Author: David Roche Bank of Japan governor Masaru Hayami missed a step when the bankruptcy of the Japanese retailer, Sogo, stopped him ending the zero interest-rate policy (ZIRP) at the BoJ’s July meeting. But he looks determined to end ZIRP within the next two months.
Zapping ZIRP will help the gathering pace of Japan’s waltz with reform. It would be great long-term news for Japan that the cost of capital is set to rise and that those (like Sogo) that don’t use it wisely will be allowed to go bust. The long-term benefit of this to investors outweighs the short-term cost of possible future bankruptcies.
Don’t expect Japanese investors to get the message quickly. They may even drive the Nikkei down further. I dropped my overweight Japanese equity position after a visit there last April. What I saw convinced me that Japanese corporations hadn’t got the message about competing in the new economy. Also, up to now, the economy, as measured by GDP, has been like the surface of a dark pond, with probably just a small ripple of movement of around 1.0% a year. A little more may be happening below the surface, where fish gobble fish, as corporate restructuring goes forward at its own slow pace. But overall, the news on Japan has been singularly grey.
There will probably be another fiscal stimulus package in the autumn. So the fiscal deficit will stay around 9%-10% of GDP and gross issuance of government paper will be over ¥100 billion in both this fiscal year and next. Japan’s public finances will continue their slow and winding path to bankruptcy. Officially, gross government debt will hit 125% of GDP this fiscal year. In reality, when the hidden bad debts of the FILP and other public projects are added in, along with unfunded pension liabilities, public sector debt is more like 400% of GDP.
This path towards bankruptcy will probably not lead to a collapse of the yen and financial markets for a few more years. Here’s why. First, maturing deposits in the post office savings scheme, which is the main source of funds for the government, are leaving very slowly. Excluding tax payments, 80% of April’s maturing deposits (which were ¥10 trillion out of ¥106 trillion maturing over the next two years) stayed on in one form or another. Of those that left the post office, the majority probably ended up in the banks, which buy government paper anyway.
Second, the shaky finances of the government’s Trust Fund Bureau are to be shored up with a private placement underwritten by the post office savings. So, against all financial logic, the TFB can go on buying government paper. And even if there were a large outflow of funds from the TFB to post office savings, provision has been made to allow the TFB to do repos of its massive ¥80 trillion JGB portfolio with the banks or, ultimately, the BoJ.
Third, the banks still “suffer” from a weird phenomenon of lending dropping behind deposits. Indeed, lending (even adjusted for non-performing loan write-offs and securitization) is still falling. That means the banks, as the intermediaries between Japan’s surplus savings and its bankrupt government, will go on using the former to finance the latter. They will buy government paper even if the BoJ starts to charge them a small interest rate for lending to them for this purpose.
Finally, capital flows abroad are going to remain small. The financial institutions are simply too scared of the new mark-to-market accounting rules to have any appetite for foreign-exchange risk, despite higher nominal yields available outside Japan. In short, the external accounts of Japan will remain in a surplus that mirrors excess corporate and household savings over public financing and investment needs.
Corporate investment or consumption won’t grow at rates that would drain these surpluses away. So, even if Japan’s current account surplus and excess savings shrink, there will still be upward pressure on the yen for a while.
But I expect the limitless resources of the authorities to stop yen appreciation above ¥100/$. If the yen started to appreciate while the economy was still weak, that would be seen as an emergency. The BoJ response would be unsterilized intervention. That’s unlikely though. More likely is that the yen noses up another few percent against the dollar and the corporate sector copes with it.
There is every sign that the link between corporate profitability and the yen has been broken, just as the bond between job creation and profit recovery has been killed by Japan Inc’s slightly greater focus on return on assets. That conditions the MoF response to yen strength because it views corporate profits and investment as the lynch-pin of any economic recovery.
When I visited Japan last spring, it was to gauge the readiness of Japan Inc for the new economy. On this benchmark, no Japanese corporation scored better than a C grade! Japanese companies, critically in sectors open to massive global competition, have no idea that the combination of the cyber economy, globalization and corporate restructuring will revolutionise their entire corporate architecture and strategy.
If Toshiba can’t make computers like Dell, and Toyota can’t make cars like GM, they are dead meat. What I found was that no so-called “leading” Japanese company viewed the cyber economy as anything more than an “add-on” to their existing business in terms of boosting sales. They don’t want to join B2B e-commerce exchanges because it would threaten their long-term relationships with suppliers. The auto producers don’t want to sell on the net because it would threaten their existing distribution networks. And no one had plans to cut costs seriously as a result of the internet economy. None of the banks has any internet strategy at all.
The blue-chip Japanese corporate economy that should be shifting to the new economy in overdrive will only do so after non-Japanese competitors have seriously damaged their businesses. That doesn’t seem like a great reason to own Japanese equities, does it?
But there are some catalysts for change hidden behind the greyness. First, Japan’s economy is picking up. Real labour earnings are now rising. Consumer confidence is returning and big-ticket sales of items like cars are making a comeback. Above all, the government’s overall measure of economic activity is moving up at a 2.5% clip.
Second, the Japanese election result for the lower house of parliament showed that Japanese voters wanted to punish the ruling Liberal Democrats (LDP), while retaining political stability. Prime minister Mori is so unpopular that he is unlikely to lead the LDP into the Senate elections next year. If Koichi Kato, head of the other big faction in the LDP, became prime minister, it would be the most positive outcome for investors. Kato stands for fiscal retrenchment and for more structural reform.
A healthier economy, a proper monetary policy and a reformist government are not going to happen overnight. But get ready to go back into the Nikkei if any of these catalysts come to the fore in the next few months.
