Japan's Warlords Meddling in the Nikkei-225, Yen, and JGB markets
"Free markets for Free men" is the battle cry for traders on Chicago's Futures markets. But if one wants to place a bearish bet on the direction of Japan's financial markets, be prepared to do battle with Tokyo's Ministry of Finance. And for traders in the Nikkei-225, Japanese yen, and Japanese government bond market (JGB's), it just seems like deja-vu all over again.
Meddling in the local bond, stock and currency markets is a time honored tradition at the Japanese Ministry of Finance. In its most brazen form, former MOF chief Masajuro Shiokawa drew up plans in February 2002, for his ministry to buy 2 trillion yen of stocks directly from banks, and asked that the Bank of Japan to increase its monthly bond purchases by a quarter, to 1 trillion yen. Then, a few weeks later the MOF authorized several buying forays into the Nikkei futures market ahead of the Japanese fiscal year end on March 31st, 2002.
By purchasing large amounts of Nikkei futures contracts before the fiscal year end, Shiokawa put the squeeze on market bears in order to help improve the balance sheets of besieged Japanese banks. T hen the Financial Services Agency, the government's top financial watchdog, penalized four foreign brokers, Credit Lyonnais, Bear Stearns, Deutsche Securities and Nikko Salomon Smith Barney for violating regulations on short-selling.
Tokyo tightened short-selling rules and increased surveillance of foreign brokers who accounted for half of the average daily trading volume on the TSE. The MOF ordered public pension funds to be buying shares to offset any display of market disappointment with the Nikkei support package. So after hitting a low on February 6th, 2002, the Nikkei 225 jumped 26%, with a rebound in the yen taking the dollar return to 32%, owing less to fundamentals than the government's efforts to ramp the index, by stopping short selling and orchestrating buying ahead of March 31st, when near-insolvent banks have to mark portfolios to market.
Tokyo's scheme was exposed by the difference in performances between the Nikkei -225, the index targeted for support, and the broader Topix index, which badly lagged the Nikkei with an 11% gain. Financial Services Minister Hakuo Yanagisawa then made it crystal clear on March 4, 2002 why Tokyo decided that giving share prices a boost mattered. "With the Nikkei at or above 10,000", he told a parliamentary panel, "banks have no need for an infusion of taxpayers' money to bolster their capital and help dispose of non-performing loans. We have done various simulations and if Nikkei stocks maintain 10,000, it should be roughly ample," Yanagisawa said.
So when a two-day deluge of sell orders on January 17 and 18th, 2006, suddenly sliced off about $300 billion off the market capitalization of the Tokyo Stock Exchange to $4.4 trillion, Japan's financial warlords quickly went into action, and shut-down the exchange, about 20 minutes earlier than usual, to forestall the execution of large panic sell orders before the closing bell. The 36 trillion yen loss in market capitalization was almost equal to the value of the entire Chinese stock market, which was valued at $329 billion.
When asked about the sell-off, blamed on the fudging of revenues at an obscure Internet company Livedoor 4752.T, Japan's top financial diplomat Hiroshi Watanabe appeared calm, saying it was not "a very unique phenomenon." Having battled currency speculators to the tune of $300 billion in 2003 and early 2004, to prevent the dollar from finding its natural level of equilibrium, below 100-yen, Watanabe knows how to bend the rules of the game.
Miraculously, over the next two days, the Nikkei-225 rebounded without hesitation, recovering most of the previous day's sharp losses. The media quoted institutional traders, explaining that Japanese stocks were cheap after the 7% sell-off, and that fundamentals of blue chip stocks shouldn't be based on the misfortunes of the 117 Internet companies traded on the TSE. That certainly sounds reasonable for the day trader.
But from an inter-market technical point of view, the Nikkei-225 shakeout was an accident waiting to happen, due to a long delayed reaction to the dollar's 7% decline from a 32-month high of 121.50 yen on December 5th, to as low as 113.60 yen on January 12th. The rising fortunes of Japanese exporters and multinationals, which make up the lion's share of the TSE, was built on a weak yen (or strong dollar), which is why Japanese MOF spends so much time jawboning the market, to support the greenback against the Japanese yen.
For most of 2005, the dollar had climbed a wall of worry, from a low of 102-yen to as high as 121.50 yen, on the back of rising short-term US interest rates. However, record US trade deficits and widening Japanese current account surpluses argued for a weaker dollar. But measuring the delicate balance between fear and greed, the Japanese investor's desire for higher yielding US dollars trumped concerns about trade flow imbalances. Until of course, the Fed signaled on December 13 th that its tightening campaign was nearing the neutral zone.
