This time a year ago, a senior Goldman Sachs International economist predicted with wide support that the dollar would now be trading at about 98 yen. Instead, at press time it was in the mid-80s. In March alone it rose almost 9 per cent and it has soared 18-20 per cent during the first five months of this year.
While economists and politicians debate the causes, airlines serving Japan or relying on Japanese finance face the challenge of how to cope or capitalise on this unexpected surge. Foreign exchange risk management has always concerned them, but never like this.
Singapore, China, and several other Asian countries have also seen their currencies appreciate against the US dollar, but nothing like Japan's yen. Most Asian economies are linked to the greenback, which is used in more than two-thirds of all Asian institutional investments. Thus as the yen-dollar gap widens, concerns grow.
In the short term, endaka is a bonanza for Japanese outbound tourists, who are discovering that overseas holidays are 20 per cent cheaper than a year ago. Even the yen's modest growth in 1994 stimulated 10 per cent more outbound traffic; this year that growth rate will probably double.
But that also means fewer domestic trips to such vacation spots as Hokkaido and Okinawa. And, more important, Japan's inbound tourism is drying up. Asians whose currencies have remained strong are still visiting Japan, especially from Singapore, Korea, and Taiwan, but for shorter stays. The rest of the world now regards Japan as too expensive.
This trend toward more outbound traffic is likely to fuel the debate over trans-Pacific capacity. In the Japan-US market, US carriers already fly 70 per cent of the seats, even though 85 per cent of them are filled by Japanese. Over the longer term, outbound leisure travel may fall victim to the same ills already retarding business travel - declining confidence in Japan's economy and relocation of more production offshore.
Analysts predict Japan will have the weakest economy in Asia this year. Japan's carriers have already seen overseas business travel fall nearly a third in the past six years, a major cause for their revenue slump. 'Downgrading from first class to business class and from business class to economy has reduced our yields,' complains Yasuo Goto, All Nippon Airways' senior manager finance and accounting.
Japan's traffic and economy are inextricably tied, and that raises long-term concerns. The yen has been rising for years, but never so fast that increasing productivity couldn't offset it. That no longer seems possible. The buoyant yen is threatening to reverse the early stages of Japan's economic recovery and push it back into its worst post-war recession. As an economics professor recently warned in Business Week, 'While the yen is going through the roof, Japan's economy is going through the floor.'
The stronger yen also affects airline costs. Japanese landing fees, fuel, ground handling and other charges have risen for any carrier that does not earn an equivalent amount of yen income. But the reverse is also true. Korean Airlines, Cathay Pacific and China Airlines have probably gained because their yen revenue exceeds yen operating expense. They are endaka's beneficiaries.
Japan's carriers ride the same rollercoaster. Both Japan Airlines and All Nippon estimate that their non-yen expenses and income are equivalent, so they rise and fall together with little net effect on operating revenue. They are 'more or less balanced,' says ANA's Goto.
But the stronger yen handicaps Japanese airlines in other ways. Since most of their costs are yen-denominated, they are at a major competitive disadvantage against rivals for which less than a tenth of their costs are in yen.
Even worse, foreign carriers serving Japan are exploiting the fare increase endaka effectively gave them. 'Non-Japanese carriers take advantage of their foreign currency-denominated costs and their yen revenues to offer lower fares in the Japanese market,' complains Goto. Japanese carriers try to match these fares in an effort to keep market share, but at a heavy loss in yield. 'We're taking a hiding,' laments Koki Nagata, JAL's vice president for corporate planning. Aside from more cost cutting 'there's nothing we can do about it,' he adds.
The yen effect on aircraft finance could be more widespread than such competitive dislocations, because Japan is one of the world's largest financiers. For airlines already indebted through yen-based loans, current forex conditions provide a brutal test of how well they have hedged.
'To minimise the impact of currency fluctuations, airlines try to tailor their debts to match the currencies of their income,' explains Obbe Kok from ING Aviation Lease. But he adds: 'None of them succeed completely.'
Cathay Pacific is sometimes cited for doing one of the best jobs. Victor Hughes, Cathay's finance director, is too modest to make or confirm that claim, but he says Cathay earns more yen than any other foreign currency and some 35-40 per cent of its debt is also yen-denominated.
Cathay's policy, he says, 'is to reduce the effect of movements in currencies against the Hong Kong dollar by arranging liabilities in the major currencies it earns.' In contrast, Thai Airways has a comparable percentage of yen debt, but nowhere near that much yen income. With the benefit of hindsight, it might have hedged by depositing yen in some interest bearing instrument at the first hint of the yen's acceleration. Instead its exposure has continued to rise with the yen's appreciation.
A carrier with significant yen exposure is unlikely to be able to refinance its debt now in a different currency. 'It's too late,' says Bertrand Grabowski, head of the Asian aircraft finance group at Banque Indosuez.
Carriers without yen income generally avoid yen debt, for the simple reason that aircraft are priced and valued in dollars. To the extent that an airline carries debt in any other currency, it will need a reserve against exchange rate fluctuations. Hence the natural tendency is to finance in dollars.
