Japan looks set to depress the value of the yen to boost trade – how China must brace itself for the impact
Japan is on an unsustainable path of a strong yen and deflation. The
unprofitability of Japan's major exporters and emerging trade deficits suggest
that the end of this path is in sight. The transition from a strong to weak yen
will likely be abrupt, involving a sudden and big devaluation of 30 to 40
percent. It will be a big shock to Japan's neighbors and its distant competitors
like Germany. The yen's devaluation in 1996 was a main factor in triggering the
Asian Financial Crisis. Japan's neighbors must have a strong banking system to
withstand a bigger devaluation of the yen.
Self-inflicted
Deflation
Japan's nominal GDP contracted 8 percent in the four years to the third
quarter of 2011, and six percentage points of that was due to deflation. Without
increased government expenditure, the contraction will be one percentage point
more. Japan has not seen this kind of sustained deflation since the 1930s.
Without government deficits, Japan's economy will decline much
more. Central government bonds and borrowings plus its guaranteed debts rose by
116.3 trillion yen during the period, equivalent to one-fourth of the level of
the nominal GDP in the third quarter of 2011. If Japan had adopted balanced
budgets, its economy would have contracted two to three times more. This will
lead to a debt crisis in its private sector.
A strong yen,
deflation and rising government debt form a short-term equilibrium that lasts as
long as the market believes it is sustainable. The yen has seen a relentless
upward trend since it depegged from the dollar in 1971, up to 83.4 from 360
again to the dollar. When wages and asset prices rise, a strong currency can be
justified. When wages and asset prices fall, a strong currency is suicide.
Japan's nominal GDP peaked in 1997 and its nominal wages did too. Its property
prices have declined every year since. The Nikkei rose in only four out of the
last fifteen years and is still close to a three-decade low.
Japanese policymakers, businesses, academics, currency traders and
the average Mrs. Watanabe all believe in a strong yen. This belief is wrong but
self-fulfilling. It has lasted so long because the Japanese government adopts
policies to offset the destabilizing effects of deflation due to a strong yen.
Hence, Japan's national debt has marched upwards along with the value of yen. It
is expected to top yen 1,000 trillion in 2012, 215 percent of GDP, 7.8 million
yen (or roughly US$ 94,000) per person, and about half of net household wealth
per capita.
The sustainability of Japan's deflationary path
depends on the market's confidence in Japan's debt market. As Japanese
institutions and households hold almost all of the government's debts, their
faith in the government's creditworthiness is the mojo for Japan's seemingly
harmless deflationary spiral.
A Vast Bubble
In a normal market, greater supply leads to lower prices. The opposite occurs
in a bubble; faith in price stability or appreciation exaggerates demand. Japan
has the highest level of government debt and the lowest bond yield. The later is
necessary for the former. Even though the yield on 10-year Japanese Government
Bonds (JGB) is only 1 percent, the interest expense is expected to top 22.3
trillion yen in the fiscal year that begins next month. This is one-quarter of
the general account budget. If the bond yield rises to 2 percent, the interest
expense would surpass the total expected tax revenue of 42.3 trillion yen.
In addition to its fiscal vulnerability to a rising interest rate,
Japan's budget deficit is still too high. The government budgeted 44 trillion
yen in net additional borrowing in the next fiscal year, nearly half of its
expenditures. It needs to double its tax revenue to balance the budget. But, as
the economy is deflating with declining private consumption, a major tax
increase would cause the economy to go down more, shrinking the tax base and
requiring even bigger tax increases to balance the budget. Even though the
government plans to achieve a primary fiscal surplus, i.e., revenue above
non-interest expense, by fiscal 2020 to 2021, it is difficult to see how.
The justification for the low JGB yield is deflation. The real
interest rate (the nominal rate plus deflation) is comparable to that in other
countries. This rationale requires deflation to persist. But, deflation shrinks
the nominal GDP or tax base. How could the government pay back its escalating
debt by taxing a shrinking economy? It can only sustain its debt by borrowing
more. This fits the definition of a particular type of Ponzi scheme.
The JGB bubble explains the seeming lack of pain in Japanese
society. A strong yen and deflation haven't led to an employment crisis because
the government deficit is pumping up aggregate demand. As long as wages decline
in line with prices, one doesn't feel the pain. Japan's household debt is only
half of GDP, about half of the level in the United States. Deflation doesn't
cause much balance sheet trouble.
The Strong Yen
Bubble
Yen bulls usually point at Japan's trade and current account surplus as
supporting factors. A trade surplus can reflect a country's competitiveness or
lack of it. Current account surplus is savings minus investment. When investment
declines, the trade surplus is boosted. When a country cuts investment, it
signals declining competitiveness. Hence, the current account surplus shouldn't
be viewed as a supporting factor for strong currency.
The
combination of a weak economy and strong currency are always suspect. But it has
lasted for so long that even foreigners take it for granted. I think this is
some sort of mass hysteria. Most people only remember a strong yen. On the other
hand, most people haven't seen rising property or stock markets either.
Japanese culture is group-oriented. Individuals usually embrace
group activities. This psyche was the reason that Japan's property bubble became
so big in the 1980s. In terms of value above the normal level, Japan's bubble
was five to six times the size of the bubble in the United States. After the
property bubble, the group psyche shifted its power to a strong yen, pushing
Japan's economy onto the path of a rising yen, deflation and rising government
debt.
