Could Gold Serve as an Exchange Rate Hedge in Japan?

Gold is the asset that has attracted people for thousands of years and this attraction continues to the present day because, according to Worthington and Pahlavani (2006), unlike most commodities, gold is durable, relatively transportable, universally acceptable and easily authenticated. The demand for gold is ever increasing, not only for jewelry, coins, and bars but also for many industries, such as electronics, space, as well as medical technology. Especially gold is still a form of currency in many countries after the collapse of the Bretton Woods system in 1971. Many economic analysts suggest that gold prices are determined and influenced by a number of factors, such as mine production, fabrication demand, and the recovery of gold from scrap. Much greater influence is exerted by trends in central bank sales and purchases. Most important of all is trend in investment demand. Investors buy gold for a number of reasons. They buy gold as a hedge against any economic, political, or currency crises. They also buy gold for diversification and financial arbitrage when investment confidence is increasing because they have the common sense that physical assets, unlike financial assets, are the best way to hedge against recession and inflation. The developments of the gold market are followed closely by financial analysts and monetary policy makers and gold price is regarded as a good criterion of the inflationary trend in the future for it moves earlier than official measures of inflation. Fisher (1930), the economist who first pointed out the relationship between expected inflation and interest rate, provides the theoretical basis for this study. Fisher (1930) concludes that expected nominal asset return comprises expected return and expected inflation rate. In other words, when expected inflation rises, asset return will rise. Later, the primary empirical test on inflation hedge of assets including U.S government bonds and bills, real estate, labor income, and stock returns was done by Fama and Schwert (1977). Ghosh et al. (2004) point out that people buy gold for two purposes. The first is the “use demand”, where gold is used directly in the production of jewelry, medals, coins, electrical components, and so on. The second is the “asset demand” for gold, where it is used by governments, fund managers and individuals as an investment. The asset demand for gold is traditionally associated with the view that gold provides an effective “hedge” against inflation and domestic currency depreciation. When it comes to inflation, the value of gold is considered to be preserved, for its price will increase along with the rise in the general level of prices. In other words, it is believed that a higher inflation rate is what gold prices said should be happening. However, the question is that how well gold hedge really works. Each country has its own economic conditions or characteristics. This issue is worth examining and verifying with non-linear model which might discover the key reasons that the linear model is unable to do.In this article, we attempt to examine whether gold could be an exchange rate hedge in Japan using data from 1986 to 2007. In the literature of this area, most research has focused on a linear relationship—rather than a nonlinear one—between returns on gold and the exchange rate of the Japanese yen. In the present paper, we used the depreciation rate of the yen as a threshold variable to distinguish between a high depreciation regime and a low depreciation (or appreciation) regime. With this setting, we build a threshold vector autoregressive model to investigate the causality between the gold return and the yen depreciation rate. We found that when the yen depreciation rate is greater than 2.62%, investing in gold could avoid the depreciation loss. This finding, that the effectiveness of gold as an exchange rate hedge depends on the depreciation rate of the yen, could be beneficial to Japanese government monetary policy and to investors with Japanese yen in their portfolios. JEL classification: C32; F31; F33