The debate now going on at Wall Street houses like RBC Capital Markets, Bank of America/Merrill Lynch, Goldman Sachs, and Nomura Securities isn’t about whether Japan will recover from what its prime minister has already called its greatest crisis since World War II.
It’s about what policy moves Japan will enact now to put it on the road to recovery after a devastating 9.0 magnitude earthquake and tsunami, and a resulting catastrophic nuclear reactor crisis that threatens the country.
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Tens of thousands of homes, as well as business offices and infrastructure such as bridges and roads, must be rebuilt in Northern Japan.
Already, Japan has been struggling to get out of its zombie "Lost Decades" of stagnant growth via massive government interventions that have caused it to become the most indebted nation in the world, with debt that is double its economic output.
At the same time, Japan has been caught in political drift, two prime ministers, three finance ministers, and three foreign ministers in less than a year and a half. Leadership turmoil has heightened fears about a credibility problem in the global markets.
Consensus: The Bank of Japan [BOJ] will inflate away the country’s debt, igniting heated debate about the efficacy of such government interventions. The Bank of Japan [BOJ] is stepping in with $367 billion in liquidity for the markets, or 11% of its balance sheet.
The BOJ is also attempting to keep long-term rates low by doubling the amount of government and other bond assets as well as REITS and ETFs it will buy from the debt markets. The BOJ has decided to expand its bond asset purchases by ¥5 trillion yen, for a total of ¥40 trillion yen, or $500 billion.
Japan has already been pumping massive stimulus into its financial system to arrest a decades-long deflationary spiral, which began after the international currency agreement known as the 1985 Plaza Accord to cheapen the yen.
The U.S. had pushed the accord on Japan and Germany to weaken a strengthening yen and deutsche mark against the dollar, so that the U.S. could export its way out of a deep recession in the ‘80s. Exporters like a cheaper currency because it makes it easier to sell their goods overseas.
But lessons from the failed Plaza Accord shows that a cheaper currency is not a silver bullet, as Japan's import restrictions and tariffs on U.S. products blocked U.S. companies from selling goods into Japan's strengthening markets.
Moreover, lost on the policy makers was this bit of common sense: Printing money only increases the price, not the value, of an underlying good or asset.
Wall Street Analysts React to Japan’s Policy Moves
Marc Ostwald at Monument Securities notes that the “pressure being brought to bear on the BOJ to operate an inflationary policy is now so enormous as to be almost inescapable, we also take note the effective desire to devalue the JPY [yen] by 20% vs. the USD [U.S. dollar] All of this looks very inflationary for the global economy, and a further large barrel of oil for the risk asset price fire.” Cheapening the yen further would help Japan’s dominant export sector seeking to sell cheaper goods.
But RBC Capital Markets’ Elsa Lignos says that the BOJ’s moves have helped weaken the yen only slightly, to 82.05 from 81.20 against the dollar. Nomura’s currency analysts are forecasting a strengthening yen in the short-term, dependent upon further intervention by the Bank of Japan, as the businesses and the government repatriate the currency back into the country for recovery and rebuilding efforts.
Meanwhile, rolling power outages due to the nuclear crisis, and a sharp fall in economic activity and consumption in Japan will likely keep core inflation zero to negative, as the crisis exerts deflationary pressures that "will outweigh inflationary pressure from supply shortages," Goldman Sachs says.
Investor Confidence Key
Investor confidence in Japan's debt management is key to how Japan’s central bank reacts. BOJ has frequently stepped in to Japan’s currency markets to artificially lower the yen, which in turn made it easier for Japan’s automotive and electronics manufacturers to sell cheaper exports in order for the country to grow out of its debt crisis.
Moody’s says worldwide investors may “at some point” reach a fiscal “tipping point” in their confidence in Japan’s balance sheet, and at that point force Japan to offer higher yields in the form of a risk premium on its bonds.
The earthquake and tsunami “may have shifted such a potential tipping point a bit forward, unless Japan’s political parties are galvanized by the crisis to also address the country’s long- term fiscal challenges,” Byrne has also said, noting recovery costs will stall moves towards cutting Japan’s “large” budget deficits. That could mean the BOJ buys even more government debt in the open market.
After its stock and housing markets crashed in the early ‘90s, Japan embarked on a government spending spree to awaken it out of its ensuing zombie decade of stagnation.
Japan enacted ten stimulus bills over eight years in the ‘90s, but its economic growth continued to remain flat.
Japan’s Ministry of Internal Affairs & Communications says the country’s debt is now at $11.12 trillion, or 204% of GDP. Fitch Ratings is forecasting that Japan’s debt to GDP ratio will likely rise beyond 223% by year-end.
