Europe
Mortgages and Consumption in Old and New Europe
November 03, 2006

By David Miles | London

We see great scope for mortgage markets in parts of Europe to grow rapidly over the next 10 years, particularly where the stock of lending is currently very low (A much more detailed report is to be published on Monday 6th November). The stock of owner-occupied housing in much of Central and Eastern Europe (CEE) is substantial while the amount of mortgage debt remains very low. But the availability of debt in Central and Eastern Europe has recently increased significantly. We consider what the impact of that might be, focusing on how it might shape the dynamics of consumption, savings, house prices and construction.

What we have seen over the last decade within Western Europe, and very recently in parts of Central and Eastern Europe, is substantial convergence in the price and availability of mortgage debt. The impact of significantly greater access to mortgage credit is potentially very great — as evidenced by the effects in the past on spending, construction and house prices in parts of Europe following significant liberalization. Lending remains so small in some parts of Europe — and again this is most marked in the east — that it is reasonable to expect particularly fast growth in the stock of debt there. If that happens, it could have significant implications for overall spending. In aggregate emerging eastern European economies are large enough that such shifts in spending would have global implications. In 2006 the combined income levels of the 10 accession countries that joined the EU in May 2004, plus those of the candidate countries and Russia, was roughly the same as the GDP of China. So the impact of greater availability of mortgage debt upon consumption in eastern Europe is as important to the world economy as what happens to consumer spending in China.

Availability of credit and the cost of mortgage debt have not been dramatically different across much of Western Europe for some time. So the remaining big differences in the stock of debt probably reflect to a significant degree other factors that are likely to be deep seated and possibly slow moving — for example the operation of bankruptcy laws.

France, for example, has a relatively low stock of mortgage debt relative to GDP. But this does not reflect an exceptionally high cost of mortgages, nor unusually restricted access to mortgage credit. In contrast, until very recently the cost of debt in many CEE countries has been much higher — certainly when measured by the nominal interest rate on debt, which is the most relevant factor for many households. Even more significantly, until very recently the availability of debt has been dramatically lower in many Eastern European countries than has been the case further west. These factors have kept the stock of mortgage lending in Central and Eastern Europe tiny.

But both factors have changed substantially in the very recent past — debt is now more available in many countries and now often at a price that is comparable to that in Western Europe. We anticipate that these conditions are likely to persist and that, as a result, the amount of mortgage lending across much of Eastern Europe is likely to rise rapidly.

Until very recently, nominal mortgage interest rates in most eastern European countries were very much higher than further west. But recent convergence has been dramatic. For example, Latvian and Polish mortgage rates are only just over 1% above their German equivalent. The increasing availability of foreign currency loans has brought even more dramatic convergence in the nominal interest rate on debt between Eastern and Western Europe. Mortgage interest rates in Estonia declined to 3.6% in 1Q 2006 and in Lithuania to 3.4%, below the average rate in Germany (4.4% in 1Q 2006).

The potential for growth in the stock of debt for CEE countries is large. Amongst the central and eastern European countries highlighted in the graph, debt to GDP ratios are rarely much above 10% and generally well below it. Yet owner occupation rates are high. Amongst western European countries with comparable owner occupation rates, the average mortgage debt to GDP ratio is around 60%. No one should expect the stock of GDP in the CEE countries to rise by the equivalent of 50% or 60% of annual GDP in the space of a few years — such an adjustment could clearly take longer. But even if it was spread across 15 years, lending would rise by the equivalent of almost 4% of GDP a year, and that is on top of the rise in mortgage debt that itself reflects growing economies.

What might the impact of such growth in the stock of debt be? It would be highly likely to trigger some combination of:

1. Faster consumption and lower saving: As younger households are able to buy houses earlier in their life without the need to save so much, and as older, existing owner occupiers are better able to tap some of the wealth in their homes to finance spending.

2. Higher house prices as greater availability of credit increases the demand for housing.

3. More construction and renovation work to residential property as the financing available to households to pay for such work is much enhanced. Many emerging economies have wide ownership but low quality of housing. A high proportion of the housing stock often has been of poor quality and in states of disrepair. This suggests significant scope for investment in construction and upgrading of the housing stock, as credit becomes more widely available. In addition, complementary services, such as insurance, credit rating and legal services, are likely to benefit in this changing environment.

