The Bank of Japan's zero interest rate policy since early 2001 has created an incentive to borrow in Japan at close to zero interest rates, and employ the borrowed money to buy high yielding assets such as US 10-year Treasury Notes.
For instance, an individual borrows ¥106,200 from a Japanese bank at 0.5% interest rate, which he then exchanges for US$900 (the exchange rate is ¥118 per US dollar). He then uses the $900 borrowed money together with his own $100 to invest in US Treasury Notes for a yield of 4.5%. After one year the $1000 becomes $1045, implying that after interest expenses of $4.5 our investor makes a profit of $40.5, which amounts to 40.5% return on his $100.
As long as the dollar stays stable or does not fall against the yen our investor is going to make a hefty return on his money.
However, the whole thing could reverse very rapidly should the US dollar depreciate against the yen. Let us say that the yen has appreciated against the US dollar and it is trading at the end of the year at ¥115 per US dollar. In this case, on the maturity date, one year after, our investor must repay $928 — this means that his profit falls to $17, or 17%. Obviously should the yen appreciate much more — let us say to ¥112 — then his repayment to the Japanese bank in dollar terms will amount to $953 implying a loss of 8%.
So it is not surprising that most yen carry trade players have become very fearful of the recent appreciation in the yen against the US dollar. (On Thursday March 8 the price of US dollars in yen terms fell to below ¥116 against ¥118.44 at the end of February).
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Most analysts maintain that the yen carry trade has boosted world liquidity and this in turn has given a boost to asset prices in all parts of the world. It is held that as a result of the strengthening in the yen an unwinding of the yen carry trade is likely to ensue, which in turn could lead to the decline in the world liquidity. A fall in world liquidity in turn could pose a serious threat to financial markets and to world economic activity, so it is held.
There is a problem with the whole notion of world liquidity. What is this term supposed to mean? Before attempting to tackle this issue we must establish what is meant by the term liquidity and what rising or falling liquidity means.
The meaning of monetary liquidity
The subject matter of liquidity emanates from the interplay between the supply and the demand for money. People demand money in order to facilitate trade. By means of money a product of one specialist is exchanged for the product of another specialist. The nub of what makes a particular thing money or a medium of exchange is that it offers to the holder of money a greater purchasing power than any other good.
In short, money (being the most marketable entity) enables an individual to secure a greater variety of goods than any other good could do, i.e., it has a much greater purchasing power than any other good.
People therefore don't want more money in their pockets as such but more purchasing power. According to Mises,
The services money renders are conditioned by the height of its purchasing power. Nobody wants to have in his cash holding a definite number of pieces of money or a definite weight of money; he wants to keep a cash holding of a definite amount of purchasing power.1
So when an increase in the demand for the medium of exchange, i.e., money, has taken place it means that people now want in their possession more purchasing power than before. With the greater purchasing power of money more goods and services can be now secured. Or we can also say that more goods and services can be now exchanged for money.
For instance, as a result of an increase in economic activity and the subsequent increase in the production of goods, an increase in demand for money emerges. Consequently, given an unchanged supply of money and a given purchasing power of money, the result is a shortage of money. So how is this shortage resolved? By what means will the increase in the demand for money be accommodated? (People now want more purchasing power than is available).
The emerging shortage of money can be labeled as a fall in monetary liquidity. This fall in liquidity sets in motion a process, which accommodates an increase in the demand for money. Since now more goods and services are going to be sold (exchanged) for an unchanged stock of money this means that prices of goods and services are going to fall, or the purchasing power of money is going to rise. (Remember that price is the amount of money per unit of a good). The increase in the purchasing power of money thus accommodates the previous increase in the demand for money for a given money supply. In short, the fall in prices eliminates the shortage of monetary liquidity.
An increase in the supply of money for a given demand for money and for a given purchasing power of money will result in a surplus of money or an increase in monetary liquidity. (There is now more money than what people require at a given demand for money and a given purchasing power of money). A given stock of goods will now be exchanged for more money.
Consequently, this will lead to a fall in the purchasing power of money, i.e., rise in the prices of goods, the prices of assets, and the prices of services. The fall in purchasing power brings into balance the quantity of money supplied with the quantity of money demanded. In short, the rise in the prices of goods and services reduces the initial increase in monetary liquidity.
A change in monetary liquidity doesn't affect all goods and asset prices instantly — there is a time lag. As a rule the effect from a change in monetary liquidity tends to manifest first in financial asset markets before moving to the other markets.
