Thursday, January 1, 2015

Japan Is About To Enter A Crisis Of Faith

The Sun Is Setting Over The Land Of The Rising Sun
Across the world many people have given a big thumbs down on Japan's great economic experiment. The recent re-election of Prime Minister Shinzo Abe indicates the people of Japan still have faith in their government, why, and for how long are the two big questions we must ask. Abe hopes his electoral victory will give him a mandate to tackle the more difficult elements of his “three arrows” reform agenda and get the economy moving. Meanwhile Fitch Ratings recently said it expects to downgrade Japan’s credit rating sometime early next year after the government delayed a sales tax hike, this would follow a similar downgrade by Moody’s as concerns grow about the country’s unprecedented debt pile. Fitch wants to see what type of budget Japan compiles for next fiscal year but has conceded that there is little chance the government will cut spending enough to offset revenue lost from the tax hike delay.

The Japanese Prime Minister's victory in elections this month is seen as an endorsement of his economic policies and increased his chances of staying in office until 2018 in a nation with little diversity or dissent. To date, Abe has successfully focused on infusing the market with cash through fiscal stimulus, and job creation via central bank policy. Much tougher will be restructuring Japan’s change resistant economy through political reforms. Abe’s decision to delay a sales tax hike has proved popular with voters, but it has eliminated any chance of meeting the government’s deficit reduction targets. The tax hike planned for October 2015 has been delayed for 18 months after an earlier tax increase in April 2014 helped push the economy into recession. The governments target of halving the primary budget deficit as a ratio of GDP during the next fiscal year now appears unreachable and Japan’s second target of eliminating this budget deficit in fiscal 2020 is becoming less credible with each passing day.

 It should be noted that Japan would be sitting in far worse shape if it were not for the transfer of wealth 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, America also supports Japan 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. Thus far the current Bank of Japan policy has quietly and systematically distorted financial markets across the planet. As this unfolds investors and the mega-banks are drastically reducing their Japan Government Bond (JGB) holdings. The risk of who gets hurt in the case of a default has shifted from the private sector to the people of Japan as the BOJ splurges on government bonds.

Years ago Japan was considered to have much better control of its destiny than many other countries because its bond were owned by the people of Japan and not controlled by outsiders such as is the case in America where other countries own a large share of its debt, but it should be noted the dollar as the world reserve currency makes America somewhat a unique situation. In the past, many economists argued that high debts would not trigger a crisis, because Japan's ample current account surplus made it a net creditor to the world. Now that the current account surplus is deteriorating, this has brought unwanted attention to the pile of debt and on Japan's ability to service it. Today Japan faces a wall of debt that can only be addressed by printing more money and debasing their currency. This means they will be paying off their debt with worthless yen where possible and in many cases defaulting on the promises they have made. Japan's public debt now stands at around 230% of its GDP and is the highest in the industrialized world.

Currently, the primary budget deficit excludes debt servicing costs and income from bond sales, if not the situation would be even more foreboding. The best advice you can offer someone who is creating a big hole of their own making is to tell them to stop digging, this is the advice someone should offer up to Japan, but in this case it is probably to late. 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 leading to a variety of possible scenarios on what the end game will be. We are seeing fostered upon the world one of the biggest Ponzi Schemes of modern economic history. The Japanese stock markets soared towards a six-year high recently as the yen tumbled because the Bank of Japan again boosted stimulus. All this occurs as the nation’s pension fund props up this market saying it will buy more shares.

An interesting footnote is that as the economic noose continues to tighten around Japan a new law deemed the "Specially Designated Secrets Act" came into force a matter of days before the election. Under the new law, citizens possibly including both whistle-blowers and journalists, can be jailed for up to 10 years for revealing state secrets. Critics fear the law has the potential for misuse, and could be used to curtail press freedom. Reporters Without Borders called the new law “an unprecedented threat to freedom of information” other comments include, "They are gathering puppets as audiences at their unpopular election campaigns" and "PM Abe is controlling the mass media with threat & money".  It is becoming more obvious Abe is on a mission and if a crisis of faith develops he will not hear the voices of the people making the situation even more dire in a land where the culturally homogeneous population often finds it is in agreement.

At some point a person has to question the reason behind the euphoria surrounding Abe's policy because a weaker yen means it is more costly to import fuel and other commodities into the resource poor country. The expansive monetary policy by Japan at some point is likely to end its deflation and lead to price increases. That is the good news, the bad news is that the evidence so far on QE2 and QE3 is not reassuring and it is questionable if Abenomics’ monetary loosening will significantly raise the long term growth rate of Japan’s real GDP, this monetary policy carries substantial risk and side effects.  Ever since the Yen went into play many economist have said what Japan is doing is actually quite dangerous. As the people of Japan begin to realize they are marching in lock step over a financial cliff faith will be lost and a crisis will develop. When they finally break ranks the concern is that a loop will develop that feeds on itself. As the yen falls and people in Japan realize that it is liable to continue, more and more people will want to put their money abroad, at that point the yens fall may become unstoppable.

Much of this can be blamed on the Bank of Japan's attempt to force a reallocation of capital from Japanese Government Bonds further out on the risk curve. As they continue down this path it is only a matter of time before the credibility of the BOJ is lost and the yen will take its final plunge. As investors in Japan's government bonds begin to believe that Abenomics will be successful in bringing back inflation it is 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 anticipated 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 when Japan does finally crumble it will be felt across the world.

We must not forget that in our modern world money can cross a border with the press of a key on a computer. Money has gained wings, it can flee and move about with rapid speed, and it can leave destruction in its wake. The financial news flowing from Japan has become so loaded with conflicts of interest and internal deals created to prop up one weak institution with another that it would be called comical it the ramifications were not so serious. This incestuous financial behavior where excessively close institutions resistant to outside influence work hand in hand to manipulate and create the impression that growth and prosperity is just around the corner will not end well.  I contend the cross-border flow of money leaving Japan is well on its way and is the reason some stock markets have remained so resilient . Simply put, the fundamentals for Japan are lousy. We should assume that as confidence fades a panic will start with the big  questions being, where will this wealth go, and into what kind of asset?

Footnote 8-18-2015,   Note the yen remains a freckle off its multiyear bottom and could make new lows at any time.  Since writing this article several more post concerning Japan have been posted a few that you may find interesting can be found below.

1 comment:

  1. Possibly we err in trying to force all views into a political context.

    Japan's society may not exhibit political heterogeneity or nascent defection from its dominant political orthodoxy, but the widespread (and justified) hand-wringing about the behavior of very large numbers of its young adults and their subculture are likely notable.

    Political change is what we're taught to examine in this age of Peak Collectivism, but the behavior of individuals in non-(politically)-organized ways that may be far more important.

    Reportedly large numbers of Japanese young adults are not dating, not marrying, and are withdrawing from traditional (or even natural) social interaction. This behavior, unorganized but apparently growing, dooms the entire Japanese experiment in ways so profound that no one seems able to even discuss it.

    The Abe government can turn its borrowing & credit-creation debasement of the yen into a massive game of musical chairs, but what it can't do is keep the lights on in Japan's "make real things" industries.

    What's next? Is the BoJ going to monetize a quadrillion more yen of bonds so Abe's cronies can pay Japan's young women to produce the next generation of taxpayers before the entire country becomes one big old age nursing home?