4. Lower household saving is likely to mean that current account positions move into deficit (or surpluses are reduced). The deterioration in the current accounts is the counterpart to the capital account flows which would result if, as seems likely, much of the extra mortgage lending comes from overseas mortgage lenders.

Bottom Line: Easier access to credit is likely to create dramatic, albeit risky, growth opportunities, especially in the housing- and consumer-related sectors, and particularly in emerging economies where financial liberalization still has the scope to deepen significantly. Saving rates will be lower, trade balances will shift, house prices will rise further and construction and renovation will be boosted. In aggregate emerging eastern European economies are large enough - with a combined GDP comparable to that of China - that such shifts in spending would have global implications.

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Europe
Coping With Globalization, So Far
November 03, 2006

By Eric Chaney | New York

Globalization is generating a lot of anxiety among EU citizens; it is most often associated with irreversible job losses, downward pressures on wages and even losses of political independence. Yet, evidence that the EU has suffered from globalization so far is scarce. In fact, a careful look at trade of good and services indicates that the European Union is coping with the challenges implied by globalization better than the US or Japan. However, this benign outcome cannot be taken for granted: if EU countries do not make their economies more flexible, miss the opportunity to capitalize on their strengths by liberalizing services and increase the return on innovation, globalization could lead to a dramatic loss of welfare in Europe, or at least in some of its countries. These are the conclusions I draw from an interesting research note by Karel Havik and Kieran Morrow (H-M) of the EU Commission (Global Trade and Outsourcing: How Well is the EU Coping with the New Challenges, Economic Papers N 259, October 2006).

First, the good news. On H-M’s findings, the EU-15 block has managed to keep its global market share in traded goods practically unchanged at 15.4% over 1998-2003 (globalization), vs. 15.5% over 1992-1997 (pre-globalization). By contrast, the US has lost 0.8 points (from 12.8% to 12.0%) and Japan 1.9 points (from 8.8% to 6.9%). The most spectacular winner is of course China, with a 1.6 points rise from 2.8% to 4.4%. In fact, more recent WTO data show that China’s market share has dramatically increased since then, to 8.9% in 2004, while the EU share was constant. The explanation of the EU-15 performance is its comparative advantage in ‘medium-high technologies’ (20% of global trade in 1998-2003), in ‘difficult to imitate research intensive goods’ (19.7%) and to a lesser extent, in capital-intensive goods (15.6%). For each of these three categories, the EU-15 has a strong revealed comparative advantage, as shown not only by its share of global exports but also by sector trade balances. At the product level, the largest comparative advantages are in that order: passenger cars, pharmaceuticals, specialized equipment goods, parts and accessories for motor vehicles and telecom equipment. The rapid growth rate of trade of ‘parts and components’ compared to overall global trade growth is clearly the result of globalization, as companies break supply chains and outsource the resulting bits in various locations, according to their relative comparative advantages. In this regard, EU-15 companies have managed to take advantage of globalization by outsourcing production in Central and East European countries and insourcing assembly lines. The car industry is a good example of this successful strategy.

The EU-15 performed even better in services. In 2003, the EU-15 block had 35% of the global market of traded services, followed by the US with 25%. More important to gauge revealed comparative advantages and using the same two periods as for goods, the net balance on trade in ‘other services’ (i.e. other than transportation and travel, which are growing much slower) improved from 0.2% to 0.4% of GDP, while it decreased slightly for the US, from 0.6% to 0.5%. Running surpluses, both economies are in fact benefiting from globalisation in services, in contrast with Japan and China, which are running deficits. The big winner from the globalization of services, especially IT-enabled services is of course India, which moved from a deficit of 0.2% of GDP to a surplus of 0.6%. A more detailed breakdown shows that European comparative advantages are in financial services, insurance, IT and construction services, while India’s strength is mostly concentrated in ‘other business services’.

