The Yen - I Need To Have An Opinion

by: Ruerd Heeg


Currency speculation makes now more sense than ever before:

Large imbalances in the world economy are waiting to be corrected.

Low interest rates reduce the downside risk of short positions.

As an investor in foreign stocks I can not avoid currency speculation anyway because I need to have an opinion on the currencies of the stocks I am investing in.

In this article I will discuss why shorting the yen is a good bet.

I'm a net-net investor. I trade stocks with more current assets net of all liabilities than their market cap. Unfortunately there are not many stocks so cheap. At least, in developed markets like Europe, the US, Canada and Australia. So to get sufficient diversification I also invest elsewhere. At the moment 40% of my net-nets are in China and Hong-Kong and about 40% in Japan. It's the Japanese stocks I want to talk about in this article.

Like Soros, I just need to have an opinion

In the long run stocks prices correct for exchange rates. So if the Japanese yen goes down Japanese stocks go up, especially the exporting ones. But usually there is a delay. And with net-nets the best holding period is often less than a year. Therefore, if my net-net goes up and the yen goes down my net profit could be zero. So when I invest in, for example, the Japanese net-net Funai Electric (OTCPK:FUAIY) or Shinko Shoji (OTCPK:SKSJF) I need to have an opinion on the exchange rate of the yen. Even though I'm not a currency trader. BTW, this is my version of a quote from George Soros in his book The Alchemy of Finance.

I could simply hedge my bet by shorting the yen. This is remarkably cheap nowadays: borrowing yens costs between 1 and 1.5% per year. Since on average returns on Japanese net-nets are high and I have a margin account this simple bet is good enough for me. I don't need to short yens using less transparent instruments like currency options on the YUK index or exchange traded notes like Proshares UltraShort Yen ETF (NYSEARCA:YCS).

If I want more leverage I can simply borrow more yens in my margin account. This can be done by buying the USD.JPY currency pair. And this is what I have done. Despite having made my yen bet a bit larger I still prefer small bets over big bets. This is one of the many differences between most of us and a genius like Soros. Small bets enable me to make better decisions especially at big swings. So I haven't added much leverage: my borrowed yens are now 1.6 times the value of my Japanese net-nets.

The Japanese economy

Japan is the developed country with the largest government debt in the world. Japan also has a trade deficit. Inflation is low but the Bank of Japan is working on it. It's conducting a large monetary experiment where they monthly buy government and other bonds for a huge amount. They want to increase the inflation because that would reduce the government debt. Higher nominal incomes would certainly increase taxes and maybe spending and investing as well. Higher nominal incomes would decrease the Japanese government debt as a percentage of the GDP. But wait a minute, the Japanese government debt is at the moment about 240% of the Japanese GDP. So there needs to be a lot of inflation for this percentage to shrink to a high but more future proof level of 90%.

No growth

There are good reasons for government debt for things like infrastructure spending. And government debt is not the same as private of company debt. For example public investments in infrastructure can last much longer than most private investments. If such public investments increase GDP, extra tax proceeds can be used to pay off debt from decades ago. Even government investments in education could be paid off this way.

But what would be the overall effect of Japan's high government debt levels? Economists have analyzed the debt levels of many countries over many years. They found that debt levels above 100% of the GDP tend to be a drag on most economies. See for example this ECB working paper. So there is some reflexivity here.

Japan is also aging which makes it even more unlikely that a long term period of high growth will reduce the government debt. In fact, I think that the ultra high growth of last century was an exception. Neither Japan nor other developed countries will experience such a long period of ultra high growth again. That may sound unlikely because most of us have experienced many years of high growth. Our parents and grand-parents have seen decades of high growth as well.

But before that there were thousands of years of low growth. So low growth is the normal and a return to low growth is just a reversion to the mean. At the moment Japan's economic fundamentals support this view: there is demographic decline, high government debt, a lack of investments and a trade deficit.