International Monetary Fund Deputy Managing Director Naoyuki Shinohara last month called the nation's indebtedness "unsustainable" in the medium term.
"We have to keep sending out messages to the market that Japan will properly repair its finances and that it has fiscal discipline," Japan’s Finance Minister Yoshihiko Noda said in response.
But Tom Byrne, senior vice president at the credit rating agency Moody’s Investors Service in Singapore, says “we don’t see an immediate fiscal crisis” in Japan, adding “we see that the market will readily fund the government right now.”
Japan’s Borrowing Outstrips Tax Revenues
The earthquake and tsunami came at a time when Japan’s borrowing has outstripped its tax receipts for the third consecutive year. Japan’s ¥44.3 trillion in government debt will exceed its ¥40.9 trillion in tax revenues this fiscal year.
Meanwhile, Japan’s debt service is rising, now at ¥21.5 trillion. Its population is also aging, and government spending on social security is rising, too, now at ¥28.7 trillion yen.
All of these fiscal pressures were behind the reason why Japan’s government was moving to cut spending on public infrastructure by 14%, below ¥5 trillion, before disaster struck.
Interest Costs On Japan's Debt At Issue
Japan’s debt strategy, and its growing inability to service its debt, has been an issue for years now at the credit ratings agencies.
Standard & Poor’s recently downgraded Japan once again this past January due to its lack of a “coherent strategy” to reduce its debt, and fears that its tax revenues won’t suffice to pay interest costs on its borrowing.
Moody’s Investors Service also lowered its outlook on Japan’s rating, noting its fiscal strategy may fail to stop “the inexorable rise in debt.”
Fears over Japan’s economic recovery, and subsequent servicing of its debt, become starker due to the fears that radiation will contaminate the goods it sells overseas. The nuclear meltdown is already delaying recovery, since electrical outages and rolling blackouts planned through April will delay economic activity needed to get the country back on its feet. Wall Street estimates show a potential annualized 13% loss in Japan's GDP.
Automotive and electronics parts manufacturing make up sizable proportions of Japan’s GDP, and these sectors in Japan could be severely hampered by radiation.
Consumers simply will not buy cars or electronic gadgets and computers containing components made at factories near radioactive fallout due to fears over health risks and because radioactivity corrodes parts. Deutschebank is already reporting that U.S. manufacturers may benefit here.
Moody’s Byrne notes that cost estimates for the economic damage may “likely increase in the weeks and months ahead,” as “already ripple effects beyond the devastated zones are being seen in curtailed electricity supplies and suspended production in some automobile, and petroleum refining plants.”
Fitch Ratings put out a note indicating Japan faces a potential “credit negative situation” if there is any evidence of substantial permanent loss to output.
Japan Loses Triple-A Six Years After Kobe ’95 Quake
In 1995, in the rebuilding after the Kobe earthquake, tax revenues surpassed debt issuance by ¥30 trillion.
But after the ’95 quake, Japan saw its tax receipts coming in lower than expected due to flat economic activity.
Japan then lost its Triple-A rating in 2001 due to its growing welfare state, largely the reason why Canada, Sweden and Finland also lost their Triple A, as the ratings agencies noted tax revenues were no longer enough to service their debt.
A Triple-A rating indicates a country is highly unlikely to default on its debt, and it also lets countries borrow cheaply.
A downgrade means countries have to lure investors in with higher yields. And because consumer loans are tied to government bonds, a downgrade has wide ripple effects, as rates on mortgages, credit cards and car and business loans rise.
But lately, due to the economic downturn, investors have shrugged off downgrades, caring more about safe havens, RBC Capital Markets reports. RBC also notes that bond yields actually dropped in Japan and other countries six percentage points on average after rating downgrades in the late ‘90s--the markets seemed to believe Japan was in recovery mode.
Japan’s Aging Population
Market watchers like to point to a seeming strength for Japan, the fact that about 90% of Japan's debt, or bonds, is owned by Japan’s domestic savers, with little government borrowing in international markets.
But that might not be the strong point market pundits think it is.
Japan’s government cannot simply seize private savings to pay for its recovery.
The zero-rate regime that Japan’s central bank launched in 1999, after fallout from the Asian economic crisis, meant savers earned nearly 0% interest on bank savings accounts. Facing microscopic returns on their old age pensions, Japanese investors turned to its bonds.
But as Japan’s population ages, its growing phalanx of senior citizens have already started drawing down on those savings to live.