Going forward, the EU performance is clearly at risk. First, even though wages are rising fast in the coastal part of China, the abundance of cheap labour in the rest of the country will continue to make China (and now Vietnam too) the best place for labour intensive industries. In other terms, the pressure of globalisation is going to intensify, not to weaken. There is more: because Europe is weak in the ICT sector, judging by its trade balance, the concentration of efforts by many Asian exporters in this sector had harmed the US and, to a lesser extent, Japan, more than Europe. However, Asian exporters and above all China are likely to invest their trade surpluses precisely in the sectors where Europe is the most successful such as passenger cars. Last, the dramatic fall of communication costs will most likely accelerate the outsourcing of services, in favour of India but not only. There is no easy way to cope with the challenges of globalisation both widening and accelerating. The best antidote remains in my view to capitalize on Europe’s competitive advantages such as highly sophisticated services and to reward innovation much more than is the case today. This requires further liberalisation of services and a faster move toward the integration of financial markets in Europe, with probably negative consequences on jobs. This also requires an in-depth review of incentives to innovate and finance innovation in order to enhance the return on innovation. Tax policies may help, but competition policies too. In this regard, the EU Commission itself may have some homework to do.

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Currencies
Asian Currencies to Lead the Break-out of the Ranges
November 03, 2006

By Stephen Jen | London

Summary and conclusions

I believe that the best opportunities in currency markets in the coming weeks will be with the AXJ currencies. At the same time, the majors are likely to remain in a broad range for a little while longer: though the market is eager to sell the dollar, I suspect that weak data in the US now will be followed by stronger data later, in turn keeping the majors in their familiar ranges for the time being. Having said this, among the G3 currencies, the JPY has the best chance of being the first major currency to break out of its familiar range, in my view. I suspect we will break out of the ranges for both the major and the minor currencies before the year is over, with the Asian currencies outperforming both the USD and EUR.

The US will likely soft land

Echoing the view of our US economists, I have a constructive outlook on the US and the global economies. In my mind, the world is still reaping the benefits of goods and financial globalization, and what we are witnessing is a very benign rotation of growth away from the US to the rest of the world. The US housing market will propel a soft-landing in the US, as slowing consumption is offset by capex and net exports. Moderate growth in 2Q and 3Q is likely to turn out to be temporary, and the US economy will likely reassert itself.

The Fed also holds this view. In the past four years, the Fed has been correct at all the turning points, and following the Fed’s view, in retrospect, would have been a fantastic trading rule.

I won’t go into the details of the debate on the US economy here, as there is ample discussion elsewhere, but would like to stress that the bond, equity and credit markets have very different opinions on this debate. The ‘composite view’ from these three markets, however, is rather benign. Our work on predicting the probability of a recession in the US in the coming 12 months suggests that, while a bond-market based model would say that the recession risk is approaching 60% — on par with the probability that prevailed before the previous two recessions in 1991 and 2001 — the ‘composite’ view from the bond, equity and credit markets puts the risk at only 13% at end-October, down from 19% a month earlier.

I believe that the bond markets have an exceedingly bearish outlook on the US economy, even though bond investors may not be as bearish. Part of the bid in bonds may be related to foreign liquidity (the excess savings argument), and part may be a reflection of bond investors’ fear of ‘missing out on the bond rally’. In any case, we believe that looking only at the bond markets gives a distorted view of the US economy.

The Fed will likely remain on hold; other central banks likely to catch up

I maintain the view that the biggest obstacle to further tightening by the Fed is weak economic activity, while the greatest barrier against rate cuts is lingering inflationary pressures. Given what we know about the housing market, lower potential growth and inflationary pressures, I believe that the Fed will remain on hold for a while, likely until next summer.

An important assumption of my view that USD/JPY has peaked and will trend lower over time is that Asia should be able to de-couple from the US, if the latter only soft lands. This should allow Japan and AXJ to continue to recover, and the BoJ to normalize its monetary conditions. Similarly, the BoE, ECB, RBA, SNB, Norges Bank, Riksbank and other central banks that need to tighten further will be able to do so.

The dollar, partly as a result of a prospective compression in the policy rate differentials, is likely to experience a cyclical depreciation, not because the Fed will cut the FFR, but because the rest of the world will still be able to continue to normalize rates, even if the Fed terminates its tightening campaign.

