What yen bears do not understand, and why you should not be afraid of FX risk when buying Japanese shares

by admin on June 11, 2012

A consistent theme by foreign investors who stay away from Japan, aside from the copious bad news, is the so-called “exchange rate risk”.

This is the idea that buying yen is not as safe as keeping your money in Euros or dollars. What is interesting is that this idea has remained so popular over the last two years, as the yen has soared in value (79.6 to the dollar at the time of writing, relative to a low point of around 100 in 2009).

Now, with Japan potentially facing a current account deficit for the first time in ages, largely driven by increased energy imports due to nuclear power plant shutdowns, talk of a plunging yen is rife.

So what is the risk to your yen investments?


As I broadly explained here, in order to analyze this kind of potential event, you need to split it up into a sequence of actions that may (or may not) happen.

The current postulated sequence of events is as follows:

Yen bear mind map

Yen bear mind map

However, sharp eyed armchair economists will note that:

Since the 1995–2005 period, net investment income inflows into Japan have contributed more to the current account balance than net trade flows.” Kiel Institute for the World Economy, 2012

Japan BoP disaggregated

Japan BoP disaggregated

This means that even if Japan makes a loss on trading high-tech goods for food, it can still make it up in investment income.

Imagine an old guy fixing cars in exchange for food, which he used to get a surplus on, but now may make a loss on (due to getting old.)

Will he go bankrupt? Not if he has a huge portfolio of bonds and direct investments paying him stable interest and dividends.

Dynamic equilibrium analysis

What is dynamic equilibrium analysis?  Is this just a name designed to make someone sound clever?

 A dynamic equilibrium is where you do something, and something else reacts to it. And, an analysis of that situation would require thinking about what the reaction will be.

For example, if you buy your girlfriend a bunch of roses, she will be very happy, which will be a good time to let her know some bad news, which she will hopefully take relatively well, due to her focusing on the roses.

Back to the slightly more abstract, imagine that Japan started importing huge amounts of very expensive natural gas (which, in fact, it is doing), and the price of other things it imported went up while the things that it exports went down in price (not far from reality).

What would happen? The demand for yen would go down, and the demand amongst young holders for assets traded in US dollars would go up. The yen would fall.

This is where the dynamic bit comes in. What would happen to the yen thereafter?

Yen bear mind map 2

Yen bear mind map 2

Obviously, the competitiveness of exporters in Japan would rise, which would be good for the economy, until the exported their way back into a stronger yen.

But what if there was a structural shift toward importing more stuff in Japan? Then there would be a more long-lasting effect of boosting exports.

What does this mean to me as a foreign investor?

This means that if the yen falls due to trade reasons, then the economy and stocks will do relatively well. However, there should be some mean reversion as the exporters undermine their own competitiveness with time. The degree to which this effect will last will depend on the above import/export factors.

In other words – worrying about the yen is much less rational than worrying about other currencies.

Also, while thinking about this, take into account the above point about capital flowing into Japan from its accumulated investments. That capital needs to be continually exported if the yen is not to rise too much. In an expansionary phase, Japanese companies will invest more overseas, bringing the yen down relatively more, and in a pessimistic phase the opposite will happen.

Second-order affects

Lastly, on top of the picture painted above, you need to superimpose continually improving productivity of Japanese industry, which has been accelerated by the pain of a high yen.


As an investor in Japanese stocks, you do need to worry about cyclicality, but you do not need to worry about the yen entirely collapsing due to the three factors of: huge investment inflows into the country, the dynamic equilibrium of the yen giving rise to better performance in the yen falls anyway, and continual improvements in efficiency.

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