed out before, the present concern is that much of the imbalances have been due to the massive leverage employed in the world financial markets, in particular, the Japanese currency as a potential source of leverage, as its currency could have been sold short via currency forward swaps, an off balance sheet transaction which does not appear in official statistics. So where does one get present estimates? According to the Economist, ``through record net “short” positions in the yen futures on the Chicago Mercantile Exchange.”

We don’t know if such estimates are accurate or if any prospective interventions would succeed or simply be another feckless exercise to please the growing chorus for the Japanese to intervene. What we understand is that with such clamor, unlike the Chinese, the Japan may heed the calls for them to take action.

Finally, the Economist relates of a similar incident in the past (emphasis mine), ``In fact, the main trigger for an unwinding of carry trades is likely to be not Japanese interest rates, but an upsurge in currency volatility. That is what happened in 1998, when enormous yen carry trades had built up. After Russia's default in August and the subsequent near collapse of Long-Term Capital Management, hedge funds reduced their leveraged positions and the yen started to rise. Then in October the Japanese government announced a plan to recapitalise its crippled banks, which further bolstered the currency, forcing those who had bet against it to cover their positions. The yen jumped by 13% within three days.’”

Well so much for intervention; with the political equation heating up it won’t be far when George Soros’ theory of self-fulfilling bias may in itself trigger an upsurge in currency volatility.

Be careful on what you wish for.