Risk-taking is normalizing

I have long argued that there are four key parts to the discussion on the cyclical aspect of the USD outlook: (1) the US economy, (2) de-coupling, (3) the Fed and (4) risk-taking. Risk-taking is a function of the other three factors. If I am correct — that the US economy will soft land, the world can de-couple from the US, and the Fed will be ‘caught up’ by the other central banks — risk-taking should normalize. By ‘normalization’, I refer not only to the absolute size of risk-taking, but also the pattern of risk distribution.

Since May/June of this year, risk in emerging markets has been pared down, but there has been plenty of risk-taking in the major equity markets and the bond markets. As the investment community becomes less concerned about the risk of an outright recession in the US, it will adopt a more normal pattern of risk-taking. Net equity flows into emerging Asia should normalize, as should net equity flows into Japan.

Blue sky versus storms

Essentially, investors have to commit to a big-picture view for 2007: Will we be in a fear-filled environment where the name of the game will be to hide from the storms, or will we be in a benign environment where the aim is to find the bluest patch of sky? I belong to the latter camp, and believe that the Asian currencies should do well.

The JPY has formed a medium-term bottom

I continue to believe that the JPY has formed a medium-term bottom against both the USD and the EUR.

Here are some thoughts I have.

1. The announcements by the central banks of Russia, the UAE and Switzerland to raise their holdings of JPY are important. Though I don’t think diversification by these central banks in and of itself will support the JPY, I suspect central banks are coming to the realization that they may already be underweight the JPY, and that the JPY is so under-valued that this is not a bad time to start to accumulate JPY assets.

2. Under PM Abe, Japan is adopting an even more aggressive stance toward inward FDI (foreign direct investment). In June, the target of doubling the FDI stock to 5% of GDP by 2010 was announced. Japan’s demographic reality compels the government to adopt policies (e.g., FDI) that are positive for productivity growth. Further, from the ‘lost decade-and-a-half’, the Japanese public has learned the virtue of foreign competition in Japan. Now, with the JPY being so under-valued, it is a great time for foreign investors to think about buying Japanese companies. Valuation matters. I believe that the JPY is likely to have reached a level that now makes direct investment in Japan rather attractive.

3. Japanese retail outflows may be peaking. The decline in Japan’s ‘home bias’ — part of which may be motivated by demographics — may be coming to an end. Already, we are picking up anecdotal signs that foreign investment trust funds are now significantly under-subscribed, suggesting that Japanese investor appetite for foreign assets may be abating. First, with the JPY being so weak, the asset purchasing power is so eroded that it makes less and less sense to buy foreign assets at these JPY prices. Second, the MoF is genuinely uncomfortable with the JPY being so weak. It may have already commenced verbal intervention to discourage excessive outflows from the retail investors. I will try to find harder evidence of this hunch I have. But at this point, I suspect that the JPY has established a medium-term bottom.

Whether and when the JPY can start to strengthen against the USD and the EUR is a function of two things: (1) the BoJ and (2) a resumption in equity inflows. After the BoJ’s October Outlook Report, I remain comfortable with the expectation that the bank could raise the policy rate in December. Regarding equity flows, just as they began to return to AXJ three weeks ago, after a long drought, I believe that global investors will also start to invest in Japanese equities.

USD/Asia the best trade for the coming year

Until the tentative resumption of net equity inflows to AXJ that began three weeks ago, AXJ currencies had actually performed remarkably well, as they weakened only modestly between May and September, with virtually zero equity inflows. They have since regained composure as net equity inflows resumed. USD/KRW reached its peak straight after North Korea’s nuclear test on October 9, and this was indeed a great KRW-buying opportunity. Since then, USD/KRW has fallen 25 big-figures. In recent weeks the CNY, the SGD, the THB, the KRW and the INR have outperformed the IDR, the MYR, the PHP and the TWD. I expect the latter four to gradually catch up: There is no reason why the still high-yielding IDR should not benefit from the normalizing risk pattern, and the MYR should rise with the SGD.

I have four thoughts: (1) Continued net equity inflows will remain one of the most important conditions for my bullish call on the AXJ currencies to come true. USD/AXJ’s down-trend from January to April was interrupted by broad-based risk-reduction in the emerging space, but the process is unwinding now. (2) USD/CNY’s descent will be steady and determined. We are heading towards 7.70 by year-end. (3) Despite what I have said about USD/Asia, the HKD peg will be retained. 7.75 will be defended by the HKMA, and 7.80 will be retained as the central parity. (4) AXJ central banks don’t want more reserves — they will no longer intervene aggressively, as they had done until early 2005, to defend the dollar. This is the defining difference between 2006 and all the prior years. This was also one of the main reasons I turned very bullish on the AXJ currencies in November 2005. If downward pressures mount on USD/AXJ, USD/AXJ will be allowed to trade lower.

