It is a fact that when it comes to the oddly resilient Japanese hyperlevered economic model, the bodies of those screaming for the end of the JGB bubble litter the sides of central planning’s tungsten brick road. Yet in the aftermath of last month’s stunning surge in the country’s trade deficit, this, and much more may soon be finally ending. Because as Caixin’s Andy Xie writes “The day of reckoning for the yen is not distant. Japanese companies are struggling with profitability. It only gets worse from here. When a major company goes bankrupt, this may change the prevailing psychology. A weak yen consensus will emerge then.” As for the bubble pop, it will be a sudden pop, not the 30 year deflationary whimper Mrs. Watanabe has gotten so used to: “Yen devaluation is likely to unfold quickly. A financial bubble doesn’t burst slowly. When it occurs, it just pops. The odds are that yen devaluation will occur over days. Only a large and sudden devaluation can keep the JGB yield low.Otherwise, the devaluation expectation will trigger a sharp rise in the JGB yield. The resulting worries over the government’s solvency could lead to a collapse of the JGB market.” It gets worse: “Of course, the government will collapse with the JGB market.” And once Japan falls, the rest of the world follows, says Xie, which is why he is now actively encouraging China, and all other Japanese trade partners of the world’s rapidly declining 3rd largest economy to take precautions for when this day comes… soon. Oh, and this: “ If the bond yield rises to 2 percent, the interest expense would surpass the total expected tax revenue of 42.3 trillion yen.”
Why has Japan been able to sustain its deflationary collapse for over 3 decades? Simply - an ever rising currency.
A strong yen, deflation and rising government debt form a short-term equilibrium that lasts as long as the market believes it is sustainable. The yen has seen a relentless upward trend since it depegged from the dollar in 1971, up to 83.4 from 360 again to the dollar. When wages and asset prices rise, a strong currency can be justified. When wages and asset prices fall, a strong currency is suicide. Japan’s nominal GDP peaked in 1997 and its nominal wages did too. Its property prices have declined every year since. The Nikkei rose in only four out of the last fifteen years and is still close to a three-decade low.
Japanese policymakers, businesses, academics, currency traders and the average Mrs. Watanabe all believe in a strong yen. This belief is wrong but self-fulfilling. It has lasted so long because the Japanese government adopts policies to offset the destabilizing effects of deflation due to a strong yen. Hence, Japan’s national debt has marched upwards along with the value of yen. It is expected to top yen 1,000 trillion in 2012, 215 percent of GDP, 7.8 million yen (or roughly US$ 94,000) per person, and about half of net household wealth per capita.
The sustainability of Japan’s deflationary path depends on the market’s confidence in Japan’s debt market. As Japanese institutions and households hold almost all of the government’s debts, their faith in the government’s creditworthiness is the mojo for Japan’s seemingly harmless deflationary spiral.
There’s that. And also that it is nothing but a ponzi. In Xie’s words.
The justification for the low JGB yield is deflation. The real interest rate (the nominal rate plus deflation) is comparable to that in other countries. This rationale requires deflation to persist. But, deflation shrinks the nominal GDP or tax base. How could the government pay back its escalating debt by taxing a shrinking economy? It can only sustain its debt by borrowing more. This fits the definition of a particular type of Ponzi scheme.
Deflation is ok, if in addition to collapsing GDP, it is paralleled by declining wages.
The JGB bubble explains the seeming lack of pain in Japanese society. A strong yen and deflation haven’t led to an employment crisis because the government deficit is pumping up aggregate demand. As long as wages decline in line with prices, one doesn’t feel the pain. Japan’s household debt is only half of GDP, about half of the level in the United States. Deflation doesn’t cause much balance sheet trouble.
Unfortunately this is unsustainable by definition, as the divergence is a finite series at which point it become self-destructive. And yet the strong Yen is the glue that ties the rickety house of cards together… for now.
Despite the fact Japan has had a bad economy for so long, the yen has remained strong. It reinforces the Japanese psyche on the issue. The strong yen has become a cult.
The international financial market believes in a weak yen from time to time. In 1998, the short-selling by foreigners briefly caused the yen to touch 140 against the U.S. dollar. But, as the Japanese hold all of the yen, if they believe in the yen, foreign short-sellers get punished eventually. Over time, yen bears are all weeded out of the market. The remaining yen traders are all believers in a strong yen.
So far so good: any cult can exist in its own bubble if left to its own devices. However, as much as it is trying to avoid it, Japan’s secular role in international society is changing, and very soon the habitual self-delusion of its citizens, politicians, and FX traders will do nothing to offset the advent of reality.
While the Japanese can always take care of business within, they cannot control the outside world. The country’s Achilles heel is losing trade competitiveness due to the destructive impact of deflation on business confidence and the strong currency itself. When a trade deficit emerges, it signals the beginning of the end.
Japan has lost competitiveness in a swath of industries that it used to dominate. Its automobile industry is losing out to Germany, South Korea and the United States. Japan’s automobile industry used to be competitive in cost and far superior in quality to its global competitors. But the world has changed. The yen has dropped below 110 from as high as 160 against the euro. The South Korean won was about ten against the yen and is now 13. Cost-cutting cannot offset such a big change in exchange rates. The U.S. auto industry cut its labor costs and debt burden through the government bailout. It is now more competitive than Japan’s.
The automobile industry is the pillar of Japan’s economy. Its decline leaves Japan’s economy nowhere to turn. Indeed, if the auto industry leaves Japan, it will become a poor country.
Japan’s electronics industry, still significant to its economy, is losing out big time to its Asian competitors. Nothing hot in electronics is made in Japan now. U.S. companies like Apple leverage China’s manufacturing sector to turn out hot products. South Korea is embracing the vertically integrated model and churning out competitive products like Japan used to.
