The Japanese Earthquake's Effect on the FX Market
On 11 March 2011, a level 9.0 earthquake hit Japan. Unleashing 300 times more energy than the 1995 Kobe earthquake, it was the largest in modern history, resulting in a tsunami that wiped out many coastal villages on the northeast coast. This destruction was compounded by a handful of explosions in the Fukushima Daiichi nuclear power station, releasing a stream of radioactive material into the atmosphere and water, which has yet to be brought under control.
The human and economic costs have been immense, resulting in mass homelessness and rolling blackouts across the country due to a loss of power generation – with nuclear power accounting for 30% of total energy, 6% has been lost. Additionally, the prefectures affected by the disaster account for 4% of manufacturing and 6% of agriculture. The latest estimate of the cost of damage is at JPY25 trillion, or 5% of Japan’s gross domestic product (GDP).
The immediate financial response to the disaster from Japanese and international authorities was aggressive and unified. The Bank of Japan (BofJ) pumped JPY15 trillion of liquidity into the economy, along with hints that more is to come. It also purchased equities to lend support to crashing stocks and announced supplementary deficit spending to help pay for the recovery. The total amount of this is not known as of yet, but it likely to go beyond JPY10 trillion (2% of the GDP).
The week after the earthquake, faced with a disorderly rise in the value of the Japanese currency, the G7 countries carried out their first co-ordinated intervention in currency markets since 2003.
The reaction from foreign exchange (FX) markets to the catastrophe was puzzling and, at first blush, counterintuitive. Figure 1 shows the hour-by-hour value of the US dollar in terms of yen. The initial sharp appreciation (downwards direction in the graph) is hard to understand for the currency of a country that had just undergone a severe macroeconomic shock.
What’s the explanation for this reaction? The yen appreciated sharply on the belief that there would be large levels of asset repatriation to pay for claims and damages by Japanese insurance companies. Furthermore, Japanese households, hold over US$500bn of foreign assets in FX investment trusts and Uridashi bonds (bonds denominated in a foreign currency and sold directly to Japanese household investors), as well as speculative margin trading accounts. These holdings of foreign assets have been one of the ways in which Japanese savers have responded to the many years of near-zero interest rates in Japan, and both their ability and willingness to hold them are a key measure of ‘risk tolerance’ among international investors.
Traders feared that these holdings – both insurers’ and households’ – may be sold off and repatriated, both to sustain household spending through the disruption and as part of a general flight from risk amid the uncertainty. Furthermore, there were fears that hedge funds and speculators were positioned the wrong way – shorting the yen – and would have to cover in a panicky, illiquid market. The disorderly price action in the days immediately after the earthquake seemed to lend credence to these fears.
Figure 3: Price of a US$/JPY Put Option, Strike = 1.3 US Dollar Cents per JPY, Expiry 8 April 2011
Source: Bloomberg
As these graphs demonstrate, the volatility of the yen has been astonishing. Anybody who relied on the yen for their payables/receivables and dealt only in spot contracts rather than hedging their currency would have been hit hard, with unpredictable rates sending their profit and loss (P&L) figures up and down by large amounts in a very short space of time.
In the aftermath of the earthquake, a stronger yen was about the worst possible scenario for Japan. The infrastructural and socio-political impact of the earthquake and a loss of confidence in the region would combine with the loss of competitiveness of Japanese exports and threaten to tip Japan back into recession.
The situation came to a head on 16 March US time/17 March Tokyo time, when the yen rose to 76.50 against the US dollar in the stated panicky, illiquid market. The Japanese Ministry of Finance proceeded with verbal intervention, or ‘jawboning’, declaring that the G7 nations were readying intervention. This alone was enough to stabilise the yen.
The threats were followed through a few hours later, when early 18 March morning the BofJ, the Federal Reserve, the European Central Bank (ECB) and monetary authorities in Canada and the UK proceeded to sell a joint total of about JPY2 trillion in the FX markets, the first co-ordinated intervention in the markets since 2000. This brought about a sharp weakening of the currency and capped a week of extraordinary FX volatility.
The evolution of the Japanese currency in the coming months is uncertain. It is possible to identify the critical driving factors, but it is much more difficult to predict their relative strength.
While insurers’ repatriation of assets is expected to be positive for the JPY, the majority of the damage incurred was uninsured, meaning that claims for Japanese insurers are unlikely to exceed US$10bn – not a large figure in comparison with the daily turnover of international FX markets.
More difficult to estimate, and potentially more meaningful, is the impact on the yen of any collective decision by Japanese households to significantly reduce their holdings of foreign assets. Whether because of the need for liquidity in the face of the earthquake disruption, or a general change in the risk appetite change in risk appetite of households, any meaningful reduction in the US$500bn that Japanese households are estimated to hold in foreign assets would be bullish for the yen.
However, there will be bearish flows that will pull the yen in the opposite directions. First, a sustained appreciation of the yen will almost certainly see further BoJ/G7 intervention – the US$25bn worth of currency sales from 18 March can be repeated several times over.
Second, we are likely to see the Japanese current account turn deeply negative for the next few quarters, as imports of materials, supplies and equipment needed for the rebuilding effort temporarily increase Japan import bill. This means that the support the yen has enjoyed from Japan’s persistent trade surplus is likely to ebb, at least temporarily.
It’s this uncertainty over possible responses that will keep the yen volatile well into the rebuilding process, highlighting how dealing with currencies is unpredictable, volatile and inherently risky – not just during a major event, but afterwards, too.