Bottom line

I expect USD/AXJ to break out of the ranges first, in the very near future. It might take a bit longer for the majors to break out of their ranges, but I expect the JPY to take the lead when that happens.

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Currencies
Tracking the World's Official Reserves
November 03, 2006

By Stephen Jen | London

Asia still a major holder of reserves

As of September, the world’s total official reserves were US$4.714 trillion, an increase from US$4.175 trillion at end-2005. Asia still commands the largest pool of reserves, with close to US$3 trillion, or around two thirds of the world’s total. Japan’s reserves continue to grow at a pace of US$35-40 billion a year, not because of intervention, but from investment returns. China’s reserves have continued to grow as a result of both investment returns and large balance of payment (BoP) surpluses. Most other central banks in Asia have ceased to intervene to buy dollars.

Investment returns will be a major driver of future reserve growth: based on a 5% annual return, Asia’s reserves would grow at around US$150 billion a year without further interventions. This is a very large sum, as it is equivalent to approximately one third of Asia’s annual current account (C/A) surplus.

Contrary to popular presumption, the GCC countries have a tiny amount of official reserves (at only US$90 billion). Most of their BoP surpluses have been funneled into ‘Sovereign Wealth Funds’ and, similar to the way in which Norway handles its oil receipts, they have not kept the surpluses in the form of central banks’ reserves.

Reserve Diversification: Who is ‘Important?’

In the past few days, the Central Bank of Russia, the Central Bank of UAE and the Swiss National Bank announced their intention to continue to diversify out of USDs, with a favourable view toward the JPY. Russia has around US$252 billion in reserves - the fourth largest in the world. But the UAE and Switzerland have only US$25 billion and US$36 billion, respectively. What the latter countries decide to do with their reserves has very modest direct implications for the market, though their announcements clearly signal the preferences of their central banks and those of the central banks of other countries.

Interventions to abate, we suspect

The official reserves of most countries have reached ‘saturation levels’: further increases in reserves are no longer unambiguously desirable from those countries’ perspective. We expect central banks to become less interventionist, and for most of the future increases in reserves to come from interest earnings: on a reserve stock of US$4.7 trillion, a 5% annual return translates into US$235 billion.

Sovereign Wealth Funds Increasingly Important

The GCC countries drive global assets markets through their ‘Sovereign Wealth Funds,’ such as the ADIA (Abu Dhabi Investment Authority). Petrodollars are difficult to track as they have not been managed in same way as official reserves and so have become ‘lost’ in the sea of private capital flows. Going forward, we see Asian central banks under increasing pressure to go the same way, by diverting some of their new reserves - either newly purchased USDs through interventions or interest earnings on the existing stock of reserves - into other Sovereign Wealth Funds so that they can be exposed to higher-risk-higher-return assets.

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Currencies
HKD: The HKD Peg Will Never Go
November 03, 2006

By Stephen Jen | London

The HKD peg is here to stay

As the rate of crawl of USD/CNY accelerates, there is increasing speculation that the HKD peg may also be dismantled. I know that one should never say ‘never,’ but I strongly reject this speculation, and argue that the HKD peg will not be dismantled for many years. The CNY/HKD cross breaching through parity may be politically meaningful, but is not relevant for our purposes. The clear trade recommendation is to fade this speculation and maintain a long USD/HKD position as it falls toward the 7.75 barrier.

CNY/HKD approaching 1:1 getting people excited

As the CNY is guided higher, it is approaching the 1:1 parity vis-à-vis the HKD. At the same time, with the USD/HKD parity having drifted below its central target of 7.80, some investors are speculating whether the HKD peg will also be dismantled, and, in general, what might happen to USD/CNY as it approaches the 7.80 mark.

The main source of downward pressures on USD/HKD is foreign equity inflows to HK to take advantage of the IPOs of Chinese enterprises. Despite the 100 bp of negative carry, foreign equity funds don’t bother sourcing the funds locally, as the expected capital gains on the IPOs far exceed this negative cost of carry.

