Pushing The Reset Button In Japan?

By Claus Vistesen

The past week has shown the dark side of media coverage and the analysis of current events. It is a test on just how much information you stuff down the public’s throat. In the narrowness of my own world, the financial industry has a tendency to produce an extra amount of hyperbole in situations of geo-political tensions and/or natural disasters with unknown consequences. In some sense this is a reflection of one of the oldest theories of finance and economics in the form of the efficient market hypothesis and how it tends to break down in the context of extreme uncertainty. Still, I swear that if I open one more report whose authors are have turned into self-made nuclear scientists overnight, I will bin it!

Yet, the long term consequences of the ongoing upheaval in North Africa and the Middle East as well as how Japan manages to rebound from the worst crisis for the country since the Second World War are important for investors. In the following post – and with a promise of no mention whatsoever of nuclear fuel rods or Chernobyl – I will evaluate some of the potential effects on Japan’s economy (and indeed, Edward Hugh has beat me to it over at JEW, so do have a look there too).

Saving for a Crisis?

In some sense it is too early start putting a numerical figure on the costs for reconstructing Japan, but it also almost certain that the economy retains the capability to rebuild itself and, thus, to stage a strong "technical" growth rebound.

Yet, the crisis may also lead to a number of structural changes.

As a first point, I would note that the earthquake is likely to speed up the path towards the inflection point at which the BOJ starts monetizing the marginal flow of Japanese government bonds (JGBs) or Japan starts to borrow externally. In principle, I would hold these two scenarios to be one or the other, but in reality we could see a combination.

Two points are important.

1. Japan owes much of its growth rate and indeed its ”survival” to a very strong net international investment position. This is crucial to understand. Japan owns much more assets abroad than foreigners own in Japan and this adds a positive income flow which adds to gross national income (GNI).
2. A strong net investment position essentially translates into positive external savings and  leads to a positive income balance which, alongside the trade surplus (or deficit), makes up the current account . This means that when we speak about Japan as export-dependent, it is a misnomer. Japan is much more dependent on positive net foreign asset income (the income balance) than the exports of excess widgets. If the CA/GDP is about 3% in Japan, 2% is the income balance and 1% is the trade surplus (as a rule of thumb). Obviously, on the margin export flows matter a lot. But added together over time the ”national wealth effect” from the income balance is higher.

In relation to reconstruction efforts, the standard story is that Japan would have to repatriate these foreign assets, effectively selling foreign assets, receiving USD, EUR, AUD, etc and converting them back into JPY. This would then lead to JPY appreciation, which would further crimp the Japanese economy.

Now evidently, this week’s snappy moves in the JPY has nothing to do with this as this is likely to be a slow process. But structurally, this may become an important and real challenge for Japan. According to the initial judgement of the situation by Fitch, existing capital buffers for the Japanese insurance industry (and indeed the global re-insurance)should be plentiful. This suggests that this is a non-issue, but given the evolution of savings in Japan relative to the demand for JGB financing, there is already a very large future claim on these foreign assets. More specifically, Fitch is arguing in the context of potentially downgrading Japanese insurers due to the capital loss of paying for the rebuilding efforts. And thus the analysis can not be directly related to Japan’s foreign assets.

Megan McArdle is less sanguine;

(…) while the global reinsurance industry will bear some substantial losses, in many cases, the losses will be borne by the government–or by people and companies whose insurance does not cover the damage that was done.  The nuclear industry was required to buy insurance through a special industry insurer with liability limits that now seem laughably small–about $2 billion.  And many of the damages simply aren’t insured at all.

In a cynical way, this squares off well with Fitch’s concrete assessment of the insurance industry in that they are likely to dodge the main costs. On the other hand, as Megan also points out, this is certain to put an even stronger strain on Japan’s already strained government finances.

Indeed, even if the reconstruction dos not drain anywhere close to all of Japan’s foreign assets, it would constitute a de-facto claim on these assets either directly or because it would lead to a higher flow of JGBs into the primary market that is in need for buyers.

There is an alternative of course. As I have argued before, it would be infinitely more attractive for Japan if the BOJ printed money to fund the reconstructing so that the export machine did not falter. But again, this would bring us closer  to the point at which the BOJ would effectively be the only bid for the marginal flow of JGBs. You might call this the obviously irresponsible crisis response. However, remember that Japan is still stuck in deflation and thus the cost of such policies is effectively zero at this point.

The big macro picture here is then that Japan may now be forced to run down its only source of savings and essentially its main source of economic growth.

The metaphor here is very simple. Let us say I am unemployed and only earn very little income from the bits and bobs of small jobs I can find (i.e I have a low ”trend growth in income” as Japan does). However, my uncle left me a pool of money and these are all parked in tasty dividend stocks which gives me some income each year so that I can live well.

Now, my house burns down and I have no insurance. What do I do?

Well, I do the only thing I can. I would need to sell those stocks in order to build a new house with the proceeds, but then once my house is rebuilt, my portfolio of dividend stocks will be much smaller and I will earn less dividend income (and I will still unemployed!). This, in a nutshell is the issue for Japan. When I have no more dividend stocks, I go to the bank and they either charge me an interest rate I can’t pay or tell me to bugger off altogether.

