A Japanese Tale (continued)

As explained in Part 2 of this essay, one can assume that there has as yet been no large-scale repatriation by the Japanese of foreign assets from the US. Given the way that activities of large institutions, corporations and government in Japan – including, by all accounts, the Yakuza or Japanese Mafia – are reputed to be centrally coordinated to a substantial degree, it would appear as if they are behaving in concert and will not act in this respect unless they all agree – or perhaps be instructed? – to do so. If matters do in fact reach that critical stage where the Japanese take actions that will trigger a world-wide recession, of course. In which case, as explained in A Japanese tale, they will do their best to have the blame for what happened assigned to anyone else but themselves.

This means that any significant level of repatriation, most probably as a result of a coordinated effort by the Japanese, should signal the event through a renewed, steep and sustained strengthening of the yen against the dollar and also against other currencies, probably to a lesser degree. Remember that the yen carry was in full swing for probably the better part of 3 years. The amount of funds that flowed from Japan to the US during this period is unknown, but surely only a fraction of the total position that resulted from this flow were unwound during the few months between August and October – and this probably mostly by hedge funds. Positions acquired by Japanese institutions may well be largely intact, as well as what remains of the yen carry trade of the hedge funds.

Repatriation, which would result in a weakening dollar, would imply sustained selling of US assets. For some time now, the yen has been relatively stable, reducing the incentive to start repatriation. However, if – or when? – Wall Street peaks and falls by a sufficient margin to put pressure on the paper profits of the yen carry, renewed hedge fund selling could push the yen even stronger, placing Japanese investors in the US under increased pressure to sell out and repatriate. Again, such liquidation of US assets might be frowned upon by the powers that be in Japan, with the result that repatriation by the Japanese themselves, when and if it happens, takes place as a trickle and not a flood. Unless, of course, Japanese banks also panic and break ranks to begin repatriation of their US assets.

Nevertheless, a sharp and sustained decline on Wall Street would offer advance warning that the dollar could well come under pressure again. A sustained fall in the value of the dollar combined with a steeply falling Wall Street would surely trigger some further repatriation from smaller Japanese investors, which would add to the value-destroying avalanches building rapidly on Wall Street and the dollar. Thereby adding to the risk of massive repatriation if Japan's financial survival is later perceived to be at stake.

How will the bond market behave during such events? At first, a weak Dow should result in another asset allocation switch, back from equities to bonds, which would cause yields on Treasuries to decline again. This would help to balance the effects of a weaker dollar and postpone any decisions to repatriate investments in the US Treasury market. However, if the slide in Wall Street lasts long enough, or if interbank flows reverse during this period, the resulting liquidity and credit squeeze on people who were heavily invested in equities and were unable to get out – or to get out in time – would have a negative effect on individual and corporate interest rates and junk bonds. Which events would have another knock-on effect.

Interest spreads would widen, placing hedge funds like LTCM and other with similar positions under renewed and exceedingly strong pressure. This would finally prompt the unwinding of their very large arbitrage positions, which they had opened by buying corporate debt and selling Treasuries. To unwind these positions, they would have to buy back the Treasuries and sell corporate debt, thereby pushing the already widening spread much wider and increasing the credit squeeze on individuals and corporations. A strong Treasury market would exacerbate the flight to quality from Wall Street, giving equities a further death blow.

As happened when the hedge funds sold out in the August-October 1998 Dow sell-off, as speculated above, during this new yen-carry panic on the spreads it will again be a case that he who panics first takes the least pain. Which means – seeing that spreads already have been trending wider for much of 1998, thereby causing the LTCM crisis, among other problems – that even now there must be very strong psychological pressure acting on the hedge fund managers to do something quickly about their spread positions to avert a real catastrophe.

One good effect – from the perspective of this essay – of any unwinding of interest arbitrage will be the firm Treasury bond market that results from large scale purchases of Treasuries. This would reduce the incentive for Japanese investors to sell US bonds. Yet, if the money that was used to establish the positions in the first place was obtained wholly or in part through the yen carry, a strong yen arising from other reverse flows would probably off-set any gains on the bond market and thereby add to the incentives for Japanese investors to unwind their Treasury positions as well.

It is clear that a rapidly strengthening yen would be warning that a crisis is in the process of eruption. However, from the above discussion it seems that a steep, sustained fall on Wall Street – in association with firm Treasuries, while other interest rates are rising to place hedge arbitrage positions under pressure – might be an even earlier warning that a crisis is imminent.

