Sunday, June 19, 2016

The Yen And Its Failure To "Fail"

To consider the Japanese yen a "safe haven" currency flies in the face of reason. For years many economist have looked at Japans economic path and predicted an economic crisis brought on by the growing debt of its government. The myth promoted by the central banks that a major currency cannot fail is accepted as fact by many people however, the rapid demise of either the yen or the euro is all that will be needed to reveal the truth and remind people everywhere that our system of fiat money is held together only by faith in the system and a prayer. Clearly a clear timetable for such an event is very difficult to predict. Several factors playing into such a scenario and how fast such an event might take to unfold after its onset remains difficult to answer. In recent years as Japan has undertaken a policy to weaken its currency and to strengthen its exports America has until recently remained mute in sympathy of the problems Japan is facing. Nothing good is really occurring within the Japanese economy. Prime Minister Abe has even said he will delay a sales tax hike because it threatens to derail the country's fragile recovery. The reality is that much like the situation that developed in Greece it is clear that Japan is facing a wall of debt that it will never be able to repay. The difference is that Japan controls the press that prints its money.

Small Shifts From Bigger Players Move The Yen
In the future Japan's debt can only be addressed by printing more money and debasing the yen. In truth this means they would be paying off their debt with worthless yen where possible and in many cases defaulting on promises made. Japan's public debt, which stands at around 250% of its GDP is the highest in the industrialized world. It seems that because of its minute size people tend to forget that the island nation of Japan is an economic powerhouse. When looking at the GDP of Japan we find the country ranks third behind only the United States and China. Japan is an export driven economy meaning it sucks in raw materials from all over the world, adds value to them, and then spews out finished goods. This leaves the country and its economy dependent on and vulnerable to the countries buying its products. A weak yen makes these goods more competitive on the world market and propels the economy forward.

The yen is part of a somewhat self defending system that includes the four big boys or major currencies. These players known as reserve currencies are considered the most liquid and sound in the global economy. The value between them constantly fluctuates and as one currency temporary falls out of favor investors shift into the other three seeking the least bad choice. As long as savers, investors, and institutions keep their wealth stored within these four currencies  and continue the delicate balancing act of avoiding the worse and exiting the most overvalued the system remains relatively stable and will continually readjust partly because it is so self contained. Each of these currencies has its particular strengths and weaknesses however, the most vulnerable of the two are probably the Japanese yen and the Euro which is the official currency of the Euro-zone, which consists of 19 of the 28 member states of the European Union. A key weakness of the euro is the questionable accountability of its controlling institution.  

Japans Huge Debt - Click For Larger Chart
Over recent decades because of its size in the global economy the current Bank of Japan policy has quietly and systematically distorted financial markets across the planet. With super low interest rates it has become a key player in the carry trade. In recent years investors and the mega-banks have drastically reduced their Japan Government Bond (JGB) holdings. Much of the risk of who gets hurt in the case of a falling yen or a default is shifting from the private sector to the Japanese public as the BOJ splurges on JGB's. As Japan continues down this path it is only a matter of time before the credibility of the BOJ is lost and the yen will plunge. For a long time I along with many economist have taken a dim view as to the yen and its value in coming years however, timing when it will succumb to economic reality has been hampered because of how it is insulated and intertwined in world markets.

Demographics paint a bleak picture going forward because Japan is stuck with an aging and shrinking population that is evermore expensive for the government to provide for. Adding to its woes the Fukushima nuclear disaster shuttered its nuclear power plants and forced the country to import more expensive energy alternatives. All in all neither monetary nor fiscal policy will adequately solve Japan's problems. Continuing to run fiscal deficits only means that government debt is pushed onward and upwards. Simply put, the fundamentals for Japan are lousy. It should be noted that Japan would be sitting in far worse shape if it were not for the wealth currently shifted from America to the small island nation each year. America spends billions each year defending Japan and puts much of this money directly into the economy. Another way America supports Japan is by purchasing many of the goods the country produces. The massive trade deficit America has with Japan feeds large amounts of money into Japan, without this money the massively indebted nation would be in even more trouble.

For years it has been noted that a key strength that Japan holds is its ability to control its own economic fate and that it cannot be held hostage to foreigners, because the people and institutions of Japan hold its debt. In the past we have seen outside creditors can wield a great deal of sway over a nation that is deeply in debt. It is not uncommon for creditors to squeeze, threaten, and even blackmail a country that owes them a great deal of money. Recently, as the yen has moved higher many analyst claim Japan is unable to halt its advance. As for the current idea that Japan may not be able to drive the yen lower even if it makes an effort to do so. I contend it is bunk because a country can always drive its currency downward however, supporting it is much more difficult. To drive a currency lower a country only needs to print and sell their currency using it to buy one or more of the other three reserve currencies. Part of recent strength seen in the yen may be contributed to the fact Japan has strong economic ties to the collapsing economy in China and thus is used as a conduit to move wealth out of China.

Unlike many other leading economies, Japan has been battling deflation or falling prices for the best part of the past two decades. At some point expect this to change as reality takes hold. To support their stock market the BOJ has even gone to buying stock. When investors in Japan's government bonds begin to believe that Abenomics will be successful in bringing back inflation it would be logical for owners of  JGB's to move out of low yielding securities and buy foreign bonds or equities. The moment the Japaneses stock market fails to rise enough to offset a falling yen and inflation this will turn into a tsunami of  money fleeing Japan and constitute the end of the line for those left holding both JGB's and the yen. This has been a long time coming and I contend the cross-border flow of money leaving Japan is why some other stock markets have remained so resilient in our slow global economy. When Japan crumbles it will be felt across the world.

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