Introduction

Just over a week ago, it was speculated here that unusual market behaviour in Tokyo could be interpreted as being an attempt by somebody to obtain a very firm close on the Nikkei at the end of March, the Japanese financial year end. That effort, which started early in March, must be have cost a good deal of yen; which raised the question why it is being done. One possible answer, presented in the essay, was that it could have been done by Japanese banks who needed a boost to their capital reserves in view of the large write-offs they have had to accept on bad debt.

Why ramp?

Previously, Japanese banks could conceal the extent of their bad debt, as a result of the 10 year decline in their economy after the bubbles burst, by means of various subterfuge – such as lending money to struggling companies with which to pay interest on their loans and premiums on their mortgages, thus preventing these to be classified as delinquent. However, now there is a need to 'come clean' ahead of the government assistance plan for poorly capitalised banks under the 1999/2000 budget; in oder to qualify for assistance banks may have to divulge their true situation.

If, as is widely thought, banks in Japan really have to deal with write-offs of about $1 trillion or more, the effects on their capital reserves must be disastrous. Even for Japan, who not long ago rated 8 of the 10 largest banks in the world, writing off a cool $1 trillion dollars against capital and reserves would be a disastrous blow. One that could place the continuing operation of some banks on the line.

While the banks wait for government assistance to come through under the new budget, they still need sufficient capital to maintain their lending book. If capital and reserves fall below a certain level, the rules set by the BIS (Bank of International Settlements, the Central Banks' Central Bank) they would be over-exposed to risk and have to start calling in loans – something nobody in Japan would like to see at this delicate point in time.

Since Japanese banks are entitled to use unrealised profits on their investment in Japanese companies as part of the capital reserves, and since they have vast investment on the Tokyo exchange, an increase in the Nikkei Index would offer the most sure means of giving a massive boost to their reserves.

And perhaps ensure their survival until the government steps in with its rescue plan.

The (attempted) ramp and its implications

Between the beginning of March and Friday, 19 March, the Nikkei improved by 17.7%, from below 14 000 points to nearly 16400 points. Since it is estimated that the book value of the banks' investments is on average about 14000 points, the situation had improved dramatically. From being basically square on their books, unrealised profits must have improved by about 15% of their overall investment in the stock market.

How much this increase in unrealised assets really represents may not be known, but it surely is a very large amount – 15% of the very large investment by the banks in the Tokyo stock market is itself a large amount and well worth the effort of trying to ramp the Nikkei. The question remains, though how this measures up against what was wanted.

Secondly, the market did not follow through with the good performance after 19 March. On that day the Nikkei close at 16379 points, but by 31 March – the official year end – it had declined to only 15837 points. This is still 13% above the reported break-even level, but is already somewhat less than the high 10 days earlier and represent a fall of more than 20% in the amount of unrealised assets as recorded on 19 March. This late weakness could not have been the desired end to the financial year!

In very much round figures, one might estimate that the banks could have perhaps $1.5 trillion invested at cost, which implies that the improvement in unrealisable assets could be about $200 billion. This can support some few trillion of loans, depending on the nature and risk of the loans, but it still falls far short of the amount of bad debt that has to be written off against capital and reserves.

It is likely to be even substantially less than the as yet undeclared bad loans that will now creep out of the woodwork to qualify for assistance. Which would leave the banks with an unenviable decision to make – do they declare the full amount of their bad debt in order to obtain the promised government assistance or do they continue to conceal the true situation because it so just so bad that revelation could mean they would have to call in loans? Thereby to precipitate a new financial crisis in Japan?

The aftermath

It is thought that the failure to sustain the ramp all the way to the end of the month has its cause in heavy supply, as holders of shares took advantage of the ramp to unload into the ramp effort and the wider demand it had created. By doing so, sellers could achieve by far the best prices since August 1998.

