Japan: Catharsis Or Crisis?

The recent landslide victory of the Liberal Democratic Party (LDP) on a platform that promised positive change for the long-struggling Japanese economy has thrust a somewhat forgotten Japan back into the headlines. Indeed, as Goldman notes, asset markets have already responded aggressively to the prospective changes with Japanese equity markets climbing to multi-year highs and the Yen declining to multi-year lows against the US dollar and the EUR. But, as Kyle Bass has recently explained, very real questions remain about the ability of the LDP and new Prime Minister (PM) Shinzo Abe to deliver on promises and break the damaging cycle of low growth and deflation that has become well-entrenched in the Japanese economy over the last five-plus years. These doubts are reinforced by concerns about the health of the domestic banking sector and of Japan Inc. in general. “Abe-nomics ‘appears’ positive, but for how long?” Goldman asks and Hamada’s recent concerns over ‘going too far’ are very real – though in general Goldman’s positive ‘take’ is a useful counter-point to Bass’ somewhat more realistic apocalyptic endgame thesis.

Overall, Goldman believes the recent developments suggest a still positive outlook for Japanese assets despite their recent run, but it’s clear that promises will need to continue to translate into action – and some very difficult longstanding issues will need to be addressed – in order to sustain the recent positive momentum over the medium-to-longer term.

It’s been a rocky path for Japan in recent years:

with the Japanese government taking over (it seems) all fiscal and monetary decisions:

But it appears things are approaching a tipping point one way or another with the following dates all important:

Is Japan on the verge of a financial crisis?

No, but it could become vulnerable to one over the next 5 years or so.

There are two factors to consider when assessing vulnerability to a financial crisis: solvency – the ability of the government to pay the debt that it has accumulated – and liquidity – the ability of the government to fund its deficit on an ongoing basis. There are large concerns about Japan’s solvency. Its debt/GDP ratio exceeds 200%, which is by far the worst in the world, and there is almost no hope in eradicating that debt. It also runs a large fiscal deficit owing to falling tax revenues, which is closely linked to anemic economic growth, and rising expenditures on public works and social security as the population continues to age.

But, in terms of liquidity, the situation is actually healthy, with high domestic savings to fund this deficit, as domestic investors continue to pour money into JGBs. That savings will likely be sufficient to fund the deficit for at least five years.

What are the headwinds to achieving higher growth and inflation?

Japan faces severe structural headwinds, particularly stemming from demographics. The population is decreasing and aging rapidly, which means fewer people in the workforce to support a growing social burden. We estimate that demographic challenges have reduced growth by 0.3 pp annually over the past decade. In order to envision meaningful and sustainable improvement in economic growth, these problems must be addressed through policies that work to increase the size of the workforce such as providing greater incentives and opportunities for women and the elderly, as well as foreigners to join the Japanese workforce. One of my main concerns about the economic policy proposals of PM Abe is that there is little focus on these demographic challenges and how to combat them.

I do not believe that monetary policy alone can solve all the structural problems, but I do think it can meaningfully increase growth and inflation if it can weaken the Yen further.

How essential is further Yen weakening to the economic recovery?

Very essential. In my view, the $/JPY needs to sustain a level of $/JPY 90 or weaker in order to see meaningful economic improvement and rising inflation; the best case scenario would be a relatively stable level of around $/JPY 95. The question of what is the right level is complicated because it’s not just Yen/Dollar that is important but also Yen/Euro and even more so Yen/Won for certain industries, such as the electronic industry, which competes with Korean manufacturers and has suffered tremendously from the very sharp move in the Yen/Won following the global financial crisis as the Yen appreciated against the US dollar and the Won depreciated. So you really have to look at the effective exchange rate, which is the weighted average of exchange rates of Japan’s trading partners. That said, I think a comfortable exchange rate is somewhere near the weaker level that persisted before the failure of Lehman Brothers in September 2008.

What do you think would be the most effective way to achieve further depreciation?

Exchange rates should not be targeted. Instead, exchange rates should be thought of as a byproduct of the right policies, and the right policies are the expansion of monetary policy, most likely through some type of QE, fiscal stimulus, and growth strategy, such as deregulation, and incentives for innovation.

USD/JPY has risen 14% since late September, in conjunction with a buildup in speculative Yen shorts off the back of PM Abe’s forceful statements. This time around, we believe that PM Abe’s statements will need to be backed up with action to sustain (or extend) the recent move.

What have been the key drivers behind the recent move? History would suggest that interest rate differentials and risk sentiment are some of the most likely culprits but recent developments in rates and risk are only consistent with about a third of the JPy move. Two other factors are:

i) A deterioration in the external balance

ii) Speculation

The key culprit that likely explains the rest of the move is the buildup in speculative short Yen positions in anticipation of new deflation-defeating policies proposed by PM Abe. JPY speculative positioning on the exchanges has remained at very stretched short levels for 6 weeks now.

FX is a relative game and we need to bear in mind that the Federal Reserve is also engaging in QE. Thus the outlook for the Yen is not entirely clear cut. Given that the recent move in the Yen has been driven by speculation of change, the rhetoric needs to turn into action to sustain (or extend) the recent price moves.

But while Goldman remains medium-term constructive on Japan and believes a ‘balance’ will be found before a weaker JPY crushes the spending power and living standards of the domestic economy, the market remains completely mesmerized in its nominal (and perfectly correlated) rise…

and yet, the chance of a snap-back remain extremely high given the massively ‘crowded’ long Japan trade…


Source: Goldman Sachs

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