Japan’s fiscal mirage is a warning sign

Investors should be wary of Japan … its latest fiscal measures won’t achieve the desired results.

Summary: Theoretically, the Bank of Japan’s massive quantitative easing program should spark a huge economic boom there and flow directly through to Australia given our sizeable exports program to Japan. But the economic realities present an entirely different picture.
Key take-out: Japan’s market has soared this year, but the long-term realities of its economy suggest there will be more pain ahead.
Key beneficiaries: General investors. Category: Economics and strategy.

The great hope from the Bank of Japan’s aggressive and ‘bold’ monetary easing is that it leads to another Japanese renaissance: renewed prosperity.

You can see why. The easing program is huge – the central bank now will print about ¥7 trillion per month (slightly less this year), or a total of about ¥60 trillion this year and ¥70 trillion in 2014. In Australian dollar terms, that’s about $60 billion per month, or $720 billion per year, which is about 50% of the value of our economy (or 13% of the Japanese economy). Proportionally, that is almost double what the US Federal Reserve is doing.  The stated aim is to double the amount of money in circulation, to lift growth, and end deflation (a 2% inflation target is the explicit goal).

This is a great for Australia – notionally. A monetary easing of some 13% of GDP, and a fiscal expansion of about 1% of GDP – Japan’s economy should boom. And, in all the excitement over China, it’s often forgotten how important Japan actually is to Australia. Check out table 1.

Table 1: Japan’s importance to Australia

Japan

% of total

Rank

Total exports

8

3rd

Resources

13

2nd

Energy

38

1st

Iron ore

16

2nd

Coking coal

34

1st

Thermal coal

50

1st

Oil and gas

57

1st

Easy, buy our coalminers and energy stocks!

There’s just one problem. This latest easing program isn’t going to work the way people think it will. Consider the mechanics of what quantitative easing (QE) actually is. All the central bank does is print money to buy government bonds, exchange-traded funds, stocks (whatever they want) off Japanese banks. So the newly printed money ends up in the accounts of Japanese banks. That money will only hit circulation if Japanese citizens feel like borrowing money – which they don’t (shown in chart 1 provided by the International Monetary Fund).
Graph for Japan’s fiscal mirage is a warning sign

They haven’t felt like borrowing money for the better part of 25 years – interest rates have been close to zero since 1999 – and that’s with a significant number of other quantitative easing attempts. So why would this make any difference? It won’t.

Consumers aren’t really going to borrow or spend more for three reasons:

  • A greater cultural propensity to save. No binge spending habits like in Anglo economies;
  • An ageing population and,
  • A heavily indebted government. This diminishes the ability of the government to assist the elderly, and so it is only prudent for citizens to plan for their own retirement and health needs. The state increasingly can’t or won’t be able to afford it, and households know this.

Similarly business won’t all of a sudden start investing either. Why? Well PhD theses have been written on this. Basically it comes down to crony capitalism, a failure of leadership ultimately and an overreliance on macro-economic policy tools. Overly cautious and lazy business leaders. Again, it’s not because interest rates haven’t been low enough or the government hasn’t printed trillions of yen before. There is no sign this is about to change, and any change would take many years to implement anyway. You can’t change a culture overnight.

That’s not to say all this effort will go to waste though.

Consider that Japan has experienced growth of just under 1% per year since 1999. That’s low and compares with average growth of about 2% in the US, 1.2% in Europe and about 3% in Australia.  Now, in most of those years, growth was driven either by public consumption or net exports – and it’s actually here where QE will have some support. Just not as much as everyone hopes.

One reason is that Japanese exports account for only about 15% of gross domestic product (15% for the US, 20% in Australia, 50% for Germany and 30% for UK). About 20% of those exports are cars and semiconductors.

Now while the yen has depreciated by 20% since late last year, all that has really done is taken the yen back to where it was in 2009.  Longer term, the yen has still appreciated quite substantially against the $US – 20% above where it was from 2003-07. More to the point, the Fed is still printing and so is the UK; Europe and maybe even the Koreans will join in. So the yen isn’t that cheap, and there is a limit to how far the Japanese can push this without retaliation.

The second reason is that public consumption is already doing more than its fair share in propping up the economy - with little scope for it to do more.  Take a look at Japan’s public accounts. They are atrocious. For the years 2012 and 2013, Japan’s budget deficit is expected to be around 9-10%. That’s to add on to an existing debt burden of about 240% of GDP, with net debt of around 145%. Every year then, Japan’s government needs to raise debt to finance its spending (10% of GDP is about $600 billion, every year). You’ll note this is the exact amount the Bank of Japan intends to print, and is the ultimate reason why it conducts QE.  If it wasn’t for QE, net debt to GDP would have risen much more sharply. The total financing burden is even worse - nearing 50%, sometimes above, of GDP.

So then, all this latest bout of QE will achieve is to allow the government to continue running massive deficits without adding to total debt. This isn’t new growth though; more holding up existing government consumption patterns without a lift in debt. To the extent that it weakens the yen, we may also see a brief lift in Japanese exports. Again this growth can’t be sustained while Japanese businesses don’t invest and other nations print money as well. Growth comes through investment, not cheap monetary illusions.

So Japan’s monetary easing at best can be hoped to maintain the status quo – growth on average of about 1% per year. Unfortunately, that’s not going to provide much of a boost for the Aussie economy or our resource stocks.

Other than that, there are a couple of other key implications from the BoJ’s actions that readers should consider:

  1. I’m underweight Australia, readers know this, but I would keep away from Japanese stocks as a buy and hold investment. That they’re up about 40% since December is great – trade it by all means, you’ve done well if you have, and there could be more on top. But it’s not a long-term fire and forget investment. I see no reason for long-term optimism on Japan. Buyer beware!
  2. Readers also need to look very seriously at strategies to protect their wealth over the next five years. Note the silence among mainstream economists. No one is criticising the Bank of Japan. They are being “bold” we’re told – praised even. Think of what that signifies or signals to other large heavily indebted nations. It’s a gigantic green light for further debasement and ongoing QE programs elsewhere.

Consider that if the government of Japan is successful in either lifting growth or inflation (or both), then it will actually have to increase the pace of QE even further. Why? Because if it does actually get higher inflation, think of the consequences. Interest rates would rise. For a government that already spends 10-15% of its budget on interest repayments (20-25% of tax revenues) this isn’t affordable, even with the vast wealth of Japanese households – a death spiral would ensue, unless the government lowered yields with further bond purchases.

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