Updated: Jun 22
From the 1960s a period of record growth propelled Japan to become the second-largest economy in the world. This ended in the mid-1990s after the popping of an asset price bubble, beginning the "Lost Decade". The Japanese yen has been floating since the collapse of the Bretton Woods system in 1973. In the mid 1990s the tool of choice to promote a revival of economic growth in Japan was monetary expansion. Interest rates fell sharply and the yen-dollar exchange rate depreciated strongly. Today Japan is the world’s second largest developed economy (third largest by nominal GDP). Japan is the world's third largest automobile manufacturing country, has the largest electronics goods industry, and is often ranked among the world's most innovative countries leading several measures of global patent filings.
Taking a deeper look into the Japanese’s economy, the net value of assets held by the government, business and individuals is +3.674.680 US$MM (2020 Q3). Japan is the world’s number one creditor country, followed by Germany (+2.707.614 US$MM), China (+2.199.680 US$MM) and Hong Kong (1.735.264 US$MM). Switzerland finds itself at the 9th place with a NIIP of +819.015 US$MM (2020 Q2). Japanese GDP was 4.910.580 US$MM in 2020, the Swiss one 707.868 US$MM. The US finds itself on the opposite side of the list with the world largest negative NIIP of -13.950.200 US$MM. For reference, Italy has a negative -28.259 US$MM NIIP.
Japan has currently negative -0.1% interest rates. Switzerland has negative -0.75% interest rates. Both the Japanese yen and the Swiss franc are therefore low(negative)-yelding currencies. Because the Swiss franc and the Japanese yen are regularly used as a safe haven currency in times of crisis, the SNB and the BOJ were forced to go below zero. Five years ago, the SNB lowered its key interest rate to -0.75% in order to avoid a further appreciation of the Swiss franc. In 2016 the same policy was implemented by the BOJ, with negative -0,1% rates to avoid a further appreciation of the yen.
There are two reasons why central banks impose artificially low-interest rates. The first reason is to encourage borrowing, spending, and investment. The second reason for adopting low-interest rates is that when national governments are in severe debt, low-interest rates make it easier for them to afford interest payments. Japan has a very high debt to GDP ratio.
The thesis saying that safe haven currencies countries tend to have low interest rates, a strong net foreign asset position, and deep and liquid financial markets, is confirmed. Both Japan and Switzerland do meet all these criteria.
The safe haven status of the yen has been confirmed by several studies. Ranaldo and Söderlind documented that the Japanese yen appreciates against the US dollar when US stock prices decrease and US bond prices and FX volatility increase.
The yen is widely considered a safe haven currency, i.e. a currency that appreciates when global investors’ behavior becomes more risk-averse or economic fundamentals are more uncertain.
Since the mid-1990s, there have been 12 clear episodes when the yen has appreciated in nominal effective terms by 6 percent or more within one quarter and these coincided often with events outside Japan. Since 2008, when the world economy was hit by the financial crisis, the yen appreciated steadily against the U.S. dollar in effective terms in the aftermath of various shocks.
The following are a few examples illustrating that appreciation of the yen during episodes of increased global risk aversion is recurrent.
The global financial crisis in 2008/09 was associated with a large Yen real exchange rate appreciation by over 20 percent.
In May 2010, higher market distress in the face of the European sovereign debt crisis led to a large jump in the VIX, followed by a 10 percent yen appreciation against the euro within a matter of weeks.
Following the Great East Japan Earthquake in 2011, when Japan was rocked by a 9.0-magnitude earthquake that caused widespread damage to the country’s eastern coastal region, the yen appreciated further.
In February 2013, also the uncertainty surrounding the outcome of the Italian elections led to a whopping intra-day appreciation of the yen against the euro of 5.25% and about 4% against the dollar,
The 2016, a year of important economic and political events (outside Japan) determined a over 10% appreciation of the Japanese Yen.
The yen tends to appreciate in the aftermath – first two quarters – of risk-off episodes, whether the appreciation is measured as nominal, real effective, or bilateral against the U.S. dollar.
A question that may arise is if it is the risk-off appreciation caused by net capital inflows? Several studies found no evidence that risk-off episodes trigger any sizeable capital inflows into Japan. Large movements in the yen during risk-off episodes occur without any detectable movements in net capital inflows or outflows.
