The Japanese yen - why is it a safe haven?

25 Aug 2016

By Shadforth Financial Group

The yen is the official currency of Japan and has been considered a safe haven currency for decades. A safe haven currency is expected to retain its value during financial market weakness and when risk aversion increases. In times of financial market deterioration, investors move from riskier investments to lower risk investments, in this environment a safe haven asset will typically at least retain its value.

Yen performance during bouts of market weakness

Safe haven qualities have been historically evident in the yen, as shown in Chart 1, which compares the performance of the yen relative to the Nikkei 225, a popular index of Japanese shares. Chart 1 shows the yen has moved in the opposite direction to the Nikkei 225 during periods of financial market weakness. The yen has performed well during bear markets such as the one following the 2008 global financial crisis, and also during times that are characterised by rising risk aversion. There are a number of reasons why this is the case and why the yen is seen as a safe haven.

Chart 1: Yen rises when shares fall

Japan is the world’s third largest economy in terms of nominal Gross Domestic Product (GDP) and this makes the yen the world’s third most traded currency and a proxy for Japan’s manufacturing and export strength. A strong yen also depresses the share prices of Japanese export companies because it makes their exports less competitive as their cost increases in other currencies.

Japan owns more than it owes

Japanese investors own over USD $3 trillion more in foreign assets than foreign investors own in Japanese assets. This large net foreign asset position, combined with Japan’s large current account surplus make it the world’s number one creditor nation. This is particularly important during periods of risk aversion.

A behavioural consequence of risk averse periods is that investors will typically move their assets back home in order to ride-out global market volatility. A strong net foreign asset position contributes to flows into the yen when markets turn risk averse as Japanese companies and investors repatriate assets. This process involves Japanese companies and investors selling foreign assets, converting the proceeds into yen and purchasing domestic assets.

The resultant inflows of cash caused by repatriations are part of the reason why the yen appreciates when markets become risk averse, helping to reinforce the yen’s safe haven status.

Low interest rates in Japan contribute to the yen carry trade

Japan has struggled with growth and inflation since the 1990’s so Japan’s central bank has adopted monetary policy measures, including the introduction of negative interest rates. This means it’s unlikely that investors flock to the yen during periods of risk aversion because of Japan’s economic strength. Chart 2 illustrates how Japan’s benchmark interest rate has been very low since the mid-1990’s.

Chart 2: Japan's official interest rate

A more probable explanation for the yen’s performance when markets become risk averse is the unwinding of carry trades. A carry trade is a strategy involving borrowing funds at a low interest rate and investing in higher yielding assets, typically overseas.

The yen carry trade has been particularly popular with Japanese investors who are reluctant to deposit their money in Japanese banks where interest rates are close to zero. Japan is different from many other countries because a large number of small, non-professional investors as well as professional investors use this strategy. Investors and companies borrow yen at low interest rates, exchange them for higher-yielding currencies and then either hold the foreign currency or invest the funds in overseas assets.

When markets become risk averse, the safe haven status of the yen is reinforced as investors sell foreign assets and convert foreign currencies back into yen, driving it upwards.

Japan’s economic weakness doesn’t support the yen’s safe haven status

The primary reason the yen acts as a safe haven currency is because its historical movements are ingrained in investors’ minds and has become a self-fulfilling prophecy. If an investor knows that a pattern, such as, an appreciating yen exists in risk averse markets, the yen will see inflows even though investors are unsure exactly why.

While there are a number of factors that are partly responsible for the yen’s safe haven status, such as, Japan’s strong net foreign asset position and the yen carry trade, the safe haven status of the yen needs to be questioned because of the weakness of Japan’s economy. Japan has the highest debt to GDP in the world and this indebtedness is a considerable headwind to future  economic growth. The yen’s safe haven status will continue to be questioned by some, while fundamental weakness in the Japanese economy remains, but it may not actually change.

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