October 20, 2009
Japan’s setting sun
For years, HCM has written about Japan’s inability to reform its financial system in the wake of its own bubble economy. This is not a topic we have touched on lately, largely due to the fact that events in Japan were subsumed by the global financial crisis and the United States’ own race to the economic bottom. Nonetheless, Japan remains a crucially important component of the global financial system, and some are warning that its economic outlook is growing ever bleaker.
Japan is the second largest holder of U.S. debt with $720 billion on its books (only China, with $800 billion, and the Federal Reserve, with almost $5 trillion according to The Gartman Letter, is larger). The country’s gross national debt is equivalent to 217 percent of its gross domestic product, compared with 81.2 percent for the U.S. (but don’t worry, we are working hard to catch up!) and an average of 72.5 percent for the G-20 nations, according to the International Monetary Fund. The most troubling challenge facing the Japanese is their demographic future: over the next 40 years, its population is projected to fall by 20 percent while the number of working men and women is expected to drop by 41 percent. The country is facing a situation where an aging population will have an insufficient number of workers to support it.
The second most troubling challenge facing Japan is its sclerotic and corrupt political system. Last month, the Democratic Party of Japan (DPJ) defeated the deeply entrenched Liberal Democratic Party (LDP) with promises to dramatically reform the country. Readers should remember that the term “bridge to nowhere” originated in Japan’s public works projects designed to feed work to the LDP’s cronies while doing nothing to add to the productive capacity of the island nation’s economy. Some observers are optimistic that the DPJ will bring much-needed reform to Japan, just as they were encouraged by the election of Prime Minister Koizumi a few years ago. Unfortunately, the LDP is so deeply entrenched in Japan’s power structure that the best case scenario is that some modest change might occur at a snail’s pace while the ineluctable demographic trends continue to march forward.
In a recent story in Barron’s, several Japan experts expressed concern over Japan’s ability to service its debt in the future. Goldman Sachs’ Tokyo-based economist Tetsufumi Yamakawa warns that Japan’s annual budget may hit 10 percent of GDP for the next three years if the DPJ’s promised stimulus programs are passed (this sounds very familiar to those of us in the U.S.). Mr. Yamakawa is also concerned that the interest rates on Japan’s public debt may soon become persistently higher than the country’s nominal GDP growth, which would lead to permanently growing government debt. That may well occur, but GDP growth would have to be extremely low (which is certainly possible) since Japan’s interest rates are unlikely to rise to any meaningful extent in the foreseeable future. In fact, the world can continue to expect a prolonged period of low interest rates as it attempts to heal from last year’s crisis. Japan’s benchmark government bond, the JGB, currently yields about 1.3 percent. HCM doesn’t expect any dramatic rise in this yield, although some disagree.
There is only one thing we know for certain about Japan – things move very slowly. Japan is unlikely to give rise to any type of near-term crisis. Instead, the Japanese economy is far more likely to go out not with a bang but with a whimper.
Interestingly enough, the Japanese Yen is no longer the currency of choice for the global carry trade. That dubious honor has been assumed by the U.S. dollar. It is always tempting to draw comparisons between Japan and the U.S., but the differences are far greater than the similarities. From demographics to culture, the U.S. is a far different place than Japan and has demonstrated a far more aggressive approach to dealing with its financial crisis than Japan has taken with its slow motion meltdown. If anything, U.S. authorities have learned from Japan that aggressive action is necessary to prevent a prolonged slump. This has forestalled the immediate crisis but created long-term imbalances that will have to be addressed. In many respects, even in today’s increasingly flat world (to borrow Thomas Friedman’s lingo), Japan remains a special case. The lessons it offers for other are important, but they are limited. Nonetheless, what happens in Japan over the coming years will have an important impact on investors throughout the world and should be watched carefully.
Michael E. Lewitt
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The HCM Market Letter
Michael E. Lewitt, Editor
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