Japanese Vision for Growth Gets a Poke in the Eye
For four decades the Japanese economy secured more than its fair share of coverage in the financial press. Dominating the economic headlines were the manufacturing and export expansion of the 60’s and 70’s and the phenomenal market rally that took the Nikkei to almost 40,000 during the 80’s. Thereafter commentators focused on the lost decade of the 90’s caused by the property market crash, bank balance sheet shrinkage and the death of Japanese equity wealth by a thousand cuts.
This decade has seen the rise of China’s economic profile, with the PRC now destined to replace Japan as the world’s second largest economy. Such is the dominance of Chinese related articles it’s easy to forget Japan is still an economic goliath, albeit in relative decline. And the cause of that decline can be summed up in one word; deflation.
There’s something deeply embedded in the Japanese economy and psyche of Japanese businesses and consumers that has caused deflation to be a secular and persistent challenge for the Bank of Japan for the past 20 years. The problem with deflation is that it maintains the real value and burden of debt, whereas a healthy rate of inflation, 2-3%, over the years gently erodes the real economic cost of borrowed capital. It is inflation that has given the western economies the luxury of consuming more in the present, with debt in nominal terms eroded by the passage of time. Deflation throws another spanner in the works of economic growth. Why buy a new car, or new machinery, in fact why buy anything today that will be cheaper in a few months? The result is structurally weak demand, an interest rate so low it’s barely visible to the naked eye and a flight of capital to higher yielding currencies (the New Zealand and Australian dollars have been a favoured destination for retail and institutional investors for years). Deflation is a nasty poke in the eye for demand, capital investment and growth.
In fact Japanese interest rates have been so low for so long, the Yen has been systematically sold (shorted) not just by Japanese investors but by a legion of hedge fund managers for years with the proceeds placed just about anywhere that offered a higher return. Admittedly that carry-trade, along with most risk embracing investment strategies, grew to bubble proportions and burst in 2008 but with investors embracing risk again, greed replacing fear, that transaction (short Yen, long anything else that moves) is likely to re-surface.
Investors unsure about the viability of continued Japanese deflation, preferring to focus on the unprecedented global stimulus measures, that should be inflationary, should look closely at the latest Japanese consumer prices data. Prices fell 1.7% in the year to June, prolonging the sequence of deflationary months (year-on-year) to four in row. The main contributor to the decline in prices is energy, with oil settling into $60-$70 channel compared to last years roller-coaster ride to $147.
Investors could suggest that the global economic recovery could re-inflate energy and commodity prices, prompting inflation and thus curing the Japanese “I’ll buy it later when it’s cheaper” philosophy. Unfortunately, higher energy costs are paramount to poking the Japanese economy in the other eye. Japanese energy imports can peak to 97% of its oil and 96% of its gas needs. Japan is similarly deficient in other key energy and mineral related commodities. Higher energy and commodity prices just leave Japanese consumers with less to spend on domestic goods, further hurting demand.