So on December 16th, after witnessing the dollar plunge 3-1/2 yen to 116-yen, Japanese FM Sadakazu Tanigaki climbed up to the podium to do psychological battle with currency traders. "Looking at the past few days, we have seen some violent moves. We must closely monitor the market." Tightening the screws a little further, his deputy Koichi Hosokawa called yen fluctuations "relatively big, and the yen's movement was too rapid and the MOF is watching the market with great attention."
In the past, whenever Japanese authorities have intervened in the market to curb the yen's rise, ministry officials have used the secret code words, will "take appropriate action as needed." But the MOF left these key buzz words out of their message, on December 16th, keeping its powder dry for another day.
Still, the verbal threat was enough to help the dollar rebound by 2-yen to 118-yen a few days later, lending optimism to Nikkei-225 traders that the MOF would provide a safety net for the falling dollar, 24 hours per day, five days per week. But Tokyo was caught off guard, when Yu Yongding, a top economist of the People's Bank of China warned for the second time in a month, that Beijing had to diversify its bulging currency reserves out the dollar. Traders estimate that China is holding 70% of its $818 billion of currency reserves in dollars.
Suddenly, the dollar plunged again, this time from 118-yen to 113.50 yen, after Yu's remarks, and the Nikkei rally stalled out at 16,500. Tanigaki then switched tactics and used the key buzz words on January 9th, "As the G-7 statement has said, foreign exchange should reflect fundamentals and move in a stable manner. The G-7 approves of governments taking appropriate action when moves are out of line with those conditions." The "A" word for "appropriate" was enough to place a floor under the US dollar at 114-yen.
Tanigaki held a private consultation with US Treasury chief Snow, and Fed chief Greenspan on January 10th, to discuss the dollar/yen. Snow hears the pleas of Detroit automakers that need a dollar /yen rate of 90 to 100 yen to compete with the likes of Toyota and Honda. However, Tokyo also holds $682 billion of US Treasury bonds, and Washington cannot afford to alienate its biggest creditor by calling for a cheaper dollar. The US is on track to borrow 34% of gross global government borrowing in 2006.
Standard and Poor's predicts the US government issue $364 billion of medium- and long-term debt this year, up 14% from 2005. President Bush will also ask Congress for another $70 billion for the wars in Iraq and Afghanistan, on top of $330 billion for the wars so far, for this fiscal year.
But perception of risk free trading in Japanese blue chip stocks, due to the automatic MOF safety net for the dollar, is creating bubble like conditions on the Tokyo Stock Exchange. Japanese individuals are jumping on the Nikkei bandwagon in a big way, trading 104.3 trillion yen of stocks in the fourth quarter of 2005, compared with 109.3 trillion yen for overseas institutions. A year earlier, individuals accounted for only 29.8 trillion yen, as overseas investors traded 47.8 trillion yen.
Daily trading on the Tokyo Stock Exchange more than doubled to 391.6 trillion yen in the final three months of 2005, surpassing records from the so-called bubble years of the late 1980's. And Tokyo has left itself as much ammunition as necessary for foreign exchange intervention starting April 1st, keeping its borrowing ceiling for its foreign exchange special account unchanged at 140 trillion yen ($1.2 trillion).
Yet the perception about the BOJ's guaranteed safety net for the falling US dollar is misguided. Japanese authorities sold a record 20 trillion yen in 2003 and another 15 trillion yen in the first three months of 2004, but were left holding a $75 billion trading loss from its historic intervention, after the dollar fell to 102-yen in January 2005. Ultimately, the dollar's recovery and the Bank of Japan's good fortune were engineered by the Federal Reserve's steady determination in lifting the federal funds rate above the US inflation rate.
The dollar's recent recovery to as high as 119.50 yen on February 3rd, from 114-yen two weeks ago is also based on expectations of another quarter-point Fed rate hike to 4.75% in March, and not the empty threat of BOJ intervention. Still, the Japanese MOF will continue to jawbone the dollar, in its unrelenting drive to inflate exporter profits and lift the Nikkei-225 into higher ground.