If true, this excess of supply should have continued after the end of the month for as long as prices remained reasonably high. Instead, the Nikkei took off on the 1st of April and by 8 April had gained more than 6% to easily exceed the high of the suspected ramping effort reached on 19 March. In the process, the Nikkei had broken up out of the longer term bear channel shown on the daily chart 10 days ago and repeated here.

The increase has lasted long enough and went high enough for it to not have been an April 1st joke on the banks. The question then becomes, what is happening? Is it strong local demand into the new financial year? Or is it that overseas investors are seeing a recovery in the Japanese economy by 2nd half '99 and is getting in on the ground floor?

The dollar-yen rate will tell us if any significant inflow of funds into Japan had taken place to account for the surge in the Nikkei. On 4 March the rate was ¥123.3 and by 19 March the Yen had firmed by 5% to ¥117.1. This coincides with the first surge in the Nikkei and implies this initial surge could have been (partly) funded from overseas.. It remains doubtful though that brokers acting on overseas instruction could have behaved as strangely as was observed during the first few weeks of March – as described in the first article on the Nikkei. However, by 9 April the Yen had weakened again by 3.3% to ¥ 121 so it seems unlikely that this second surge was due to an inflow of funds into Japan.

By all indications therefore, overseas investors were not buying Yen in quantity to invest on the Tokyo stock exchange. Some commentators referred to renewed buying by local funds, using money that only became available in the new financial year, as the cause of the steep rise This cannot be excluded, but it is clear from the weaker Yen into April that there was little or no flow of funds from overseas to account for this steep resumption in the rising trend from the 1st of April.

Who is buying, and why?

I received a communication from Dr. Chih Kwan Chen, in response to the first article on the Nikkei, that offered a very plausible explanation for this development. He believes that it is the 'Yen carry' all over again. Hedge funds are again taking advantage of 'super low interest rates' in Japan to borrow heavily, presumably in the hope of showing a good profit on almost zero-cost loans.

This time, though, instead of exporting the funds for investment in the USA, they are investing the proceeds of the cheap loans in Japan itself. Which is why the Nikkei is rising steeply with little or no evidence of money flowing into Japan..

Chih Kwan believes that the hedge funds were too badly burnt when the Yen firmed strongly against the dollar in August/September 1998 for them to repeat that folly. Perhaps they too perceive a recovery in Japan and now use cheap Japanese loans to get into the market near its basement level. (By the way, Chih Kwan has a thought provoking analysis of macro-economy at his personal web page. He presents an interesting view on the role and effect of super low interest rates within a global economy. Interested readers can find it at http://pages.prodigy.net/ashino4112 and follow the link to the article itself.)

After some thought on the matter, I now speculate whether the overseas funds were not part of the buying spree in early March, that pushed up the Nikkei by more than 17% and which suited the Japanese banks perfectly well. And which I originally ascribed to the Japanese banks themselves. This thought leads one logically to wonder whether the Japanese banks may not have sold this idea to the hedge funds in the first place.

Under the circumstances, it would not be too farfetched to imagine the following offer from a Japanese bank to the hedge funds: "Japan is going to start its recovery later during 1999, seeing that the government is going to solve our bad debt problems and also inject the biggest stimulatory package in history. We believe the Nikkei is going to continue through the roof (again!) and we are willing to lend you unlimited amounts of money at much less then what you had paid on your gold leases, provided you invest the loans on the Tokyo Stock Exchange."

It does not stretch the imagination much further to imagine the following conversation at an investment meeting of some hedge fund:

Chairman: "It would make sense to invest in Japan at this low cost. Risk is substantially reduced if we can get the money at zero cost and if the Nikkei takes off in response to stirrings in the Japanese economy we could score really big. We do not want to bring the funds into the US, as we did before, as the risk/reward ratio has changed for the worse"

Rocket scientist; " Mr. Chairman, we all know that, as you imply, the Dow is now dangerously overbought. If Wall Street should suffer a significant correction, this would be reflected in a weaker bond market, since much of the hot money that flowed into the US during the past few years would depart again – for Japan among other destinations. The dollar would weaken substantially and the yen should benefit the most among other currencies. If we are invested in Japan we would score not only the gain on the Nikkei arising from new investments in a growing economy, but there should be a very nice profit on the exchange rate as well.."