In any case, I believe the 7.80 is irrelevant for USD/CNY, while remaining very relevant for USD/HKD. 7.75 will be defended by the HKMA and currency traders should take advantage of the current distorted situation and stay long USD/HKD in both the spot and the forward markets.

I make the following points.

1. China and Hong Kong are completely different economies. China is a production/export-oriented economy, while most of the value-added activities in HK are concentrated in the financial services. HK is indeed still the primary entrepôt for China, but this is not because the HKD is ‘cheap’ and competitive. Rather, history, geographic convenience, good ports and shipping facilities and the good logistics that HK offers have been much more important.

While, for China, the benefits of an independent monetary policy are gradually outweighing the costs (this is why Beijing decided, back in 2000, to move toward currency flexibility), for HK, currency stability is much more important. HK has never been particularly reliant on a cheap currency. Instead, a stable currency provided by the currency board regime has served the economy well and will continue to be a primary nominal anchor for HK.

In short, the CNY flexibility has virtually no implications for the HKD, and the HKD peg has no implications for the CNY.

2. The CNY is appreciating, not depreciating. During the Asian Crisis of 1997/98, the CNY came under significant depreciating pressures, due to contagion. Back then, there might have been a case made about the competitive pressures impinging on HK. However, right now, the CNY is appreciating. There is absolutely no reason, from a competitiveness perspective, that HKD or any other currency in Asia needs to strengthen in response to a strong CNY.

3. The HKD is convertible; the CNY is not. Investors should also appreciate the significance of the fact that the CNY is far from fully convertible. The lack of convertibility makes USD/CNY passing through the 7.80 mark irrelevant. There is no reason why CNY: HKD should trade 1:1. Our year-end target for USD/CNY is 7.70, and I expect USD/CNY to continue to trend lower in the coming years.

4. In the very long run, the HKD could just ‘fade away’; no explicit de-peg is needed. Since the CNY is already a second legal tender in HK and is circulating in parallel with the HKD, the HKD could just one day be supplanted by the CNY. As the CNY gradually becomes an international currency, it will become the dominant legal tender in HK. No explicit de-pegging of the HKD is necessary.

Bottom line

The 7.80 parity is irrelevant for USD/CNY, but will remain very relevant for USD/HKD. I continue to believe Asian currencies will do well against the dollar; the glaring exception will be the HKD. USD/SGD and USD/KRW may be good proxies to capture the prospective USD/CNY move, but the HKD peg will not be dismantled for many years.

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Currencies
USD: The Risk of a Recession Within 12M is Now Only 13%
November 03, 2006

By Stephen Jen | London

We have updated our recession predictor, using the latest available data as of end-October: end-October for all the financial data, and end-September for the real data.

Bond markets and equity markets continue to diverge, in terms of the implied views of the US economy in these markets. The 3M-10Y yield spread widened further to 31 bp (an inverted yield curve) in October. As a result, Models 1 and 2, which include only the bond market prices, now yield higher probabilities of recession compared to September: the 12M forward recession risk based on Model 1 is now at 60% and the risk based on Model 2 is at 34%.

At the same time, the S&P has continued to perform well, suggesting that the implied view on the US economy has actually improved from September. Further, the credit market is telling a similar story.

Examining the bond, equity and credit markets, as Model 7 does, we find that the probability of a recession in the coming 12 months falls from 19% in September to only 13% now. (Note that we last reported a probability of 20%, but the September building permits growth has been revised since we conducted that calculation.)

We have also updated the six alternative scenarios that we track.

Overall, we remain comfortable with the view that the bond markets over-reacted to the slowdown in the housing markets, and that the structural US bears may have gotten ahead of themselves in predicting a recession in the US.

While there is likely to be considerable volatility in the data in the period ahead, we believe the most likely outcome remains one where the US soft lands, and the risk of an outright recession in the US remains low.

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Currencies
JPY: Type 3 JPY Carry Trades: Fact or Fiction
November 03, 2006

By Stephen Jen | London

Summary and conclusions

In this note, we challenge the notion that there are large JPY-denominated loans extended to non-Japanese borrowers. All the evidence we could find points to JPY loans being too modest to be an important source of JPY weakness. Ruling out JPY loans leaves Japanese capital outflows as the most potent type of JPY carry trades.