The answer to the question what are the factors determining the yen appreciation may have to do with portfolio rebalancing through derivative transactions.
Portfolio rebalancing transactions, such as derivative transactions, are not fully captured by BoP statistics. For example, when risk perceptions change, exporters or overseas affiliates of Japanese companies may decide to lock in the exchange rate through hedging, or given Japan’s sizeable net foreign asset position, holders of foreign securities may take a long yen position. As such, these derivative transactions may not just reflect short-term speculative behavior, but may just reflect prudent risk management. There is support for this conjecture as risk-off episodes are associated with increases in net non-commercial exposures to the yen in the derivatives market. A similar effect is found for the Swiss franc, which increases the plausibility that those transactions play an important role in safe haven currency dynamics.
Foreign currency derivatives affect the spot exchange rate to the extent that they redistribute the exposure to each currency risk across agents, but derivative trading could also affect spot FX prices through market frictions (defined as anything that interferes with trade). For instance, because banks break forward transactions between a spot and forward desk, forward transactions may generate pressures in the spot market. Currency swaps affect the spot over time as they are equivalent to a series of forward transactions. Options affect the spot rate through hedging that usually takes place through the forward market.
To assess the behavior of FX derivatives markets during risk-off episodes, a study (Dennis Botman, Irineu de Carvalho Filho, and W. Raphael Lam) focuses on non- commercial positions recorded in the Commitment of Traders in FX Futures Report (CFTC), based on trading at the Chicago Mercantile Exchange (CME).
Risk-off episodes trigger increases in the non-commercial net long position in the yen, mostly through a reduction in short positions, more so than for the Swiss Franc and in contrast to the euro. Twelve weeks after the start of a VIX spike, non-commercial positions on the yen are on average 20 billion U.S. dollars net longer than otherwise. This is a significant information that provides evidence that the yen appreciation could reflect either a causal effect of portfolio rebalancing through derivative transactions or the workings of self-fulfilling expectations causing both currency appreciation and portfolio rebalancing.
The graph above represent the Japanese Yen net non-commercial futures positions. We can clearly see a large increase in net long positions during the 2008/09 financial crisis and the following 2010/11 European debt crisis; the net long positions increaed in 2011 when Japan was hit by the earthquake; in 2016, a year caracterized by important economic and political events: Chinese’s stock market crash of arount 20% in a week, OPEC cut (production limit) determining a crude oil jump over 5%; Brexit: Britain voted to leave the EU and the election of Donald Trump as the new president of the US. All those risk-off events determined a increase in the net long yen positions. We can also see that currenly, during the 2020 crisis triggered by the Covid-19 pandemic, the current net long position in the Japanese yen is at its highest (largest) level since October 2016, positioning at levels that were reached during the above explained 2016 major political and economic events.
In summary we see that surprisingly yen risk-off appreciations appears unrelated to capital inflows and do not seem supported by expectations about the relative stance of monetary policies. Instead, portfolio rebalancing through offshore derivative transactions that occur contemporaneously to yen risk-off appreciations may be the main factor determining this safe haven currency appreciation. Also, the global unwinding of carry trade positions is another factor.
Although being a safe-haven country may appear enviable, when risk-off episodes recur, policymakers in safe haven countries face the challenge of dealing with sharp real appreciations or surges in capital inflows.
From a policy-making perspective, risk-off appreciations may be undesirable. If temporary, real appreciations impose adjustment costs to the economy and lead to economic dislocation when exchange rates eventually come down. If persistent, but by no means permanent, real appreciation and capital flows surges have the potential to build-up vulnerabilities in either private or public sector balance sheets.
i) ECB Working Paper, No. 1288: Getting beyond carry trade: what makes a safe haven currency? By Maurizio Michael Habib and Livio Stracca;
ii) IMF Working Paper: The Curious Case of the Yen as a Safe Haven Currency: A Forensic Analysis by Dennis Botman, Irineu de Carvalho Filho and W. Raphael Lam;
iii) Swiss National Bank: Capital Flows and the Swiss Franc by Pinar Yesin.