Japanese carriers are the exception. Although they could finance in dollars, they have generally opted for yen for reasons ranging from patriotism to attractive local rates. Again, with the benefit of hindsight those deals may not have looked so good. A JAL spokesman admits: 'In the future, JAL will be more diverse in seeking fleet finance.' It may even consider operating leases, which have not been one of its preferred options.
Both JAL and ANA have also employed forward exchange transactions as a hedge. ANA's Yasuo Goto says the carrier has used fixed dollar rate forward purchase contracts to 'standardise' fleet purchasing costs. These contracts account for less than a third of ANA's dollar obligations over the next five to six years, according to Goto.
In 1985, when the dollar surged against the yen, JAL entered $3.6 billion worth of ten year forward contracts at a fixed dollar rate of ´185. The dollar's surge proved, of course, to be temporary and JAL has paid handsomely for guessing wrong. The only comfort is that its loss is spread over the 13-15 year depreciation period for the aircraft purchased with these contracts.
Japanese banks are also willing to lend in dollars. According to Mark Schultz, a Perkins Coie specialist in Asian aircraft finance, 'dollar lending for aircraft makes good business sense since aircraft are largely dollar-denominated collateral.' He cites the example of a South American carrier which borrowed in yen. As the yen appreciated, its yen debt grew relative to the aircraft's dollar-based value despite the airline's regular payments. 'The end result was that the Japanese trading company [lender] found itself severely under-secured.'
Schultz, who was seconded for a period to a Tokyo bank, says current banking conditions in Japan 'are the toughest in 40 years' due to Japan's recession, non-performing real estate loans, and other hangovers from Japan's 'bubble economy.'
'Paradoxically, this has not meant that Japanese banks are retreating from aircraft finance,' he says. Indeed, aircraft are now considered as 'a way to pump up profits.' Schultz does not foresee Japanese banks rushing out to lend to any and every airline, 'but they will remain very active players.'
Earlier dollar-denominated loans have also stretched the lending capacity of Japanese banks, explains Bertrand Grabowski of Banque Indosuez. 'The yen's appreciation makes the value of those loans decline, the bank's ratio improves, and it can become more aggressive and still meet BIS standards,' he says.
The one aircraft finance product that will always be denominated in yen is the 20 per cent equity portion of the Japanese leveraged lease (JLL). As the largest foreign arranger of JLLs, Banque Indosuez predicts JLL popularity will continue despite the yen's appreciation. Grabowski believes JLLs do not pose the tax uncertainties of US foreign sales corporation leases or the complexities of German tax leases. 'When you come to the JLL market, you know exactly what the conditions are going to be,' he says.
The JLL has indeed made a remarkable comeback from two years ago, when it was used for only 23 per cent of all new aircraft financings. Last year JLLs financed about 40 per cent of all transactions. And because so many yen were chasing so few deals, net present value benefits shot up and the structure, traditionally reserved for the strongest carriers, became available to some second tier airlines.
It is unclear how endaka will affect the JLL. 'There are a lot of complex forces around this subject,' says Grabowski. 'The future of the JLL depends on how these forces play together.'
Two principal forces offer conflicting news for airlines. The good news is that more Japanese investors need the tax shelter offered by JLLs. The yen's appreciation means that the same yen amount will go further in financing a JLL. Grabowski offers the example of one sizeable investor. 'He's telling us, "I made my forecast for this fiscal year based on 110 yen to the US dollar. Now it's at 85. I have to do another deal. Otherwise, I will owe more tax." '
Moreover, the effect compounds. More Japanese investors are back in the market because the tax shelter on JLLs they entered in the late 1980s is expiring and they need to roll over their investments.
The result is that equity arrangers have a plethora of potential investors. Historically, arranging fees have averaged 3-4 per cent of aircraft cost. But some analysts predict the current ease in finding investors will cause equity arrangers to lower those fees.
The bad news is that Bank of Japan efforts to cool the yen's appreciation by cutting interest rates could indirectly hurt JLLs. When airlines enter a JLL, most hedge their yen exposure by making a yen deposit in an amount that will produce with interest the 20 per cent equity required at the lease's maturity in 10-12 years.
Within the last six months, the interest paid on yen deposits of that duration has dropped from around 4.6 per cent to 3.2 per cent. That means airlines must increase their deposit, and that reduces the NPV.
'At the beginning of the calendar year, you could attract some JLL proposals priced at 6-7 per cent of aircraft cost,' says Grabowski. 'Now with deposit rates going down, the yield is moving down to 5 per cent. That's quite a substantial difference.' Grabowski thinks 4-5 per cent is a critical benchmark. If interest rates drop again, putting more pressure on NPVs, he fears airlines will have second thoughts about the benefit of JLLs. 'It's a real concern,' he says.
Whether a renewed Japanese recession caused by the soaring yen will eventually destabilise the world economy is a matter of much conjecture. But for airlines it is clear already that endaka's effect extends well beyond Japan and current yen debtors.
Source: Airline Business