Jim O'Neill, chairman of Goldman Sachs Asset Management, notes that the household saving rate in Japan is heading down lower than the savings rate in the U.S. Japan’s savings surplus sits mostly in its corporate sector, which the government can only prod to deploy its cash hoard.
Japan's debt and monetary disarray grew out of the currency agreement known as the Plaza Accord of 1985, nicknamed after the Plaza Hotel in New York City, where the U.S. got Japan, West Germany, France and Great Britain agree that the dollar should be devalued against the yen and deutschemark in order to cheapen U.S. exports and increase sales of U.S. goods overseas.
The demands for devaluation by the U.S. came in order to arrest a seemingly stubborn U.S. recession and stop global trade imbalances. From 1980 to 1985, the dollar had strengthened 51% versus the yen, and by a similar amount against the deutsche mark. Companies like Caterpillar and IBM began hollering at elected officials to do some thing, and Congress began rattling the protectionist sabres (sound familiar?).
The U.S. won the planned currency intervention, eventually amounting to an estimated $10 billion spent by central banks in the currency markets to help drop the dollar in value.
But the Plaza Accord didn’t stop a ballooning U.S. current account deficit, which at that time in the mid '80s had grown to 3.5% of GDP, (current accounts are a foreign trade term, it indicates the sum of a country’s balance of trade, usually exports minus imports).
That's because Japan kept erected trade barriers against foreign imports.
However, the dollar devaluation did cause the yen to spike higher in value. And what happened next is key.
Japan’s Lost Decade
Initially misguided in their self-confidence, Japanese policymakers accepted the yen appreciation, believing destiny was upon them, believing in the strength of their then world dominant economy, even though a strengthening yen led to expansionary monetary policies that caused dangerous stock market and housing bubbles to blow, starting in the late '80s.
Between September 1985 and December 1990, the Nikkei Index trebled, and the yen rose about 40% against the dollar. By 1994, the yen would triple in value against the dollar.
Japan cheered as a surging yen led to Japanese auto makers like Toyota to build factories in the U.S. and Europe. It cheered again as its households grew in purchasing power, turning Japan into an ostentatious consumer society. A government and consumer spending free-for-all ensued.
Gold Flakes in Noodle Soup
Reports then began to circulate that Japanese business executives were sprinkling gold-flakes on their noodle soup and eating sushi off of naked women.
This orchestrated, and sizable, appreciation of the yen eventually subjected Japan to a series of asset bubbles due to lax monetary policies, and massive government and consumer spending.
When Japan’s stock market and real estate bubbles burst, the economy plunged downward into a deflationary spiral which it has yet to recover from.
Much of Japan's bubble-era gross domestic product growth was found to have come on the back of illusory bank profits, artificially inflating the country's economic output.
Two decades of malaise ensued. The yen then tripled in value versus gold from 1985 to 2000, an indication of the deflationary quandary Japan was in, notes John Tamny, editor of RealClearMarkets and a senior economist with H.C. Wainwright Economics.
Bears repeating: printing money only increases the price, not the value, of an underlying good or asset.
To this day, Japan’s banks continue to evergreen their mountain of bad bank loans, an extend and pretend method of keeping rates low to keep borrowing costs low, a policy that the U.S. is now emulating.
Witnessing the fallout of the yen appreciation science project from the Plaza Accord is likely the reason why China is now fighting off demands from the U.S., including from Treasury Secretary Tim Geithner and Sen. Charles Schumer, to revalue the renminbi.
A Soggy Economy
So was it a strengthening yen that sunk Japan, or the government’s policy response to it?
Is the U.S.’s soggy economy the result of similar massive interventions, as well as the failure to let market forces reset supply and demand by instead floating zombie banks, companies and borrowers?
Isn’t this saying kind of true, that “capitalism without bankruptcy is like Christianity without hell,” as Frank Borman of Eastern Airlines once said? Doesn’t nature have its own form of bankruptcy or cleansing, called extinction?
Japan’s deflation “was caused by us through the Plaza Accord in ’85,” says Tamny, editor of RealClearMarkets. “Real estate and market crashes can only cause deflations in the eyes of bad economists. Deflations are monetary in nature, and we foisted it upon Japan.”
Tamny notes: “Regarding debt and deficit spending, it was precisely because Germany and Japan could not raise debt post WWII that their economies soared,” adding, “Japan and Germany were shut out of the debt markets post-war, and that’s a major reason why they recovered so quickly.”
Tamny adds: What I’m saying is Japan’s recovery will be aided if its debt position makes it difficult for the government there to raise the funds. Better to leave it to the private sector.”