Japan Investment Report 2011 — The Currency That Rose on Bad News

In March 2011 Japan experienced an earthquake, a tsunami and a nuclear accident in the space of days. The yen appreciated sharply.

This confused a great many observers, because the debtor-economy intuition is deeply ingrained: a country in crisis sees capital flee and its currency fall. That is what happens to an economy that owes money to foreigners.

Japan is the opposite case. It is a large net creditor — Japanese institutions own far more foreign assets than foreigners own Japanese ones. The reflex in a domestic crisis is therefore inverted:

• Insurers face enormous domestic claims and need domestic currency to pay them.
• Their assets are substantially foreign, held abroad for yield.
• So they sell foreign assets and buy yen. The repatriation is a purchase of the home currency.
• And markets anticipate this, so the currency moves before the flows do.

The lesson generalises well beyond Japan. Whether a currency strengthens or weakens in a domestic crisis depends on which direction the country's net asset position points, and that is published free.

The second consequence was structural and larger. The nuclear shutdown removed a substantial share of electricity generation. The gap was filled by imported fossil fuels, and the import bill rose enough to eliminate a trade surplus that had persisted for decades.

This is a useful demonstration of energy security as an economic rather than a political variable: an economy importing nearly all its primary energy has a current account that is a function of energy prices and of domestic generation choices. A decision about nuclear power is a decision about the trade balance, and the two are rarely discussed together.

The third theme is that Japanese corporate cash holdings — long criticised as evidence of poor capital allocation — behaved exactly as insurance is supposed to. Firms funded rebuilding and absorbed disruption from their own balance sheets without a credit event.

Why a creditor's currency rises in a crisis

The mechanism deserves precise development, because it inverts a widely held intuition.

For a net debtor economy:

• Foreigners hold claims on the country.
• In a crisis they reduce exposure, selling domestic assets and converting to their own currency.
• This sells the domestic currency, so it falls.
• And the fall worsens the position, since the foreign currency debt is now larger in domestic terms — the mechanism the Global Investment Outlook 2013 describes.

For a net creditor economy:

• Domestic institutions hold claims on foreigners.
• In a domestic crisis they need domestic currency — to pay claims, to fund rebuilding, to meet obligations at home.
• So they sell foreign assets and repatriate, buying the domestic currency.
• The currency rises.

The additional reinforcing factors in 2011:

• Carry trade unwinding. The yen had been a funding currency — borrowed cheaply to invest elsewhere, per the mechanism in the Global Investment Outlook 2010. A risk event causes those positions to close, which requires buying yen to repay the borrowing.
• Anticipation. Market participants who expect repatriation buy ahead of it, which moves the currency before the flows arrive.

A currency's behaviour in a domestic crisis is determined by the direction of the country's net foreign asset position. The intuition that bad news weakens a currency is a description of debtors, not a general rule.

The policy problem this created was severe. A stronger currency was the last thing an economy facing supply disruption and reconstruction needed — it damaged exporters at the moment they were least able to absorb it. Coordinated intervention followed, which is one of the few instances of multilateral currency intervention in the period.

The practical screening point: net international investment position is published free by the IMF and by national statistical agencies for essentially every economy. It tells you which way a currency will move under domestic stress, and it is not a difficult number to find.

An energy decision is a trade balance decision

The structural consequence of the nuclear shutdown is the report's largest, and it clarifies a link that is usually treated as two separate subjects.

The starting position: Japan imports nearly all of its primary energy. Domestic nuclear generation was, in effect, a substitute for imports — it produced electricity from fuel that was cheap, storable and required in small physical quantities.

When generation capacity was withdrawn:

• The electricity still had to be produced, so fossil fuel generation increased.
• The fuel had to be imported, at world prices.
• The volume was large, because replacing a substantial share of a large economy's baseload generation requires a great deal of gas and oil.
• And the timing was poor, with energy prices elevated over the following years.

The trade balance consequence was direct and mechanical: a surplus that had persisted for decades became a deficit, driven almost entirely by the energy import bill.

Three second-order effects:

• Electricity costs rose, which is an input cost for every domestic producer and a competitiveness issue for energy-intensive industry.
• The currency's fundamental support weakened, since the trade surplus had been part of it — a factor in the subsequent depreciation during the reflation programme described in the Global Investment Outlook 2013.
• And energy security became a first-order policy constraint, shaping subsequent decisions on supply contracts, diversification and generation mix.

The generalisable framework:

For an energy-importing economy, the generation mix is a term in the current account. A decision to change it is a decision to change the trade balance, and the two are usually debated by different people using different vocabularies.

The Global Investment Outlook 2022 covers the same identity in Europe, where a change in the availability of imported energy produced an equivalent, larger shock — and where the preparedness question was framed, again, as insurance with a visible cost and an invisible benefit.

The cash pile that was doing its job

Japanese corporate cash holdings had been criticised for years as inefficient. 2011 is the strongest available counter-evidence, and the argument on both sides is worth stating fairly.

The critique was coherent:

• Cash earns very little, so holding it depresses return on equity.
• Capital held idle could be invested in growth or returned to shareholders.
• And large cash balances can shield management from the discipline that scarcity imposes.