Nothing symbolizes Japan’s decline like its electronics industry. It was the envy of the world and had all the ingredients to take the industry into the mobile internet era. Instead, it embraced insulation and made products just for the Japanese market. Now it is almost irrelevant to the outside world.
Japan isn’t just facing macro troubles. Its micro competitiveness is rotting away. It is just bizarre to see that the whole world believes in a strong yen when Japan is failing on such a grand scale.
This is especially true in the aftermath of the Fukushima disaster, when one of the primary drivers of economic growth – energy creation, has collapsed, and as of Today Tepco has shut down its last reactor. Thus an energy crisis imminent. It will also accelerate the transition of Japan from a trade surplus to deficit econoy. In this case the trend is certainly not Japan’s friend.
Japan’s trade balance may swing into surplus from time to time, but the negative trend is irreversible. Japan will face rising trade deficits. That makes foreigners’ views important because Japan would need foreign money to fund its deficit. When foreigners change their views, which they surely will, the yen will crash.
There is only one controlled way out for Japan: take the pain now, or let a veritable epic econoic collapse sweep everything that Japanese society stands for. Recent overtures by the BOJ show it understands what has to be done. It is, alas, not doing it fast enough.
Japan has only one way out – a massive devaluation. If the stable national debt is 120 percent of GDP, the yen needs to be devalued by 40 percent because devaluation is ultimately equal to the nominal GDP increase. The devaluation is likely to sustain 2 percent to 3 percent of nominal GDP growth for Japan beyond the repricing induced increase, which is necessary to restore Japan’s tax revenue. Deflation has caused Japan’s tax revenue to decline as a share of GDP. It can be only reversed through restoring nominal GDP. A devaluation of 40 percent can restore Japan’s competitiveness against Germany and South Korea, which will lay the foundation for Japan’s industrial recovery.
The Bank of Japan is trying to weaken the yen through expanding its balance sheet. It has an asset purchase program of 65 trillion yen and a lending program of 5.5 trillion yen. The two are equivalent to 15 percent of GDP, comparable to what the Fed or European Central Bank have done. The effectiveness is limited so far. Because Japanese businesses, households and investors believe in a strong yen, the printed yen largely stays in the country and just slows down money velocity. The U.S. dollar has risen 10 percent against the yen from last year’s bottom. This is probably due to the financial market upgrading its view of the U.S. economy rather than the BoJ’s action.
To Andy Xie, the day of reckoning has never been nearer. And to those who have grown disenchanted with the Kyle Bass view of an epic JGB bubble pop, it may be time to refresh your lost cost hedge. Because a devaluation, to be truly effective, will not be visible from a mile away: it will be sudden, and very, very shocking, unless the government opts for the worse of to evils – a bond market collapse.
Yen devaluation is likely to unfold quickly. A financial bubble doesn’t burst slowly. When it occurs, it just pops. The odds are that yen devaluation will occur over days. Only a large and sudden devaluation can keep the JGB yield low. Otherwise, the devaluation expectation will trigger a sharp rise in the JGB yield. The resulting worries over the government’s solvency could lead to a collapse of the JGB market. Of course, the government will collapse with the JGB market.
The day of reckoning for the yen is not distant. Japanese companies are struggling with profitability. It only gets worse from here. When a major company goes bankrupt, this may change the prevailing psychology. A weak yen consensus will emerge then.
Finally, no matter how it’s spun, the outcome, whether a 40% JPY deval, or a JGB bubble pop, will have devastating consequences on both the regional, and global economy.
A yen collapse will impact China and South Korea most, just like in 1998. It will trigger substantial weakness in their industries. If a banking system succumbs, the shock can bring down an entire economy, as South Korea’s experience in 1998 demonstrates.
Both China and South Korea have weak banking systems. South Korea’s banking system is one of the most leveraged in the world due to high level of household loans. In 1998, a similar shock sank its banking system that was overleveraged with industrial loans. Now it is overleveraged with household loans. A shock could sink it again.
Overinvestment and a property bubble make China’s banking system very vulnerable to such a shock. Unless China substantially increases the capital in its banking system, a big yen devaluation could cause China’s banking system to sink. China suffers from overinvestment and a property bubble, as Southeast Asia and South Korea did in 1997. In terms of the magnitude of leverage, China’s situation is much worse. Hence, a yen devaluation could wreak havoc to China’s economy.
Perhaps there is a reason why the global market (not US stock futures of course – those only care what comes out of the Chairman’s mouth) is so very concerned with what is happening in China right now: perhaps the Chinese hard landing (which will come, no doubt about it) is not so much an underlying cause of the Chinese malady but a symptom of the Japanese deflationary unwind, which like a tsunami will drag first the Koreas, then China, then Southeast Asia, and finally the world underwater. And this time no amount of trivial Greece-like headline posturing ad headlines will have any impact whatsoever.
Yet following all that, we fully expect nothing to change, because the entire world is now hypnotically rushing toward the cliff, very likely bringing Dow 36,000 with it, if only for one instant, because with nothing getting fixed, the moment of global euphoria will be truly transitory. It will be then followed by an all out deflationary collapse… or much more likely since in this day and age printing a trillion, quadrillion or quintillion, is only a CTRL+P keystroke away, hyperinflationary.
And just to show the sensitivity of the world’s most indebted nation to interest rates, here again is Andy:
Even though the yield on 10-year Japanese Government Bonds (JGB) is only 1 percent, the interest expense is expected to top 22.3 trillion yen in the fiscal year that begins next month. This is one-quarter of the general account budget. If the bond yield rises to 2 percent, the interest expense would surpass the total expected tax revenue of 42.3 trillion yen.
Yup: a mere “surge” in interest rates to a whopping 2.00% will destroy the Japanese economy.