Financial Times, Wednesday, 15 May 1996

By Barry Riley

Tokyo and the Art of Hedge Maintenance

Risk-seeing foreigners have held the Japanese stock market together during a disturbed period

So foreigners invested a record Y7, 000bn (43.4bn pounds) in net purchases of Japanese equities during the fiscal year ended March, including Y1, 100bn during the latter month. This has represented a massive commitment by global (especially US) investors to the Tokyo market's recovery potential.

But has it been worthwhile? True, after bottoming out at the end of last June the Tokyo market showed an impressive 42 per cent recovery up to the recent late-April high. But that was in terms of yen, and you had to be very smart to buy the stock market at the midsummer low.

If you had bought exactly a year ago, the current profit on equities in local currency would have been 23 per cent but the loss on the yen to a dollar-based investor would have been 18 per cent. It has therefore been essential to hedge the yen.

Curiously, the 10-year Japanese government bond yield is just about exactly where it was in May last year, at around 3.4 per cent - although it has been down to 2.8 per cent meanwhile.

Robert Fleming's Tokyo-based economist Richard Werner, who a year ago correctly predicted the Bank of Japan's liquidity boost which sent the yen tumbling, is now forecasting more of the same.

As last year, he says, the key movements will come in the third quarter, with the yen buckling to 120 to the dollar and the Nikkei advancing towards 25,000. Again, you do not need even a pocket calculator to work out that only the currency hedgers will win.

Recently, however, there have been fears about a recovery of the yen. Having bottomed at nearly 109 to the dollar in mid-April the yen has scared its bears (and further confused the Japanese institutions wondering nervously whether they should buy dollar bonds yielding 7 per cent) by rallying to about 105).

But Mr Werner focuses on liquidity, which he says continues to be plentiful in Japan while being quite tight in the US.

Therefore the dollar must rise against the yen. In Japan, not only is the BoJ printing money quite fast but the banks are at last recovering from shell shock and are starting to create net new credit again. Strong overall liquidity expansion will therefore push Japanese GDP growth towards 4 per cent.

Will this scare the BoJ into an early rise in official short-term interest rates? Commercial bank base rates are already edging up slightly. But the BoJ will not move before September, Mr Werner thinks. The BoJ is satisfied that essential structural changes are taking place within the Japanese economy (which until a year ago it was not).

Prices remain higher inside Japan than outside, so inflation cannot be imported through yen depreciation - at least, not for the foreseeable future. But a resumption of solid economic growth will be bad news for bonds in due course.