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Foreign Exchange

Japan drawn to Korean government bonds to boost competitive edge

The need by Japan’s central bank to enhance its competitive advantage, as well as diversify its FX reserves, has prompted it to seek out Korean debt for the first time, according to Asiamoney, a sister publication to EuromoneyFXNews.

Japan’s central bank is reportedly nearing an agreement with South Korea to make its maiden investment in the latter’s government bonds. The announcement for the deal might come as early as this week at the Asian Development Bank meeting, according to Japanese media. The move to invest in Korean debt might help Japan to stymie the widening spread between the value of the yen and won, which has put Japan at a trade disadvantage at a time when the country needs growth.

On January 2, 2008, one yen traded for KRW8.5. Now that has risen to around KRW14. Since early 2008, the yen has appreciated by 75%.

Comparatively, the yen has appreciated at a much slower 20% against both the Chinese renminbi and Taiwan dollar, and 35% against the US dollar.

This disparity has created a cause for concern, as Japanese companies lose their competitive advantage against Korean companies, which are able to produce comparable goods at lower prices, says Robert Alan Feldman, head of economic research at Morgan Stanley MUFG Securities. The competition has helped to erode Japan’s export surplus.

“The Korean won’s depreciation against the yen has been excessive and Japan is obviously quite concerned about yen/won cross rate,” Feldman says. “This is also unsettling for Japan because Korean companies have been taking a lot of market share from Japanese ones. Korea has moved up the product curve in terms of quality, and its prices are thus more competitive due to the currency differential.”

Japan’s status as a world export behemoth has already seemingly shifted. In January, the Japanese government announced the country’s first annual trade deficit since 1980, attributed to a strengthening yen and limited global demand for its exports, such as cars and electronics.

Japan’s finance ministry’s preliminary data pegs the country’s trade deficit for 2011 at ¥4.41 trillion ($55 billion), which is a stark contrast to 2010, in which Japan had a ¥5.3 trillion trade surplus.

In addition, an ageing labour force has made it difficult for Japan to regain its past momentum.

Comparatively, Korea ran a current-account trade surplus of $27.65 billion in 2011. Bank of Korea is has predicted a current-account surplus of $14.5 billion this year.

One Seoul-based head of Korean DCM at a bank agrees that motivation to correct this imbalance is a “central focus” for Japan and is a partial explanation for the country’s decision to invest in Korean debt now.

He explains that if Japan uses a large enough percentage of its reserve won to invest in Korean government bonds (KGBs), the demand for the won will rise, thus causing the price of the currency to rise. This will help to narrow the currencies’ swap spread.

While Japan has not announced how much it will invest in KGBs, Feldman says it might not take a great amount of investment into the Korean market to see results. “The market for the yen/won is much thinner than yen/dollar, so it will take a relatively small amount of capital inflow into Korea to effect change,” he says.

However, the yen’s relationship with the won might make this sort of investment hard to replicate. The currencies’ market is of a particular scale, and the countries interests align in a particular way, that make Japan and Korea niche competitors.

“It’s not clear to me which currency besides the won that Japan can see this same situation,” Feldman says. “I don’t see any particular exchange-rate moves or disruptions that are similar to the won/yen.”

Yet, a second reason for Japan’s investment into KGBs will translate to other markets’ bonds: the need to diversify away from the US dollar. Japan held $1.1 trillion of US treasuries by the end of February, according to the US Department of the Treasury. It is the second-largest holder of US debt outside China.

“Bank of Japan is trying to diversify its safe-haven assets away from the US dollars, and this has meant investment into Korean treasury bonds and China in recent weeks,” says one bank’s head of Korea DCM. “It’s sensible for the country to hedge its risk against the dollar or any single currency.”

Japan has taken steps to diversify its treasuries. On March 13, Japan received first-time approval to invest Rmb65 billion ($10.3 billion) in Chinese government bonds.

However, it is difficult for analysts to predict where Japan might go next with its investments. “Korea and China will be the main markets for Japan to concentrate on,” Feldman concludes. “Along with the US dollar, those are the foreign exchange priorities for the country right now.”

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