And I would re-emphasize that Japan is in a really tight spot  since domestic growth and savings are in a structural downtrend and deflation is now a reality in Japan. So it will become very difficult to rebuild those external savings.

Now for the good news. In even the worst estimates, it is very unlikely that the rebuilding efforts will eat away all Japan’s external savings and let us remember that Japan won’t sink into the Pacific. But with the power grid in need of major structural overhaul, the ensuing and looming disaster with the nuclear reactors at Fukushima, the general knock to economic growth, the already high public debt overhang, etc., one would be complacent if one did not think a little about straws and camel backs. Indeed, this is also the conclusion made by Edward:

Serious as the short term impacts may well be, in the longer run the shadow which will be cast by what is currently happening in Japan could well be very long indeed, in a way which few today can even contemplate (although see this for a good first pass). The justification for this assertion is not only our increased awareness of our collective vulnerability to the impact of natural disasters, there is also Japan’s pioneer status in one very new and very global phenomenon – population ageing – to think about. As we will see below, the optimistic prognosis (I would say denial) is that Japan will soon valiantly overcome this latest bout of adversity in a similar way to which they overcame the post WWII devastation. The Japanese will surely be valiant in their efforts (one only has to think of the spirit of sacrifice of those poor workers who have been asked to directly handle the reactor problem). But their ability to overcome adversity will not be comparable to that registered in an earlier epoch when they had the wind behind them rather than gusting straight into their faces.

Shock and Awe by the BOJ?

Even before the earthquake roiled Japan, comments were beginning to emerge that the BOJ was going to be forced into a shock and awe jolt of QE that would trump even that of the Fed. The reasons here though would have been the same as they would be now. Essentially, the BOJ is fighting a war on three fronts.

1. General freeze in money markets and general cash/liquidity levels in the economy
2. Backstopping the JGB market which could take a severe knock here. I think Ben is very right to point to the risk that the CDS on Japan is very sticky, once it goes up it does not go down. I mean, why should it really?
3. The JPY.

On the first, I think time is working for the BOJ and after last week’s extreme bout of uncertainty due to the unravelling of the nuclear reactors, pressures should already be easing. I would then hold this to be "manageable".

On the second, it could get very serious, very quickly and I would be looking closely at the BOJ balance sheet. In this week’s G&F, Chris Wood points out how the earthquake has given the BOJ room for movement;

From a valuation perspective, the Topix is now trading below book value again at 0.96x price-to-book . Global investors should use this opportunity to overweight Japan if they have not already done so. GREED & fear’s bull case rests on two foundations, as discussed here recently (see GREED & fear – An ode to the BoJ, 3 March 2011). The first point is the extent to which Japanese corporates have proven they can live with a stronger yen. This is why it is not necessary any more to believe in a weakening yen to assume an outperforming Japanese market. Second, there are clear indications that Japan has commenced a new property upturn which increases the collateral value of the banking system. On this point the earthquake has “helped” in the sense that it has prompted the Bank of Japan to increase its assets purchase programme of private sector assets, and not just JGBs. Thus, the BoJ doubled its asset purchase programme to Y10tn on Monday, with the maximum amount of purchases in index-linked ETFs and J-REITs both doubled to Y900bn and Y100bn respectively.

Two effects need to be noticed here. One is the effect from the BOJ’s expanding its balance sheet on equity markets and secondly, there is the need to support the structural deficit spending. On the latter, it is noteworthy that CDS on Japanese long term government debt has been creeping up, especially as it may prove quite sticky. This means that the BOJ may need to massage the curve on the long end. It stands to reason that mounting concern over long term debt sustainability in Japan could lead to a strong steepening of the curve. This is to say that the long term default risk of Japan could rise very quickly, since in the end, they will default at some point. So, in theory, it could simply go parabolic. I am not saying that this will happen, but think about the Eurozone. The ECB is effectively the only buyer of peripheral bonds … it could be the same for Japan and long dated bonds.

Naturally, they could move the financing down the yield curve which could mask some of the default risk as duration changes, but in the end it would be the same. But here I am shooting blanks since I don’t know the maturity schedule of Japan’s government debt portfolio.

Structurally, the BOJ faces two main challenges with JGBs. One is to soak up the annual excess issuance of JGBs relative to domestic demand and secondly there is the flow in the secondary market as pension funds run down their balance sheets to fund pension payouts.

On a third, willy nilly intervention in the spot market will work for about five minutes and then it will get bid down again. In this context, it was interesting to see that the violent move in the JPY prompted the G7 to intervene. Whether they have the clout to lean against the market here is debatable, but ironically they may soon have to back off if the BOJ starts monetizing debt as the rest of the world tightens.

Japan will Move On

In the end, we should all already be vindicated by the strong resilience shown by the Japanese people in the face of their current tragedy. I am certain that Japan will move on as a people and as a society. However, as a macroeconomy, things are looking increasingly grim. We don’t yet know what will really come of the attempts the by G7 to keep a lid on JPY appreciation and failing that, we don’t really know what the world will look like with a BOJ engaged in QE far and beyond what the Fed is currently administering.

The point here is not to kick a country which is already down but simply to face up to the realities that the costs of this truly exogenous shock will weigh down on an already unsustainable economic system. So although Japan may now see the opportunity to push the reset button in a number of corners of society, there is no economic equivalent.