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from stratfor.com
Summary
Recent changes in the status of the Japanese economy have triggered a
policy evolution that in turn is about to usher in a period of a weaker
U.S. dollar.
Analysis
Toshihiko Fukui, the governor of the Bank of Japan, announced March 9
that his administration will gradually end the policy known as “quantitative easing,” which has flooded Japanese banks with upward of
35 trillion yen ($300 billion) in funds in an attempt to encourage bank
lending.
Under normal operations, a central bank provides a certain amount of
cash to banks under its jurisdiction. Those banks then parcel out that
cash as loans to their clients as they see fit. In Japan, this system
broke down in the 1990s when the financial system stalled under the
weight of two generations of bad debts. The 6 trillion yen ($50 billion)
that the Bank of Japan granted was insufficient to spur banks that were
too weighted down by politically motivated lending to feel they could
risk taking on new clients. Six turned into 10, then 20, and ultimately
into 35 trillion.
The problem was simply one of priorities. In the aftermath of World War
II the only national goal that mattered was rebuilding faith in the
system shattered by war. Thus, the Japanese financial system
purposefully favored turnover and maximum employment as opposed to
profitability. It did not necessarily matter if an enterprise made a
product that anyone wanted, as long as it grew large and could employ
people. Loans, lots and lots of subsidized loans, were used to make the
system go and plug the gaps when it started to fail. The primary goal – “reknitting” the national fabric – was successful, but it came at a
high cost.
After 50 years of reknitting, some independent estimates now place the
total amount of private debt with minimal chances of being repaid at $2
trillion.
One effect of all this is that the state, in order to stave off a
depression, began engaging in stimulus actions. Each budget for the past
15 years sported a hefty deficit, and most of them sported one – and
sometimes two – supplementary budgets funded by nothing but more state
debt. Leaving out details like local debt, corporate debt, personal debt
or pension debt, the national government alone now owes some 160 percent
of gross domestic product, some 800 trillion yen ($6.8 trillion).
Consequently, the yield on Japanese bonds – government and otherwise – plunged to a small fraction of their European and American equivalents,
with a handful even promising a negative return. The average Japanese
government bond (JGB) return declined to a paltry 0.5 percent.
Money managers, particularly in Japan, could only look on this in abject
horror. How do pension fund managers, who need conservative investment
tools like long-term government bonds, provide for their clientele when
bond yields are low to negative and the state’s credit rating drops to
the level of Botswana?
The answer was twofold. First, do not purchase any more Japanese
government debt than absolutely necessary. In the United States and
Europe, private investors make up nearly all of domestic investment into
government bonds; but in Japan 55 percent of the debt is directly
purchased by a variety of government institutions.
The second answer was to look abroad for opportunities. (Japanese banks
were not willing to lend, so they certainly were not going to invest in
Japanese stocks.) Japanese funds’ investments into North American and
European bonds skyrocketed in 2004 and 2005, more than doubling their
market share. Those funds now actually own as many European assets as
their European counterparts, about $1.8 trillion. As the U.S. dollar
rose versus the yen – in no small part due to all the retirement
savings flooding out of Japan – the portfolios of those same pension
fund managers swelled. That flood of yen has powerfully contributed not
just to keeping both government and corporate borrowing rates cheap, but
to the recent surge in the dollar as well.
But what happens now that quantitative easing is no more?
If Japanese banks are once again willing to lend – and in February bank
lending increased for the first time in eight years – then there is
reason to become once again interested in some Japanese corporate debt,
at the very least, and perhaps even some toe-testing of the stock
markets. As confidence trickles back into the Japanese system, pension
fund managers are sure to follow, and at least some of the river of yen
that has been leaving Japan is sure to find its way back.
This all assumes, of course, that the Bank of Japan does not end
quantitative easing so rapidly it shocks the system and thus scares
pension capital from returning home. It was precisely that sort of
over-exuberance in 2001 that terminated a similar nascent recovery and
hurled the economy right back into recession; thus, this is no mere
hypothetical.
As that happens, the rise of the dollar versus the yen of the past 18
months could well level and reverse. Any inclination that that is about
to happen would likely lead to those same pension fund managers
liquidating their American positions in order to lock in their gains. In
such a circumstance, they would gladly do so. An assured 15 percent gain
in the world of pension investments, where most people are happy simply
not to lose value, is well worth the swap even if it means placing those
gains, albeit temporarily, in something as underwhelming as a JGB.
The only question, of course, is when all this will start happening.
It is quite common for Japanese firms with international subsidiaries to
repatriate their foreign profits in the final days of the fiscal year in
order to rectify any imbalances – and this being Japan, there are many – before issuing their final financial statements. That means the Bank
of Japan, while having committed itself to a policy other than
quantitative easing, is going to keep most of that 35 trillion yen
churning around in the system for the next few days.
As of April 1, however, it will be a new financial year. Between the
Bank of Japan’s steady if slow withdrawal of liquidity from the banks
and the accelerating stream of pension monies pouring back into Japan,
one of the biggest factors bolstering the dollar these past two years is
about to reverse. After perhaps two or three months of a volatile
equilibrium as new trends seize hold, the U.S. dollar is likely to begin to slide anew.
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