Carried away

John Mauldin's "Outside the Box" report this week is a report by GaveKal, entitled "What We Missed: Japanese Liquidity Flows". You should click on the link and go online to read it.

The gist is that Japan's monetary policy of the last few decades has exported US$ denominated Japanese capital liquidity to the tune of $1.8 Trillion. "To put this into perspective, this amount is roughly equal to 15% of US GDP or 3% of the total value of US assets today."

This so-called Yen carry trade has been wildly profitable to those with access to it.

On average, returns would have been higher by some 16 % over any four year periods.

Needless to say, these excess returns were identified by investors all over the world. And first and foremost in Japan. Indeed, if one is guaranteed by one's own central bank an extra return of 4% a year for investing abroad, then, sure enough, one tends to invest abroad with gusto!

How does this policy translate in numbers? Firstly, to prevent the Yen from rising, Japan's central bank reserves rose from US$180 billions to US$ 820 billions in ten years-this was the cost of the guarantee. In parallel, reassured by the stubbornness of the BOJ in preventing the yen from rising, Japanese net private sector assets invested abroad went from 0 in 1995 (an abnormally low number linked to the liquidation of assets after Kobe earthquake) to US$1 trillion now.

And of course, the Japanese investors were not the only ones to jump on the opportunity of cheap capital. A number of people around the world started to use the Yen as a cheap source of funding.

The leverage in the system has continued to grow in the face of rising interest rates from most central banks. This is a development that we did not expect and which took us by surprise. As a result, the overall leverage in the system today is probably more prevalent, and widespread than most realize (a quick example: everyone bangs on about the impressive growth in China's reserves without stopping to wonder how China's reserves, in the past four years, have managed to outgrow China's trade surplus and FDI inflows by anywhere between US$60bn and US$100bn per annum).

As illustrated by the increase in foreign assets held by Japanese, and by the impressive increase in the Japanese monetary base (now bigger than the US monetary base), a fair amount of the leverage has taken place in Yen. This is a consequence of the fact that, thanks to the globalization of the financial revolution, borrowing in Yen is still too easy. At least, it is still too easy if the World's central banks are serious in trying to tame the growing inflationary pressures.

And with that, either Japan has to rein in its monetary stimulus or the US and other CenBank interest rates will have to continue rising.