Posted by: Bevan | January 17, 2012

Trouble In The East

China and Japan are often, rightly compared for their remarkable growth stories. Following World War II Japan rebuilt and developed highly advanced manufacturing sectors that expanded and eventually outclassed the US. Their economy was the envy of the West in the eighties, with massive trade and current account surpluses, ever increasing stock valuations and a vertical real estate market. The massive debt expansion which occurred later in the piece fell apart when asset valuations plummeted in the early 90s. Years of easy monetary policy and fiscally loose government have failed to reinvigorate the nation. Now we see frightening signs that another Sovereign debt crisis is looming.

Whenever we see a “risk off” move at the moment the Yen gains value, as it has done for several years when money moves to the Nippon safe haven. The Bank of Japan (BOJ) has spent (wasted) unknown billions of Yen repeatedly intervening in the foreign exchange markets in response to political pressure from the export sector. And yet the so-called speculatively driven increase in the Yen has rolled on year after year, still according to the BOJ in defiance of the fundamentals.  Additionally a major factor is that other ‘reserve currencies’ have engaged in more aggressive monetary loosening than Japan, with relative interest rates making Japan’s meager returns more competitive.

Soon economic reality will finally come to the BOJ’s rescue and reverse the trend, weakening the Yen. The fiscally loose policies have been supported over the years by the extraordinary wealth of the private sector and their high level of savings.  This has been reflected in a high current account surplus, however this is now under threat.  Reuters recently reported that the current account surplus fell by 85.5% in November 2010 from a year earlier.  Savers support for the government is likely to deteriorate with a lack of direction and persistence of policies that have failed to generate a meaningful recovery and have left Japan with frightening amounts of debt – 233% gross debt to GDP.

The inexorable rise in 10 Year Government bond CDS's shows the increasing concern at Japan's debt burden and economic outlook (Source: Bloomberg)

The fundamentals are not attractive for Japan.  Exports are weak, the current account surplus is vapourising, CDS’s on Japanese Government Bonds are rising significantly (the cost of insuring against Japanese default, a reflection of risk in the government’s debt) – all we need is a catalyst for the trend in the Yen to turn.

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