Four types of JPY carry trades

In a previous note, we suggested, in thinking about the so-called ‘JPY carry trades’, that it might be useful to separate out distinct types of flows. Of course, these different types of JPY carry trades are not mutually exclusive.

First, ‘Type 1 JPY carry trades’ are the Japanese capital outflows, including both institutional flows and retail outflows. This is the most widely accepted definition of JPY carry trades. Second, ‘Type 2 JPY carry trades’ are the JPY-to-JPY carry trades, whereby Japanese banks and other investors ‘borrow short’ and ‘lend long’ in JPY. Third, ‘Type 3 JPY carry trades’ include foreign entities’ borrowing in JPY.

In that previous note from June 15, 2006, we already made the point that bank data do not support the view that there have been large Type 3 JPY carry trades. In this note, we re-examine the Type 3 JPY carry trades, in response to unsubstantiated claims that this type of carry trade is very large and has had a major impact on the JPY. We reiterate our claim made in the previous note that evidence is weak for Type 3 JPY carry trades weighing on the JPY. Finally, currency hedging could be considered as a Type 4 carry trade.

We make the following observations:

• Observation 1. For the world, JPY-denominated loans are tiny, in relative terms. According to data from the BIS, cross-border bank claims are very large. As of end-2005, total cross-border claims were US$21.1 trillion. By currency, the USD and the EUR account for a combined 82% of this total, while JPY loans account for only 5% of the total stock of loans outstanding. In percent of the quarterly increases in these cross-border claims of reporting banks, JPY loans did indeed account for a disproportionately high share (16%) of the total incremental increase in cross-border claims in 4Q, but USD and EUR loans still accounted for 70% of the new loans extended. The question here for us is not so much whether there were new loans extended in JPY terms, but whether these loans were large enough to drive the JPY weaker. Our judgment is negative.

• Observation 2. JPY loans through the UK financial system have actually declined. To cross-check the data from the BIS, we also examined data for the UK banking system. The overall number of JPY loans has plummeted by 40% in the year that ended in June 2006. Thus, based on the data, there is no sign that demand for JPY loans in the UK — one of the largest financial centers in the world — has increased; the evidence in fact points to the contrary.

• Observation 3. JPY loans through the Eurozone system have been dwarfed by EUR and USD loans. JPY-denominated loans of this type account for only 3.5% of the total and have actually declined in the past year. There is zero evidence from these data for the Euroland that non-Japanese demand for JPY loans has increased.

• Observation 4. JPY loans to Eastern European countries seem not to have increased either. There have also been unsubstantiated claims that the JPY is weak partly because cheap JPY loans have become popular in Eastern Europe for mortgages. As in the UK and Euroland, JPY loans account for a tiny fraction of total loans (0.4% of the total) and have actually declined in the past year (falling by 75% in the past year).

Narrowing down our list of culprits for the weak JPY

In thinking about the reasons behind the weak JPY, the culprits can be put into two categories — JPY carry trades and other factors. I consider ‘Global Funneling’ and a demographics-induced decline in the ‘home bias’ the two key factors not related to JPY carry trades. In addition to the three types of JPY carry trades we defined at the outset of this note, perhaps we could consider labeling currency hedging as a Type 4 JPY carry trade.

Data from the UK, Euroland and Hungary all point to JPY loans being a tiny fraction of total loans, and they have actually declined in the past year. The BIS aggregate data show that JPY loans are only 5% of total cross-border loans. This is too small to be a major driver of the weak JPY, in our opinion.

In our previous work, we have also ruled out Type 2 JPY carry trades as an important factor behind the weak JPY. This leaves us with Type 1 and Type 4 JPY carry trades as the most likely culprits. We intend to look into these issues in greater detail in the future.

Bottom line

There is speculation that rampant ‘JPY carry trades’ have kept the JPY weak. We have identified four types of JPY carry trades, and focused on Type 3 — JPY loans outside Japan — in this note. All the evidence we were able to find contradicts the increasingly popular view that non-Japanese investors have put on large short-JPY long-other asset positions.

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