Will Japan cause the next financial crisis? –Andreas Weitzer


When the euro crisis erupted at the end of 2009, not only retail investors, but also most banks realized that not only badly managed sovereigns in distant and exotic countries could collapse under their debt burden, but also the highly developed countries.

The haemorrhage of the balance of payments that suddenly hits the euro zone threatens the very existence of the euro. Low interest rates for all of Europe and the common currency had long masked the fact that the Mediterranean countries and Ireland too had incurred debt they could not bear.

Greek, Portuguese and Cypriot bonds lost value in violent spasms. The hardest-hit Greek government bonds suddenly shed nearly 30% – a not uncertain verdict on expected bankruptcy. The ghost was banished two years later, thanks to Mario Draghi, the current Italian Prime Minister and then ECB President, when he announced unlimited liquidity support for European banks and countries. But a lesson has been learned. Governments, like the rest of us, can go bankrupt when they lead profligate lives and debt levels reach unsustainable proportions.

Weak-minded investors like me suddenly started looking in awe at other countries. All economies saw their debt mount as a result of the Great Financial Crisis, all except China, which was already addicted to debt, determined to grow through wasteful investment at all costs and could therefore better withstand the GFC than others.

But the debt? Harvard scholars Carmen Reinhart and Ken Rogoff published an article in 2010 stating that once public debt reaches 90% of a country’s GDP, the economy will stagnate, as the cost of servicing the debt would crowd out the public and private investments.

Deteriorating public finances and deteriorating exchange rates would discourage foreign investment and cause capital flight. Despite their compelling arguments, 90% is the new normal today for all but a few, post-COVID. If we had zero growth as a result, runaway inflation wouldn’t be the headache it is.

Japan has always been the exception in this regard. With a public debt of 266% of GDP, Greece looks frugal by comparison. Its economic growth has been anemic for decades (0.4%), its population is decreasing every year

(-0.3%), its productivity is and has always been the lowest in the G20, its activity rate (62%) is low, the female labor force being poorly represented and immigration never considered.

Japan’s budget deficit currently stands at $113 billion a month, and its once-legendary current and trade account surplus has turned negative due to increasingly expensive energy imports. Yet nothing seemed to harm the role of the yen as a “safe haven” currency.

So far that’s it. Over the past few months, the Japanese yen has lost 30% of its value against the US dollar, weakening against most major currencies. Does this mean that a final judgment has come for Japan, that the world has lost confidence, or does it simply reflect the fact that the huge interest differential against the US dollar and other major currencies made investing in the yen too unattractive and futile for global markets?

First, let me, for the sake of clarity, say that the Japanese government can never go under like private entities can, or like troubled Eurozone countries might have. The BoJ can print yen at will and provide its government with all the necessary means.

This is a path that was not open to the countries in danger of the euro zone, which were linked to the euro without having the power to devalue their currency – or to replenish their coffers freely.

In a simplistic model, the only consequence for Japan would be a continued devaluation of the yen as the Bank of Japan finances the government, banks, businesses and perhaps even households with abandon. It could be inflationary, yes, but Japan has been struggling with deep-rooted disinflation for decades and could be content with a modest increase in consumption and investment.

Japan owes itself the most money – to its citizens, pension funds and central bank-Andreas Weitzer

The other reason why Japan’s debt burden is not much of a threat to foreign creditors is the fact that Japan owes itself the most money – its citizens, its pension and its central bank. Take for example the bloated balance sheet of the Bank of Japan: it owns 75% of all Japanese exchange-traded funds (ETFs), almost half of all government bonds (JGBs), it is the largest shareholder of all major Japanese companies and holds $1.2 billion in foreign exchange reserves. Japan’s claims on the outside world exceed its obligations by 50%.

When the Japanese stock market index Nikkei225 reached its all-time high on December 29, 1989, reaching 38,957.44, the yen was 145 to the dollar, much weaker than today. The Nikkei stands at 27,003 at the time of writing and the Yen at 131/US$.

The yen exchange rate, although I have tried to recognize a pattern reflecting the health or sickness of the Tokyo Stock Exchange, shows no discernible correlation with stock prices. The yen’s reputation as a safe haven is also a mystery. It crashed during the Asian financial crisis and it’s deteriorating again now, with China’s economy struggling to grow amid new COVID lockdowns and the devaluation of the yuan.

In the past, we used to worry about “currency wars,” when export-oriented countries depreciated their currencies to gain an unfair competitive advantage. Japan was always in the crosshairs and China too.

Today, when inflation in most industrialized countries is rapidly approaching double digits and businesses are passing on rising energy, labor and material prices to the consumer with impunity while sharply increasing their profit margins, we’d love to see someone actually exporting disinflation, instead of inflicting inflation on others, such as with the soaring US dollar. Investment bank Goldman Sachs speaks of “reverse currency wars”.

Before getting too optimistic, keep in mind that Japan exports much less today than in the past. Japan mostly manufactures overseas these days. Yet Japan exports its wealth. Its industries are investing overseas, and its savers, pension funds and retail investors are selling yen to buy overseas stocks and bonds, as they earn far more than their Japanese counterparts.

However, it would be hasty to see this as the main reason for the depreciation of the yen: Japanese investors selling yen to acquire foreign assets. Most Japanese overseas investment is “hedged”, which means that exchange rates are fixed at a cost. Ways to do this are through currency swaps or forward contracts, which become increasingly expensive as the willingness of counterparties to hold yen decreases.

Currently, the cost of hedging a Japanese investment in the US has become high enough to wipe out any expected gains realized based on existing yield differentials.

As a result, Japan, the biggest buyer of US government bonds, bigger even than China, cannot be counted on when the FED tries to reduce its reluctant holdings of government bonds and mortgages. to provide more liquidity while seriously fighting inflation. It will be interesting to see who buys all those US bonds instead, now that Japan is becoming reluctant to foot the bill.

I am not clairvoyant, but this could well be the trigger for a new financial crisis. Many dollar borrowers in the developing world are put at risk by the painful appreciation of the US currency, which is causing difficulties and geopolitical headaches. But these countries are too small to have a destabilizing effect on the financial markets. The same cannot be said of Japan. His reluctance to invest in US Treasuries could be a game-changer.

The purpose of this section is to broaden the general financial knowledge of readers and should not be construed as presenting investment advice or advice on buying and selling financial products.


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