Japanese exports, which affect domestic production and investment plans, rose by 17.5% to 6.34 trillion yen ($54.7 billion) in December 2005, and were 76% higher from three years earlier. The yen's 17% devaluation against the Chinese yuan helped boost exports to China to a record 915 billion yen, ($7.8 billion) in December 2005, while imports from the world's fourth-biggest economy rose to 1.1 trillion yen, the second-highest ever. China and Hong Kong surpassed the US as Japan's largest trade partner for the second straight year. Trade with China and Hong Kong rose to 24.9 trillion yen in 2005 while trade with the US totaled 21.9 trillion yen.
Overall, Japanese exports rose 26.4% in December to 6.34 trillion yen, recording double-digit year-on-year gains for five straight months, and totaled a record 65.66 trillion yen ($553 billion) last year. Yet despite the surge in exports, Japan's trade surplus shrank nearly 20% in December from a year earlier to 914 billion yen, due to a larger 27.3% surge in imports to 5.42 trillion yen. For all of 2005, Japan's trade surplus fell for the first time in four years to 8.79 trillion yen ($76 billion), and lagging China's $102 billion surplus.
Japanese oil imports jumped 60% in December from the same month a year earlier. To meet the demand of industrialists, Japanese oil refiners drew on crude stockpiles, which fell 4% to 93.84 million barrels in January, to the lowest since 1972. But Japan's Nikkei-225 has been un-fazed by two oil price shocks to roughly $70 per barrel in the past five months, insulated by the ultra-easy money policy of the Bank of Japan, much to the satisfaction of Japan's financial warlords.
A tighter BOJ money policy is long overdue, but the powerful MOF has handcuffed the central bank, and wants to delay any shift in quantitative easing until the second half of 2006, or possibly into 2007. However, the BOJ's ultra-loose monetary policy carries risks and came with a "big price of suppressing market mechanisms," such as keeping government bond yields abnormally low, said BOJ chief Toshihiko Fukui on January 26th, 2006.
It was Fukui who busted the JGB bubble in June 2003, about two months after the Nikkei-225 had bottomed at a 20-year low of 7603, in a speech given before the nation's leading bankers. "Now we are implementing measures to ease monetary policy in order to boost the economy, and that in a sense is aimed at creating situations which would drive up long term interest rates." JGB yields hit rock bottom that day at 0.48%, and within 3-months had tripled to a high of 1.50 percent.
With JGB yields spiraling upwards, the MOF sprung into action to place a barrier at 1.50 percent in September 2003. "The rapid increase in Japan's benchmark bond yields is prompting the government to watch the market with caution," said Jiro Makino, the MOF's bond desk manager. "A drastic rise in bond yields, while expectations about economic recovery are growing to some extent, would throw cold water on it," he warned. Then Vice Finance Minister Masakazu Hayashi added, "Moves of yields have been too rapid recently and the MOF will continue to watch the bond market closely," signaling the end of JGB meltdown.
But with the Nikkei-225 racing upwards towards the 12,000 level in April 2004, the yield on the 10-year JGB had jumped again, this time towards the psychological 2% level. Then the MOF's heavyweight Tanigaki stepped in to cap the rise in JGB yields. "A rapid rise in long-term bond yields is undesirable and Japan will continue to watch yield movements closely. A rapid rise could affect the economy in various ways so we need to be cautious about that,' he said.
The MOF's mastery over the JGB market is largely due to the fact that only 5% of Japan's outstanding public debt of 775 trillion yen ($6.6 trillion), or 151% of gross domestic product, is held by foreigners. Japanese banks usually march to the tune of the MOF, listening for signals of when to buy or sell. The Bank of Japan rarely moves out of step with the MOF on monetary policy. The central bank's nine-member board voted 7-2 on January 20th in favor of leaving policy unchanged.
And until the MOF's handcuffs come off, the BOJ's only mechanism for slowing commodity inflation or pre-empting a Nikkei-225 bubble is jawboning long term rates higher whenever they fall towards 1.20%. But the BOJ's influence is fleeting, because the MOF's Tanigaki usually jawbones rates in the opposite direction whenever JGB yields approach 1.60 percent.
"As the economy recovers, there could be irregular moves on the back of the ultra-easy conditions. We are carrying on a policy with such potential risks. When we have fully confirmed that deflation has ended, we shall shift policy accordingly at the right timing," Fukui declared on January 26th. Determining the timing and the degree of such a tightening move is one of the biggest question marks facing the global financial and commodity markets in 2006.
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