For instance, an increase in monetary liquidity, after a short time lag, will lift the prices of financial assets (lowering financial asset yields). As time goes by, liquidity starts to enter other markets, which results in the rise of prices of goods in these markets. Consequently, as a result of the widening in the increase in prices, the surplus of liquidity dwindles.
Once the new money has filtered across most goods and services, the purchasing power of money falls in line with the demand for money — i.e., the surplus of liquidity disappears. Conversely a fall in the supply of money for a given demand will result in less money being exchanged, i.e., sold for financial assets — thereby depressing asset prices and raising their yields. A decline in monetary pumping after a time lag will hit other markets — i.e., less money will be exchanged for goods in these markets. The adjustment culminates once the purchasing power of money increases in line with the demand for money.
Is there such a thing as global liquidity?
When we talk about monetary liquidity we always refer to a surplus or a deficit with respect to a particular money like the US dollar or the Japanese yen or the European euro. Since we deal here with different moneys, obviously these moneys cannot be added up into a meaningful total. So by saying that there is an increase in world monetary liquidity, one implies that there is such a thing as total world money. As we have seen, however, such a total cannot be established.
Goods and assets in the world markets are not exchanged against non-existent world money but against specific moneys. For instance, in commodity markets most prices are quoted in US dollars. In the European stock markets prices are quoted in euros likewise in Japan the stocks are quoted in yen. Hence to ascertain the effect of liquidity on a particular market one must pay attention to the relevant money.
Since Japan doesn't print US dollars, it cannot determine the overall supply of dollars. Japan also, cannot alter the overall demand for dollars. From this we can infer that the increase in Japanese liquidity cannot have much effect on the American liquidity, all other things being equal. Consequently, Japan cannot have much say with regard to monetary liquidity of the United States or any other country.
Despite this conclusion, Japanese monetary policy has still given rise to a disruptive process in the allocation of scarce world resources. The zero-interest rate policy of the BOJ has caused a misallocation of resources by supporting various asset classes, which if not for the zero-interest rate would not have been considered. The unwinding of the yen carry trade is likely to undermine these assets.
What ultimately matters for stock markets in various countries is the state of monetary liquidity in a given country and the state of its pool of real funding. For instance, in the case of the United States, what will matter is the state of US dollar liquidity. So regardless of the yen carry trade, if the liquidity is going to be there, and the pool of real funding is still growing, then US financial markets will continue to hold their ground.
On this score, after falling to 1% in August last year the growth momentum of our US monetary measure AMS has struggled to form a rising trend. The yearly rate of growth after climbing to 2.1% in November eased to 1.3% in February. However, on account of a weakening in the growth momentum of economic activity, the growth momentum of our measure of liquidity has been in a visible rebound since August last year (see chart). This in turn should provide support for US financial markets regardless of the yen carry trade.
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The unwinding of the yen carry trade cannot alter the other countries' liquidity, all other things being equal, but it can weaken Japan's liquidity. The unwinding of the yen carry trade could undermine Japanese liquidity only if Japanese banks do not replace the repaid loans from the unwinding of the carry trade with new lending. (We assume here that the loans were created out of "thin air.")
So in this case the unwinding of the yen carry trade could be negative for Japanese financial assets, all other things being equal. A similar effect on liquidity will also take place as a result of any credit contract (the loan was created out of "thin air") that has reached its maturity date and the loan is repaid and not replaced with a new loan.
For now, the growth momentum of Japanese monetary liquidity displays a visible strengthening. After falling to negative 10.3% in July last year, the yearly rate of growth of monetary liquidity jumped to negative 4.5% in February. The growth momentum of bank credit to the private sector has been in positive territory for the past thirteen months. The yearly rate of growth stood at 1.4% in February against 1.8% the month before.
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An important factor in the recent strengthening of the yen against the US dollar is a tighter interest rate stance of the BOJ. Since July last year the interbank call rate was pushed from zero to 0.5%. Consequently, the yield on the 3-month Treasury bill rose from 0.34% in July 2006 to 0.59% in February. We suspect that a visible fall in the growth momentum of the core price inflation might bring to a halt the present tighter interest rate stance. (The yearly rate of growth of the core CPI fell from 0.3% in August last year to zero in February.)
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Additionally, the relative money growth differential between Japan and the United States has visibly moved in favor of the US dollar versus the yen. We suggest this could put a break on the fall in the US dollar against the yen in the months ahead.
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To conclude then, as long as the pool of real funding available to Americans is still growing, and as long as the growth momentum of liquidity is heading up, US financial markets will remain well supported regardless of the yen carry trade.
- 1Ludwig von Mises, Human Action, 3rd rev. ed. (Chicago: Contemporary Books, 1966) p 421.
