Investors flock to yen, but at a cost to Japan

The dramatic rise of the Japanese yen is shining a light in another dark corner of the global financial system -- a corner that, like the U.S. subprime mortgage market, turns out to be hiding goblins.For years, investors took advantage of Japan's perennially low interest rates to borrow Japanese yen and invest in other currencies with higher-yielding bonds and assets. Now those so-called carry trades are unwinding as investors, blind-sided by the global financial crisis, sell off their holdings and scurry to buy enough yen to pay back their loans.The perverse result: The value of the yen is going up at a time when the Japanese economy is falling into recession and its stock market is melting. While emerging markets and countries with commodity-dependent economies, such as Canada, see their currencies tumble in value, Japan is the only major country outside of the United States to suffer the opposite problem.The yen gained by as much as 10 percent against the U.S. dollar last week and an even more dramatic 34 percent against the euro.A higher yen threatens to further undermine Japan's economic performance by making it more expensive for foreigners to buy Japanese-made cars, cameras and gaming systems.Investors unloaded the shares of major Japanese exporters such as Toyota and Sony yesterday, helping send the Tokyo market down 6.36 percent to its lowest closing since October, 1982.The G7 group of industrialized nations is worried enough that it issued an unusual statement of concern this week about "the recent excessive volatility in the exchange rate of the yen and its possible adverse implications for economic and financial stability."Part of the explanation for the yen's rise may be a flight to quality. Japan has the world's second biggest economy and its big banks have so far been less affected than other countries' by the credit crisis, so some investors could be seeking shelter in the yen.But analysts say the little-publicized carry trade was a much bigger factor. For years, the system for profiting from extraordinarily low Japanese interest rates seemed to offer easy money and little risk. Investors loved it, just as they loved the various exotic investment vehicles based on U.S. mortgages. Estimates of the amount of money in the carry trade begin in the hundreds of billions.The opportunity came because, with its economic growth uncertain, Japan kept its interest rates near zero for most of the past decade. Japanese and foreign investors took out low-interest loans in yen, then took them off to greener pastures, often investing in small-country currencies such as the Icelandic krona or simply putting it into stocks."The strategy was to borrow almost at zero and pop the cash elsewhere and sit back and do very well, thank you," said Geoff Kendrick, senior currency analyst for UBS in London.They sometimes saw extra gain when the value of the yen went down and the currency they were investing in rose, so when they had to repay their yen loans, they could do it more cheaply. But when the financial crisis hit and the value of the things they invested in suddenly plunged, these investors had to liquidate their investments and buy yen to repay their loans.That started a snowball effect similar to the unwinding of the subprime mortgage market. As investors rushed to get out of the carry trade and buy yen, the currency rose. Other investors saw that it was getting more and more expensive to repay their yen loans and rushed to get out of the trade. The result, said David DeRosa of DeRosa Research in New Canaan, Conn., was "blind panic."The snowball effect has been compounded because other countries are lowering interest rates to help deal with the effect of the global crisis. That further reduces the appeal of exploiting low interest rates in Japan.But Nariman Behravesh, chief economist at forecasting firm IHS Global Insight, said the rise in the yen "needs to happen." Exchange rates -- just like real estate markets, commodities and stock markets -- are realigning and moving toward more appropriate levels. "Across the markets, there were these huge speculative positions. This is the hang-over after the binge," he said.With reporting by Heather Scoffield(Distributed by Scripps Howard News Service, www.scrippsnews.com.)