Sunday, July 5, 2015

Japan And Its Shrinking Number Of Options

Japan's Economic Options Are Shrinking
A recent article outlined how Japan is painting itself into a corner and how its economy and future was still troubled at best. Reuters has gone on to reinforce this opinion when it pointed out there is no spending cap in the latest fiscal strategy draft being issued by Premier Shinzo Abe. Not only is the mandatory spending cap missing, but the draft is based on some rather optimistic economic estimates of future events. This will put the Bank of Japan under even more pressure making it difficult to expand monetary stimulus if needed. Japan's options are shrinking and "any" shift in monetary policy could cause bond yields to soar and create a panic.

Concern over the slow progress Japan is making to get its huge national debt and government deficit under control has been rising for some time. The reality is these delays could morph into a reinforcing negative loop if the markets or Japanese people begin to lose confidence. The liquidity of the government bond market has been recently questioned and if yields were to start rising it would trap the Bank of Japan into buying more bonds and holding them longer to halt an explosion in the government debt which is bigger even Greece's relative to its economy. The BOJ had been promised a stronger effort would be made by the government in confronting its fiscal deficit.

This is in many ways about "confidence", the moment it is lost the consequences will be huge. With the government financing almost 40 percent of its annual budget through debt it becomes easy to draw comparisons between Greece and Japan. The obvious difference being Japan is not at the mercy of others and is able to print currency at will. A big chunk of the budget already goes to servicing the national debt and any rise in interest rates would put Japan in a world of hurt. "Once markets become suspicious about Japan's fiscal discipline, it will be tough even for the BOJ to control long-term interest rates," said BOJ policy board member Takehiro Sato. 

A clearer picture of how the economy is fairing will begin to develop later this year after the distortion from falling oil prices has worked its way through the system.  If inflation does start to take hold it is not unreasonable to think it will pull bond yields higher as it moves up.  Another problem is that the number of banks and investors buying Japanese Government bonds has slowed to a trickle as they moved into the stock market and riskier ventures in search of higher yield. Even Japan Post Holdings, a state controlled company and the world’s biggest holder of  JGBs after the Bank of Japan recently announced with little fan fair its intention to significantly alter its investment strategy and revamp its 300 trillion yen portfolio away from these bonds.

The bottom-line is the BOJ is in the hot seat and any effort to taper its purchases could cause chaos. Unless the government restores fiscal discipline bond prices will plunge and yields soar on any attempt by the BOJ to cut its bond buying. If it doesn't, fears that the country will monetize its debt will drive funds out of Japan and send the yen into free-fall. Hideo Hayakawa, a former top BOJ economist said "The moment markets stops believing that Japan's finances are sustainable, huge market turbulence is unavoidable." We should remember Japan is still a large global player and problems there will spread across the world. 

Footnote; As always your comments are appreciated. Please take the time it check the archives located at the right to see if any other articles tickle your interest. The article below delves further into just how vulnerable the yen is going forward.

Footnote #2;  When looking at recent numbers from Japan we must remember the depreciation of the yen mechanically inflates the revenue collected abroad when converted into Japanese currency. Exports, conversely, increased at an unprecedented pace since January (+ 9.5%), to 6.5057 trillion yen (52.5 billion dollars), driven by the semiconductor and automotive sector in particular. Thus while the yen total has grown is larger in terms of volume, there was a stagnation.

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