A high government debt melts quickly away if the inflation is higher than the interest rate. Unfortunately in Japan both the interest rate and the inflation are very low. That favors the yen, if inflation in other countries remains higher than the inflation in Japan.

Again there are many factors in play. For instance if inflation goes up then the interest rate might go up as well. That will make the yen stronger but it will increase the government interest payments as well. The net effect might be that the government debt increases instead of decreases. Therefore I think it is likely that the Bank of Japan will continue purchasing government debt to keep the interest rate low. That will increase the amount of yens in circulation and therefore will suppress the exchange rate of the yen. That scenario has been described in more detail by numerous other SeekingAlpha authors.

Japanese pension funds

There is also another reason why Japan chooses policies that devalue the yen instead of policies that cause the interest rate to return to normal levels. With normal I mean at least 2%. Two percent is the lowest interest rate in The Netherlands since 1595, apart from the last couple of years. Unfortunately I couldn't find similar data for the Japanese interest rate.

Japan's government debt is owned for a large part by the Bank of Japan and by Japanese pension funds. These pension funds had to invest a large part of their money in Japanese government bonds. As part of the Quantitative Easing program the Bank of Japan buys Japanese government debt from these pension funds. In fact the pension funds can be compared to the bad banks in Europe that had invested in government debt of southern European countries. They have been bought out by the European Central Bank. So are the Japanese pension funds being bought out by the Bank of Japan.

In general low interest rate policies transfer wealth from the older generations to the younger generations. Fortunately the Japanese authorities have allowed their pension funds to invest a higher percentage in stocks. So they buy on the (Japanese) stock market. To be more precise: a large part of the proceeds from their monthly Japanese government bond sales (to the BoJ) is invested in the Japanese stock market. By buying stocks they won't suffer from devaluations in the yen since increased stock prices will compensate the decay of the yen. Going forward they won't suffer that much from the low interest rates either since they are now decreasing their bond holdings.

Positive and negative events for the yen

I don't think there are many positive events for the Japanese yen. The only significant positive events for the yen I can think of is a break-up of the euro and any war the US or Europe becomes involved in. Another smaller positive event would be the restart of most of Japan's nuclear reactors. On the other hand Japan can also become involved in a war. In fact the Japanese government will have to increase defense spending to keep up with neighboring countries China and Russia. There are already disputes with China on some islands. Furthermore the oil price might go up again which will increase the trade deficit. And as more and more Japanese retire spending on pensions and health care will increase, which may cause the trade deficit to widen even more.

Will the Japanese QE ever end?

I suppose the bank of Japan won't stop buying government bonds, at least not in the next 10 years or so. Most institutional and private holders of bonds will be bought out by the BoJ. As soon as the BoJ stops buying Japanese government bonds the interest rate will go up. That will bankrupt the Japanese government, and therefore it won't happen.

A large part of the bond proceeds will be invested in Japanese stocks. So Japanese stocks may be a good investment. In fact this is the only reason why the yen might stay strong a bit longer. Speculative capital inflows can have a big influence on the yen. For me paying less than 1.5% interest on my short position is a better bet. I don't have to be afraid the BoJ increases the interest rate, like the Russians did last year. Again, the rate is only 1-1.5% thanks to the desperate need of the Japanese government for a low interest rate.

Final remark

I won't loose much. If the yen goes down 1.5% per year my yen position will already be profitable. It can go up but as long as the QE goes on this is unlikely. And it is unlikely that the QE stops. The most important risk is the risk of more QE and worsening trade balances in Europe and the US.

So far the yen goes down much faster than 1.5% per year. It seems that the market has anticipating the QE and the pension fund reforms. So speculative capital seems to be flowing out of Japan. I should mention that Japanese pension funds have also started buying more foreign stocks. Since the last increase of my short position (2 months ago) the yen went already down more than the 1.5% for a break-even. And since last year the yen went down about 20%.

Disclosure: I am/we are long FUAIY, SKSJF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I bought these stocks on the Japanese exchanges.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.