Japan's paralyzed political system is the reason the
government has accommodated the deflation path by running up national debt. The
Japanese people, on the other hand, buy the debt because deflation makes
property or stocks bad investments and a strong yen discourages them from buying
foreign assets and deflation.
Despite the fact Japan has had a bad economy for so long, the
yen has remained strong. It reinforces the Japanese psyche on the issue. The
strong yen has become a cult.
The international financial market
believes in a weak yen from time to time. In 1998, the short-selling by
foreigners briefly caused the yen to touch 140 against the U.S. dollar. But, as
the Japanese hold all of the yen, if they believe in the yen, foreign
short-sellers get punished eventually. Over time, yen bears are all weeded out
of the market. The remaining yen traders are all believers in a strong yen.
The End is in Sight
No bubble is sustainable. While the Japanese can always take care of business
within, they cannot control the outside world. The country's Achilles heel is
losing trade competitiveness due to the destructive impact of deflation on
business confidence and the strong currency itself. When a trade deficit
emerges, it signals the beginning of the end.
Japan has lost
competitiveness in a swath of industries that it used to dominate. Its
automobile industry is losing out to Germany, South Korea and the United States.
Japan's automobile industry used to be competitive in cost and far superior in
quality to its global competitors. But the world has changed. The yen has
dropped below 110 from as high as 160 against the euro. The South Korean won was
about ten against the yen and is now 13. Cost-cutting cannot offset such a big
change in exchange rates. The U.S. auto industry cut its labor costs and debt
burden through the government bailout. It is now more competitive than Japan's.
The automobile industry is the pillar of Japan's economy. Its
decline leaves Japan's economy nowhere to turn. Indeed, if the auto industry
leaves Japan, it will become a poor country.
Japan's electronics
industry, still significant to its economy, is losing out big time to its Asian
competitors. Nothing hot in electronics is made in Japan now. U.S. companies
like Apple leverage China's manufacturing sector to turn out hot products. South
Korea is embracing the vertically integrated model and churning out competitive
products like Japan used to.
Nothing symbolizes Japan's decline
like its electronics industry. It was the envy of the world and had all the
ingredients to take the industry into the mobile internet era. Instead, it
embraced insulation and made products just for the Japanese market. Now it is
almost irrelevant to the outside world.
Japan isn't just facing
macro troubles. Its micro competitiveness is rotting away. It is just bizarre to
see that the whole world believes in a strong yen when Japan is failing on such
a grand scale.
Japan's trade balance may swing into surplus from
time to time, but the negative trend is irreversible. Japan will face rising
trade deficits. That makes foreigners' views important because Japan would need
foreign money to fund its deficit. When foreigners change their views, which
they surely will, the yen will crash.
The Only Way Out
Japan has only one way out – a massive devaluation. If the stable national
debt is 120 percent of GDP, the yen needs to be devalued by 40 percent because
devaluation is ultimately equal to the nominal GDP increase. The devaluation is
likely to sustain 2 percent to 3 percent of nominal GDP growth for Japan beyond
the repricing induced increase, which is necessary to restore Japan's tax
revenue. Deflation has caused Japan's tax revenue to decline as a share of GDP.
It can be only reversed through restoring nominal GDP. A devaluation of 40
percent can restore Japan's competitiveness against Germany and South Korea,
which will lay the foundation for Japan's industrial recovery.
The
Bank of Japan is trying to weaken the yen through expanding its balance sheet.
It has an asset purchase program of 65 trillion yen and a lending program of 5.5
trillion yen. The two are equivalent to 15 percent of GDP, comparable to what
the Fed or European Central Bank have done. The effectiveness is limited so far.
Because Japanese businesses, households and investors believe in a strong yen,
the printed yen largely stays in the country and just slows down money velocity.
The U.S. dollar has risen 10 percent against the yen from last year's bottom.
This is probably due to the financial market upgrading its view of the U.S.
economy rather than the BoJ's action.
Yen devaluation is likely to
unfold quickly. A financial bubble doesn't burst slowly. When it occurs, it just
pops. The odds are that yen devaluation will occur over days. Only a large and
sudden devaluation can keep the JGB yield low. Otherwise, the devaluation
expectation will trigger a sharp rise in the JGB yield. The resulting worries
over the government's solvency could lead to a collapse of the JGB market. Of
course, the government will collapse with the JGB market.
The day
of reckoning for the yen is not distant. Japanese companies are struggling with
profitability. It only gets worse from here. When a major company goes bankrupt,
this may change the prevailing psychology. A weak yen consensus will emerge
then.
China and South Korea
A yen collapse will impact China and South Korea most, just like in 1998. It
will trigger substantial weakness in their industries. If a banking system
succumbs, the shock can bring down an entire economy, as South Korea's
experience in 1998 demonstrates.
Both China and South Korea have weak banking systems. South Korea's banking
system is one of the most leveraged in the world due to high level of household
loans. In 1998, a similar shock sank its banking system that was overleveraged
with industrial loans. Now it is overleveraged with household loans. A shock
could sink it again.
Overinvestment and a property bubble make
China's banking system very vulnerable to such a shock. Unless China
substantially increases the capital in its banking system, a big yen devaluation
could cause China's banking system to sink. China suffers from overinvestment
and a property bubble, as Southeast Asia and South Korea did in 1997. In terms
of the magnitude of leverage, China's situation is much worse. Hence, a yen
devaluation could wreak havoc to China's economy.
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