What else is there one should be watching?

We have covered the eventuality of Japanese repatriation – or what is perhaps the much greater probability – that the hedge funds would further unwind their yen carry positions and put US markets and the dollar under pressure, thereby triggering a Japanese decision to repatriate.

There is still the question of interbank loans to consider.

We have seen that Japanese reduction of their lending position in the interbank market – which is of unknown magnitude, but can be expected to be huge in view of the positive cash flow into Japan over many years – would have a multiplier effect on the liquidity of presumably most foreign markets, but would probably hit US bank credit particularly hard. This development of and by itself could achieve much the same effect on US markets as large-scale repatriation of Japanese investments.

What would make a liquidity squeeze and the resulting jump in interest rates so much more dangerous, is that events described above – widening spreads in interest rates that force hedge funds to unwind extremely large positions in debt and Treasury markets (either as a panic decision or through the liquidation of the funds), thereby accelerating these trends – would more than likely become a trigger for the repatriation of Japanese investments in the US as a measure of self-preservation.

Any panic measures by the FRB to counteract the liquidity squeeze – such as a rapid increase in US Federal credits or the money supply to aid troubled banks – might help to address the immediate problem, but would be unlikely to reduce the crisis of credibility that would then erupt. And which would have much the same long term effects.

A double whammy that involves a credit squeeze due to withdrawn interbank loans and which then triggers repatriation, would have a catastrophic effect on the US.

From the Japanese perspective, it would also have the advantage that the initial moves would not be very obvious – at least not to most media and definitely not to the man on the street. This factor would definitely be an important consideration should the Japanese find themselves in a position where they are forced to convert their foreign investments into yen in order to bolster their dicey financial institutions and to rescue their economy.

By beginning their operation on the interbank front, their actions would be less public, first of all, and secondly, the multiplier effect would then create a magnified ripple in US and other markets that would offer them the necessary excuse to conserve their capital through repatriation. If at any time the finger of blame gets pointed in their direction, they can say that their unenviable position was caused by US intransigence and insistence that Japan institute knee-reflex measures to kick-start the Japanese economy – measures that were totally unsuitable for Japanese conditions and that in the end only served to bankrupt the government without having the desired effect on consumer spending. And, of course, in the aftermath of the liquidity crisis, by American inability to ensure a stable US economy.

They could then claim the US forced them into a corner where survival was at stake and they had no other alternative left to them except to bring home their money.

What emerges from the above discussion is that the US has become extremely vulnerable to actions by Japan – actions that can be launched on different fronts and which can quite possibly be presented as having been the result of US behaviour and pressure on Japan in the first place. The Japanese need to fins some scapegoat as they want to avoid at all costs to be seen as the origin of the economic chaos that will hit the world once they repatriate their funds. They simply have to maintain face and must avoid anything that could be perceived by history as a second Pearl Harbor.

Apart from the fact of necessity, what else could be the reason for such behaviour by the Japanese as intimated in this discussion?

It is clear that the US can not be held responsible for the key to the whole development, namely the collapse of the Japanese property and equity bubble. However, once the Japanese were in a bind, it would be typical of Japanese character and martial philosophy – such as contained in the strategies and tactics explained in Mushashi's highly rated book, 'The five rings' – to search for ways and means to obtain an advantage from their unenviable situation.

Obviously, the situation in Japan could deteriorate even further, to where repatriation of assets might well be forced on the Japanese, irrespective whether they wanted to or not. However, it could also be that they have realised the inevitability of such a course of action and have started preparations to shift the blame by distantiating themselves from the US, as described in 'A Japanese Tale'. The US had to be niggled by means of many small pin-pricks into committing rash acts that would later serve as the excuse Japan needs.

This objective may already have been reached. US statements on Japan's lack of definite action to kick-start their economy eventually approached what could only be interpreted as full-scale 'instructions', no longer mere hints or requests. Unfortunately, as explained earlier, the US solution – which hinges on increasing consumer spending through tax cuts and priming through government spending – is very unlikely to trigger any sustained increase in consumer spending by Japanese households.

It is also worthwhile to explore whether there are any other ulterior motives the Japanese may have to target the US, as seems possible from the discussion.

It should be remembered that in 1985 the US was largely responsible for the terms of the so-called Plaza Accord. The main point of that agreement was that the dollar was too strong and would cause continuous distortions in world economics. It was agreed that both the US and Japan would work towards a stronger yen. I have seen no reports how the Japanese felt about this agreement, but measured against subsequent developments they could not have been too happy about it, if not at the time then after the fact.

