Buy more yen… to increase reserve returns

February 3, 2012

Japan has not been a sexy destination for investment. In an environment of rising sovereign risk, Japan’s huge debt burden (+200% and rising) and lack of triple-A rating (Japan is rated AA-, Aa3 and AA by the main rating agencies) are not something that would attract the world’s investors, including the powerful central bank reserve managers.

However, the yen is a different story. Enjoying a safe-haven status, the Japanese currency is staying just below its all-time high around 75.90 per dollar, while it also rose to an 11-year peak against the euro in January.

JP Morgan,whose asset management arm manages $70 billion for 65 official sector clients including central banks and sovereign wealth funds, says reserve managers have been diversifying into non-G4 currencies but the strategy has not performed well.

Instead, it says, they should buy more yen.

“Diversification has targeted cyclical assets such as commodity currencies, which impart more leverage than safety to a portfolio. A much higher allocation to structural funding currencies such as the yen is required for reserve managers concerned with volatility and drawdown,” JPM says in a note to clients.

According to the latest reserve data from the IMF, central banks — which control reserves of over $10 trillion worldwide — hold 60 percent in dollars, 27 percent in euros and 4 percent in sterling and yen respectively.

This would have returned 1.5 percent in the past two years and 2.9 percent in the past five years.

JPM calculates that reserve managers would have returned a higher 3.8 percent and 4.2 percent respectively if they boosted yen allocation to 20 percent.

Allocation to the yen has been gradually declining over the years. At the start of 2000, central banks had as much as 6.3 percent in the Japanese currency.

“The yen does not rally during periods of market stress due to its intrinsic safety. It rallies because its zero cash rates encourage its persistent use as a funding currency during global expansions, thus obliging investors to repurchase it during deleveraging,” the bank notes.

“Even if reserve managers increased their yen exposure, the yen could not transform from a structural funding currency into a structural investment currency over any reasonable investment horizon. Thus further yen allocations do not undermine (the yen’s) hedge value, unlike gold.”

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