Yen bolstered by slowing Japan mutual fund flows

Japanese individuals have cut their buying of mutual funds as banks struggle to cope with a new investor protection law, leading to a slowdown in retail capital outflows that bodes well for the yen in the near term.

The Financial Instruments and Exchange Law, which took effect at the end of September, requires banks and brokerages to be more stringent about informing investors of the risks they face when investing in financial products.

Wary of falling foul of the law, banks are spending more time with each customer before taking their money. A slump in global equities has also hit inflows to mutual funds.

Traders and analysts reckon that this one-two punch could temper Japanese retail investment in overseas assets over the next couple of months, supporting the low-yielding yen.

"It will make it harder for the yen to weaken," said Toru Umemoto, chief currency strategist for Barclays Capital in Japan.

"I think this will probably be resolved sooner or later, but the impact may persist until around the year-end," Umemoto said.

The yen hit a 2-1/2-year high of 108.25 per dollar on Wednesday as worries about financial institutions' losses in credit markets hurt equities and sparked an unwinding of carry trades, in which investors sell low-yielding currencies such as the yen to buy higher-yielding currencies.

The slowdown in mutual fund investment could open the way for the yen, which traded around 109 to the dollar on Thursday, to rise to 105 by the end of the year, some analysts said.

Japanese households, which hold 778 trillion yen ($7.16 trillion) in cash and low-yielding bank deposits, have committed more and more money to mutual funds investing in overseas assets in search of higher yields.

Japan's benchmark overnight call rate stands at 0.50 percent, far below comparable interest rates of 8.25 percent in New Zealand, 6.75 percent in Australia, 5.75 percent in Britain, 4.50 percent in the United States and 4.0 percent in the euro zone.

Reflecting this, Japanese investment trusts' foreign asset holdings hit an all-time high of 37.91 trillion yen in October, having more than doubled in the past two years, figures from the Investment Trusts Association of Japan show.

SLUMP IN INFLOWS

But data compiled by Nomura Research Institute (NRI) shows that the pace of inflows has fallen in the past few months.

Net inflows to mutual funds investing abroad totaled just 338.3 billion yen in September -- a quarter of the nearly 1.3 trillion yen in July, when the yen hit a record low against the euro, a 16-year trough versus sterling and a 21-year low against the New Zealand dollar.

November has been another slow month. As of November 20, inflows to funds investing abroad stood at 259.4 billion yen.

"I don't think the impact will be small. I think there could be a big impact," said Daisaku Ueno, head of the international financial research unit at Nomura Securities, referring to the likely effect on the yen of the slower pace of fund buying.

Mutual funds that invest abroad have played a significant role in the yen's weakness until now, Ueno said.

For example, when retail investors flock to "balance-type" mutual funds that invest in a mix of global bonds and equities, that can generate a steady stream of flows to buy higher-yielding currencies against the yen, he said.

"A slowdown in that momentum will decrease pressure against the yen," Ueno said.

It was hard to say whether the decline in mutual fund inflows would last for long, Ueno said, adding that fees from mutual fund sales were a big source of revenue for Japanese banks, so they would be keen to speed up the selling process again.

"It's not as if bank lending is really picking up, so it's hard for them to make money from that," Ueno said.

If short-term interest rates were to rise in coming months and the yield curve were to flatten, that could also limit the profit opportunities of banks, Ueno said.

In addition, retail investors are likely to continue to diversify away from low-yielding domestic bank deposits and into higher-yielding overseas assets, even if the recent market turbulence gives them cold feet for a while.

Kazuharu Matsuoka, senior manager at Japan Post Bank's investment trust office, said the bank's mutual fund sales started falling around August due to factors such as adverse market conditions and efforts to cope with the new law.

But he said there had been no major change to the relative popularity of overseas investment among retail investors.

"It's not the case that there has been any sharp downturn in the ratio of investment in overseas assets," Matsuoka said.

He said that around 70 percent of the money spent by investors buying mutual funds at Japan Post Bank -- a business unit of state-owned Japan Post Holdings -- had gone into overseas assets, compared to roughly 30 percent for domestic assets.

($1=108.72 Yen)