Just look at the time frame of this accord. 1985 was well into the Gipper's second term as president. By then the US cumulative budget deficit was moving through the $2-3 trillion range and Japan was playing a significant role in the financing of that deficit. Since the debt was dollar denominated, a weaker dollar would mean that over time the Japanese would receive substantially fewer yen than what they had originally invested in US debt – very nice for the US, who would be repaying the loan in inflated dollars; not nearly so nice for Japanese who might have been better off if they had kept their funds in yen, despite the much lower interest rates.

Further, at that time the balance of trade between the US and Japan was also moving into a deficit for the first time, which meant that a stronger yen would make US manufacturers more competitive and Japanese goods more expensive, both of which could help to keep the trade balance in positive territory, or, at worst, keep the trade deficit within reason.

Two plusses for the US; two minuses for Japan.

In February 1985 the US dollar touched ¥260 after rising from ¥225 a year before. That was the high during this period of history. By July of 1986 the dollar was at ¥154, 40% lower than 17 months previously. Japanese manufacturers had to be as much as 40% more productive – or cut profits to the bone – to remain competitive in US markets. At the same time, the cost to the US of debt purchased by the Japanese before 1985 had suddenly decreased by 40% in nominal dollar terms.

What a bargain! If one did not happen to be a Japanese investor or manufacturer, that is.

After some hesitation near ¥150, even reaching higher to ¥160 in the late 80', the dollar resumed its fall in early 1990 – despite the economic crisis developing in Japan at this time as equity and property prices plummeted – to end another 47% lower at ¥80 in 1995. This is a full 67% down on its value in February 1985, the peak value of the yen in the time just before the Plaza Accord took effect.

No wonder that by the mid 90's Japanese investment in US Treasuries had reached, I believe, a low of an estimated $300-500 billion – just a fraction of the total amount of outstanding US debt. It is clear that the Japanese, disillusioned by what was happening to their dollar investments since 1985, had repatriated much of their dollar-held assets. By doing so, they added to the weakness of the dollar, prompting even more repatriation – a process that will repeat itself if the dollar again loses value against the yen.

However, after a new agreement for a stronger dollar was reached in 1995 during trade negotiations between the two countries, and when the Japanese saw the advantages to their financial institutions of the yen carry business, the trend reversed. At the moment, Japanese direct and indirect holding of US Treasuries through the yen carry trade – which include purchases by Japanese institutions as well as by US and international hedge funds – must have grown to perhaps a significant portion of total Federal debt, apart from any other investments such as in equities.

Of course, now the shoe was on the other foot – at least until quite recently. Japanese purchasers of US debt enjoyed a very good ride until second half 1998, because the value of their investment in US Treasuries kept on appreciating in value over this period, as a result of the weaker yen and the fall in the yield on the US 30 year bond from above 10% in 1985 to below 5% in 1998.

This time around the Japanese could exclaim, 'What a bargain!', while they face the prospect of receiving substantially more yen for their earlier investment in dollars.

However, as mentioned before, while that bargain gained up to 130% between 1995 and 1998, it has already lost more than 15% from its highs. Are the Japanese going to sit calmly through a repeat of what happened during and after 1985?

I for one do not think so and will be following the dollar-yen rate and trends in US yields closely to detect any signs of repatriation going on or a squeeze on liquidity.

What do I think will happen? If there is really a hidden agenda in Japan to place the US in an unenvious position and if affairs are then being centrally coordinated, the first step will be to begin a liquidity squeeze through the interbank system. If there is no basis for a conspiracy theory, repatriation will begin when institutions perceive their paper profits being eroded too far through a stronger yen and/or weakness on Wall Street or Treasury bonds. Initially, repatriation will be piecemeal, but as the effect on the yen and on US markets accumulate, more and more repatriation will take place until it becomes a flood.

Finally, there are many concerned investors who are also following these and similar developments in the markets quite closely, with far better sources of information than the rest of us. They may very well be the first people to become aware of what is going on. The kind of people who are watching these matters closely are very likely to escape into gold as soon as they perceive a crisis developing along the lines described in this essay.

A definite and sustained break above $300 might well be the first hard signal that matters are really moving into crisis mode. It would be wise to follow their example.

© 1999 Daan Joubert
All rights reserved.
daanj@mweb.co.za