The defence, which 2011 supported:

• The holdings are self-insurance. A firm with substantial cash can absorb a shock without needing to raise capital — which is precisely when raising capital is most expensive or impossible.
• The 2008 experience had demonstrated that credit availability is not reliable, per the Global Investment Outlook 2008.
• And the alternative to self-insurance is dependence on a banking system, which had its own history of stress.

What actually happened in 2011:

• Firms funded reconstruction, relocation and supply chain rebuilding from their own resources.
• There was no wave of corporate distress despite an enormous physical shock.
• And the recovery in production was faster than most estimates, partly because firms could act immediately rather than negotiating financing first.

The honest conclusion is that both positions are right about different states of the world, which is what makes the argument persistent:

Cash is a drag on returns in every year except the ones where it is the difference between adapting and failing. Whether it is worth holding depends entirely on how often you think those years arrive — which is a judgment, not a calculation.

This is the same insurance asymmetry as the Asia-Pacific Investment Report 2008 on reserves and the Asia-Pacific Investment Report 2011 on inventory buffers. Three different forms of the same trade-off, all criticised on the same grounds, all vindicated by the same kind of event.

Upstream, invisible, essential

The supply disruption revealed Japan's position in global manufacturing, and the gap between that position and its reputation is analytically instructive.

The reputation, based on headline statistics: an economy with low growth, an ageing population and declining relative economic weight.

The position, revealed by the disruption: a dominant global supplier of specialised upstream inputs — advanced materials, precision components, specialist chemicals, and the equipment used to manufacture them.

Why the two are consistent:

• These products are low-volume and high-value, so they contribute modestly to output while being essential to output elsewhere.
• They are intermediate goods, so they are invisible to consumers and to most commentary.
• And the businesses are frequently mid-sized specialists, not large listed companies with high public profiles.

Why the positions are durable, per the Asia-Pacific Investment Report 2011: accumulated process knowledge, long qualification cycles, and markets too small to attract entrants but too critical to abandon.

The investment implication is about the difference between size and criticality:

• A supplier of an irreplaceable input has pricing power far exceeding what its revenue suggests.
• Its customers' output depends on it, which is a systemic position.
• And the position is defended by qualification barriers rather than by scale, which makes it more durable than most competitive advantages.

The corresponding risk is that criticality attracts attention. Once a dependency is recognised, customers and governments work to remove it — through second-sourcing, subsidised domestic capability, or design changes. The Asia-Pacific Investment Report 2018 covers this becoming policy, and the Japan Investment Report 2019 develops the position in detail.

Why the surplus outlived the trade balance

A technical point that matters for reading any mature creditor economy.

The current account has several components, of which the trade balance is only one. The other large one for a creditor is the income balance — interest, dividends and profits earned on foreign assets, net of what is paid to foreign holders of domestic assets.

For an economy that has run surpluses for decades, the accumulated foreign asset stock is enormous, and the income it generates is large and relatively stable.

So the arithmetic can look like this:

• The trade balance turns negative, as it did after 2011.
• The income balance remains strongly positive, because it depends on the asset stock rather than on current trade.
• And the current account stays in surplus anyway.

Why this matters practically:

• The income balance is far more stable than the trade balance, since it depends on an accumulated stock rather than on annual flows. This makes the overall external position more robust than a trade deficit suggests.
• It is also partly a function of foreign returns and exchange rates rather than of domestic competitiveness.
• And it means external adjustment pressure is much weaker than for an economy with no such buffer.

A mature creditor economy can run a trade deficit indefinitely and remain a net lender to the world. The trade balance stops being the binding external constraint once the asset stock is large enough to generate the difference.

The generalisable point is that a headline trade deficit means very different things for a large net creditor and a net debtor. The Global Investment Outlook 2013's external vulnerability framework applies to the second and substantially not to the first.

What an allocator could act on

Check the net international investment position before assuming crisis currency direction. Creditors' currencies rise on domestic bad news through repatriation; debtors' fall. It is published free and it inverts the common intuition.

Treat an energy import position as a current account variable. For an importer, the generation mix is a term in the trade balance, and changes to it move the external position mechanically.

Assess corporate cash as insurance with a stated premium. It depresses returns every year and determines survival in rare ones; the judgment is about frequency, not about efficiency.

Look for criticality rather than size in upstream suppliers. Qualification barriers and process knowledge defend positions more durably than scale, and headline economic statistics conceal them entirely.

Note that recognised criticality invites substitution. A dependency that becomes visible attracts second-sourcing and policy support for alternatives, which erodes the position over years.

Read a trade deficit differently for a large creditor. The income balance on accumulated assets is more stable than trade flows and can sustain a current account surplus indefinitely.

What 2011 established

• A net creditor's currency strengthens in its own crisis, through repatriation and carry unwinding.
• An energy generation decision is a trade balance decision, and the shutdown eliminated a decades-old surplus.
• Corporate cash functioned as designed, funding recovery without a credit event.
• Japan's upstream manufacturing position was revealed as systemically important and statistically invisible.
• The income balance sustains a creditor's current account long after its trade balance turns.