In the last few weeks, data out of Japan has revealed a fundamental shift in capital flows that will continue to offer USD-JPY support, and will help offset the U.S. dollar selling pressure that has emerged in the wake of the Wall Street financial crisis. The two factors helping to underpin USD-JPY are the increased merger and acquisition flows emerging from Japan, and a shift in Japan's trade balance due to the sharp rise in the cost raw of materials such as metals and oil products and declining export volume.

The increased cross-border acquisition flows out of Japan are partly a by-product of the current global credit crisis. Japanese banks are in a better financial situation than European and U.S. banks and are in a position to invest in financial institutions abroad. Nomura has purchased assets of Lehman Brothers in Southeast Asia, the Middle East and in Europe. Mitsubishi UFJ has purchased a 20% stake in Morgan Stanley worth US$9 bln and Norinchuken Bank has taken a small stake in Credit Agricole. Thomson Reuters reports that overseas acquisitions by Japanese companies have risen to $46.1 bln so far this year, increasing by 309.5%. Some estimates have it as high as $57 bln. Measures taken by Japanese politicians and companies to protect Japan companies from foreign takeovers have stemmed large merger and acquisition inflows into Japan, with tempering any capital inflows that could offset the current Japanese investment flurry. $26.1 bln of the M&A outflows have gone to the United States, according to the Thomson Reuters data. The net outflows add $5 bln in support to USD-JPY and JPY crosses each month.



Japan's trade position shifted from a surplus to a deficit in August with Japan reporting a trade deficit of Y324 bln and the first time for a trade deficit since November 1982, aside from the month of January which is typically impacted by New Year's holidays. Higher prices for raw materials are skewing the trade balance, along with falling global demand that has seen a slide in exports. Exports rose a mere 0.3% in August, while imports rose a sharp 17.3%. Exports to the U.S. declined for the 12th straight month year-on-year, for a total fall of 21.8% and the sharpest contraction since 1980 as U.S. demand falls and exports to Europe also fell, dropping 3.5%. On the import side of the equation, mineral fuel prices have risen by 64.4% due to increasing commodity prices, fueling the rise in costs. Anecdotal reports from foreign exchange traders over this last year indicate Japanese oil importers are chasing the U.S. dollar higher in order to buy the dollar's necessary to pay for the rise in oil prices. The Nikkei newspaper reported in early August that U.S. dollar demand from importers had surged, contributing to increased dollar buying, which is now outpacing exporter sales by over $18 bln per month. The report from the Japanese newspaper stated that importer dollar demand was steady around $35 bln a month for much of last year until breaching $40 bln in October 2007, but has now risen above $49 bln. Recent raw material price negotiations with iron ore companies such as Rio Tinto and BHP Billiton have seen prices set over 90% higher in new contracts for the coming year, adding to dollar demand. The Nikkei newspaper also reported in May that the top steel companies are now seeing dollar payments exceeding dollar receipts due to the rise in raw material costs.

Other related data for Japanese export flows indicate that Japanese exporter volumes are likely to slow further, creating a further decline in exporter dollar sales and repatriation. Air cargo exports from Japan were down for the third straight month in August. U.S. data for car sales in September show that Toyota auto sales plunged 32.3% during the month, while Honda's sales fell 24.0%, Nissan sales fell over 30% and Mazda's sales fell 36%. This should see a further steep decline in dollar repatriation, limiting selling pressure on USD-JPY.

These two key factors, outward acquisition flows and a shift in the balance of importer-exporter hedging flows, indicate why USD-JPY was able to bounce sharply from 95.74 earlier this year and the reason that USD-JPY has been able to withstand USD sales despite the current U.S. financial woes. The correlation of USD-JPY and the yield spread differential between U.S. 3-month treasury bills and Japanese financing bills have collapsed to levels typically implying a USD-JPY under 100.00, but USD-JPY has failed to reach those levels due to the extra dollar demand from increased M&A outflow as well as increased USD demand to pay for imports. Similarly, USD-JPY has had a strong positive correlation to the Philadelphia Semiconductor Sector Index, or SOXX for the last two years. Though the SOXX correlation also points to USD-JPY levels under 100, the currency pair continues to find support ahead of 103.50, and remains caught in a 103.50-108.00 trading range.

At current USD-JPY levels of 105.15, exporters are not rushing to cover export receipts either with most assumed hedge targets for Japanese corporations at 100.00 to 105.00 and spot prices trading above that level. The latest Tankan survey reflecting an expected exchange rate of 102.48 for the end of the fiscal year indicating that many manufacturers have a profit cushion in current exchange rate levels. The only real additional pressure on USD-JPY has come from the heavy EUR-JPY selling since the fall to 143.99 on the cross and the lowest levels since 2006. This decline has forced exporters to aggressively hedge cross positions, with the cross having dropped below prior "assumed" internal hedge targets in the 150-160 region. Once the EUR-JPY selling pressure eases, some of the pressure on USD-JPY will be alleviated, allowing the currency pair to bounce.

On balance, this fundamental shift in Japanese capital flows is dampening the historical selling pressure that usually weighs on USD-JPY which will continue to temper downside pressure, providing support around 102.50-103.50 is the sessions ahead.

John Kicklighter a Currency Strategist at FXCM.