Japan is stuck in a time warp. Little has changed, and what has is for the worse. The economy is in dire straits. Half-hearted reform erodes the real incomes of households and corporations without the stimulus of real supply-side deregulation. Household savings rates are already historically low. Export demand is waning. The economy will be down this year and next.
The Bank of Japan’s (BoJ) balance sheet is exploding. In the financial sector, the authorities have backed off from cleaning out bad assets and loans and letting the bust go bust. Money will be made available to all – good and bad institutions. The price will be surface calm, while behind the scenes things go from bad to worse.
When I visited Japan last month, before the announcement of the new fiscal package, there seemed to be a lot of disarray among key policymakers. The BoJ thought that a weak yen was the acceptable consequence of a recessionary economy. It agreed that the need to bolster the banks and satisfy a massive flight to liquid assets would result in a big growth in power money. But it argued any price-keeping operation (PKO) – the buying of stocks to save the equity market – would not be considered by any reasonable person.
But now we know that the government has gone for yet another fiscal stimulation package. But the new ¥16 trillion ($120 billion) package does not include any income-tax cuts. Public spending remains the only weapon in the armoury of the ministry of finance (MoF). If necessary, there will also be PKOs to support the equity market, using the ¥20 trillion or so in public-sector pension funds that flow into the Trust Fund Bureau every year. The MoF seems to want the yen nearer ¥120 to the dollar than ¥130. It sees no conflict between the BoJ injecting power money into bust banks on the one hand and so weakening the yen, and intervention to strengthen the yen on the other. “We have ways of squaring the circle,” an official told me.
Japan will seek to get the maximum benefit from the upcoming Asem and G7 meetings by shouting about its stimulus package. But the historical record is that, behind the apparent size of the package, the reality will be small. At best, Japan will offset the fiscal tightening put into the 1997 and 1998 budgets. As a result, I reckon Japan will run out of growth and start to suffer a serious loss of jobs. The BoJ will continue to inject mammoth amounts of power money into the system, mainly by lending to the banks. The last option will be to let the yen go to ¥140 to ¥150 to the dollar.
That news is dire for Asia. Japan is to Asia what the US was to Mexico, with the difference that Japan, as an economic locomotive, could not pull the skin off a rice pudding. Asia needs a stronger yen, a weaker dollar, and above all, a robust Japanese economy to solve its problems. It will get the opposite. The idea that Japan will exercise economic, political, moral or intellectual leadership in Asia is dumb.
Japanese equities are grossly overpriced. Reform will not tackle the issue of bad banks and bad debts. The economy will suffer from its failure to abandon the state capitalist model and let the market clear the huge stock of wasted assets and debts. Even the current sales of stocks of Japanese bank loans are more symbolic than real. Japanese equities remain a screaming short.
Japanese government bonds (JGBs) are junk bonds in drag. I remain convinced that the Trust Fund Bureau (TFB) has squandered much of Japan’s stock of savings in loans to public sector organizations. Ultimately that will come to light, earlier rather than later if the economy seriously deflates. The government would then have no option but to print money to repay the depositors in Japan’s postal savings accounts, much of which is placed with the TFB. And that’s before tackling the lost pension-fund money held there. What would be the yield on JGBs the day this news breaks – 8% or 15%?
Of course, in the short term I may be wrong on JGBs, because all of Japan wants to own them as the safest investment. But the BoJ will have to stop supporting JGBs soon. In order to inject capital into the banks and put some limit on power money growth, the BOJ will have to stop buying, or even sell, JGBs. So one of the big support pillars will fall down.
But let’s gain altitude for a minute and look at Japan from 30,000 feet. Why has Japan’s statist economic model survived for so long? The answer is because Japan is a surplus country with the rest of the world. It’s like Korea, but with a current-account surplus and massive external assets instead of liabilities. As long as this lasts, Japan will be able to control the pace of its own collapse. The day it depends on the world for capital, it will lose that control. Then Japanese financial assets will be repriced using much higher global interest rates.
What will make all this change and produce a radical shift in the cockpit of Japan Inc? First, Japan’s external accounts will switch from surplus to deficit. I expect the current-account surplus to disappear over the next few years due to the Asian effect, despite rotten domestic demand. Foreign direct investment will remain another big outflow. And financial deregulation will turn portfolio capital inflows into outflows. Once that happens, Japan’s financial assets will get repriced. US and Japanese bond yields will converge, and ultimately, Japanese yields will move above US ones.
Second, Japan will fail to maintain the dull, grey world of full employment and mediocre living standards that is its social contract. That will eventually lead to serious social problems and a political revolution. There is no sign of that yet. The ruling Liberal Democrats are still winning elections and are in pretty firm control of parliament. But it will happen some time in the next few years.
David Roche is president of Independent Strategy, a London based research firm.
