from Follow the Money

Can the yen ever be the un-dollar?

February 23, 2007

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Binky Chadha and my friend Jens Nystedt of Deutsche Bank think so.

In a world where the (net) global flow of capital is increasingly dominated by official flows (Chadha and Nystedt note "emerging market central banks
are the largest participants in FX markets"), the yen's unpopularity as a reserve asset has certainly contributed to the yen's weakness.   Emerging markets in particular are adding to the reserves (and oil funds) at an enormous pace, yet rarely hold many yen in their portfolio.

That means, among other things, that FDI inflows from Japan get turned into demand for euros and dollars by actors like the PBoC.  Remember, China uses, in aggregate, net FDI inflows, to finance reserve accumulation, as its domestic savings is more than enough to finance its (high) level of domestic investment.

A lot of money has flowed into the euro and pound recently.  I estimate that euro and pound reserves increased by close to $300b in 2005, and close to $200b in 2006.  Those flows are one reason for pound and euro strength.   Central banks looking for alternatives to the dollar have flooded into Europe -- and shied away from Japan.

Chadha and Nystedt argue that this should change.   The right time to buy euro was in 2001, when the euro was weak.   Not in late 2004, when the euro was strong -- or, for that matter, in 2007.   By the same token, there has rarely been a better time to buy yen.   

Sure, yen interest rates are low, but, over time, there is probably a greater chance that the yen will appreciate v. the euro than that it will fall even further.  If your un-dollar choice is euro or yen, you currently can get a lot of yen for your buck, so to speak.

Chadha and Nystedt have suggested that central banks should buy yen in the past -- a call that was perhaps a bit premature.  I sympathize: my warnings about the US current account deficit were too. 

But they also note that Asian regionalism should be good for the yen.  If emerging Asia ever were to shift off a de facto dollar standard and truly manage its currencies against a trade-weighted basket, the flows into yen would be quite large:

"A move back by the Asian emerging markets to managing exchange rates against a basket of currencies and the likely use of such baskets for eventually evaluating reserve manager performance potentially imply very large shifts into yen reserves. Some countries have already begun to move in this direction and we expect them to continue to do so. If non-Japan Asian central banks start using their flow to diversify this could add appreciation pressure on the yen to the tune of ¥6.5 annually"

Even if central banks underweight the yen in their basket because of its low carry, they presumably wouldn't remain as underweight as they are now.

I tend to agree.   This would be a good time for central banks to buy yen -- central banks can diversify more easily when they go against the grain of the private market.  They then are buying what the market wants to sell -- not trying to sell something the market is already selling. 

Worried about a loss of income from low yen rates? Why not throw a few Brazilian real into the mix?   You would be adding claims on two current account surplus countries after all (here I am mostly kidding ... )

The unpopularity of the yen as a reserve asset is but one example of how the fx policies of major governments are shaping global capital flows, and global financial markets.   JP Morgan recently discovered that Asian equity market weakness is associated with Asian currency market weakness, but Asian equity market strength isn't associated with Asian currency stregnth. 

Why?  Because central banks intervene when the money is coming in, but not when it is flowing out (at least not currently).  Malaysia is the latest example.  India added $4b in the second week of February, after adding $5b in the first week of February.  And Japan, obviously, has been far more inclined to intervene in the face of yen strength (and strong capital inflows) than in the face of yen weakness (and strong private outflows).  Such assymetries add up.

I continue to be surprised by how comfortable so many in the private markets seem to be with a financial world -- at least an international financial world -- increasingly dominated by governments, not the autonomous action of private agents.   The net flow of capital globally right now correlates more closely with the net flow of official capital than the net flow of private capital.  

Private markets want to finance current account deficits in emerging markets.

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