"We know that if we started to close our positions in the top-heavy US equity market we may well trigger a correction and a flight of capital that can trap us with substantial losses – in the bond market too – even though we were already selling. A large investment in Japan would in effect be an excellent hedge for our continued and ever more risky exposure in the US. The zero cost is a real bonus. I can have rough figures for different levels of commitment in Japan for you by tomorrow morning."

These imagined conversations are of course mere fantasy. But it does make very good sense for hedge funds with large exposure to US markets – even in spreads, which are in principle already hedged hedged positions, particularly these had been funded through the Yen carry (refer LTCM) – to ceover themselves by opening a different hedge position in Japan. So much better if the cash to do this can be obtained at near zero cost.

If anything goes wrong with US markets, as the prophets of doom have been tirelessly saying – in my case for many years now – then a 'weaker dollar - stronger yen' would add significant value to investments in Japan. The dollar could perhaps lose as much as one third of its value to return to the 1995 low against the yen, while the Nikkei is still near its recent lows values and should not decline much further, even on a weak Dow. At worst, some profit should still accrue from the Japanese investment to offset against any (paper or realised) losses in the US.

And because the cost of borrowing is so low, one can establish quite a large position in Japan and could perhaps even make some net profit on the hedge!

Whether the Dow falls or not. In fact, while providing a hedge for a weak Dow, investing in Japan now using cheap funds, would perform really well if the US market remained firm and the Japan economy started to recover. Doing so comes close to being a sure bet!

The Technicals

Two daily charts are shown. The Nikkei 225 Index and the Nikkei 225 in US dollar.

Nikkei spot. Daily close

Nikkei in US dollar. Daily

The charts have very similar appearances; both have an appreciation of 21% since the beginning of March. But the dollar chart achieved most of this by the first half of March, assisted by Yen weakness, while the Nikkei itself extended its early gains with a good run into April after the intermediate high on 19 March.

On both charts a medium to long term bear channel was decisively broken, to indicate the possibility of a significant bull trend. However, there is strong horizontal resistance ahead – again on both charts. The Nikkei – in Yen and in US dollar – has to break above these levels before a bull trend can be in place. The value of 17225 points on the Nikkei and the 140.3 value on the dollar chart – if they should be reached at the same time – correspond to a dollar yen rate of ¥122.8. This implies weakness for the yen during the next week or so, if the resistance is reached on both charts at about the same time.

Two Scenarios can be developed. In the first Scenario the charts fail to extend above the horizontal resistance level (either one of the two, or both at the same time) and in the other Scenario demand for Japanese shares remains strong for the Nikkei to break higher through important horizontal resistance in what should then become a new bull market.

At the moment, a break higher appears very likely after the breaks higher from broad and longer term bear channels. The resolution of the two Scenarios have to wait until (and if?) the charts develop to the level of the horizontal resistance. What happens then will determine whether the hedge funds would have been correct if they had indeed exploited the wave of cheap money in Japan for a new version of the Yen carry.

One other possibility should be mentioned. If (expectations for) Wall Street should enter the new week on a stronger note, the Nikkei could reach the level of horizontal resistance early during the week, say on Monday or Tuesday. Any weakness in the Dow thereafter should spill over into Tokyo and draw the Nikkei lower, even if not to the same degree.

That would have the charts of the Nikkei reversing direction at horizontal resistance to resume the longer term bear trend and would effectively cancel the breaks from the bear channel on each chart.

A much weaker Dow would also make those hedge funds with a cheap Nikkei hedge in place very glad they had done so.

Perhaps the warning on quarterly performance from Compaq Computer on Friday is sufficient to bring this very speculative analysis to pass?

12 April 1999

© April 1999 Daan Joubert

daanj@mweb.co.za