The purpose of government bond markets is to allow a government more flexibility when financing its expenditure. Ultimately and in the long term only taxes can sustainably finance government expenditure, but in the short term bond markets can provide governments with a way to manage and stabilize cash flows without having to wait for tax revenues to come in. In addition, governments can decide to borrow money in order to stimulate the economy in the short term, if some extraordinary external factor has temporarily impacted the economy’s ability to function and grow.
Over the past several decades the Japanese government (along with virtually every other government in the world), has systematically maintained expenditure levels well above revenue levels, which means they have been running deficits almost constantly. This in turn has forced governments to (mis)use the bond market to continuously borrow more money to finance these deficits, and in the process they have built up enormous amounts of government debt.
Apart from an ever growing debt burden being obviously unsustainable in the long term, the problem of how to finance the interest burden is also a problem in the short term. Logically, if a government can not afford to cover its expenditure on the various public services it has committed itself to providing, and thus has to borrow, then it also can not afford to cover the interest payments on the existing debt.
The obvious ‘solution’ is to borrow more money, but of course that is so blatantly unsustainable that the cost of borrowing would rise substantially, as bond market investors recognize that the government’s position is untenable. This would quickly drive down bond prices, push up interest rates and in short order leave the government unable to service its debt and interest obligations. We have written about this in detail here).
An alternative solution is to task the central bank with ‘solving’ the problem by asking it to buy up the new debt issuance. The central bank can do this, because it has a monopoly on printing money, and it can in theory print as much money as required. This is exactly what is happening in Japan, but also in the US and increasingly in Europe as well.
So what is the problem with this approach? It seems ideal, in that government finances keep ticking over, and the government can keep funding itself and covering the expenditure that it has committed itself to, as well as paying interest on its debt. The problem is that this monetization of the government’s debt is inherently inflationary, and it will ultimately end in hyperinflation, which in turn erodes the real value of all non-productive assets (such as savings), as well as lowering the real value, in terms of actual purchasing power, of people’s wages. If inflation is running at 20% and your wages are going up by only 2%, it doesn’t take very long for you to struggle to pay your bills. And if your savings only deliver a return of 1%, then soon their value will also be eroded.
In effect, this monetization is just a huge wealth transfer from the average citizen’s savings account to the fiscally dysfunctional government, the latter of which then proceeds to squander it on historically ineffective short term fiscal stimulus programs.
In Japan this phenomenon has now reached a stage where the bond market has effectively ceased to function as intended. Like any other market, the bond market is ultimately a pricing mechanism. The actions of thousands of economic agents acting as potential buyers or sellers of government bonds, implicitly determine the value of those bonds and consequently the interest that they require in order to hold them. That is how the market is supposed to function. A free market, that is.
However, with the BoJ now being responsible for as much as 70% of government bond purchases, the pricing mechanism has been rendered severely impaired, and prices possibly completely meaningless. When a country’s central bank is a constant and completely predictable buyer of as much as 70% of new debt, the remaining 30% will have little to no impact on the pricing of that debt. If anything, the remaining 30%, which is made up mainly of banks and other institutional investors, will have little incentive to go against the BoJ. It is exactly the same effect seen in the US equity market where the S&P500 is on a steady trajectory upwards simply because the Federal Reserve is pumping liquidity into the market on a very large scale (although not quite as large as in Japan), and any rational investor would conclude that it is safer to go with the Fed than against it. The effect thus becomes self-reinforcing.
Another indicator that the JGB market is dysfunctional is that it barely reacted to the announcement on the 1st of November that the Japanese government is initiating a 5 trillion Yen spending program, ostensibly in an effort to offset the negative impact of the upcoming increase in the consumption tax. The non-reaction in the bond market displays the apathy that now seems to have taken hold in that market.
That aside, when observing the obvious ridiculousness of increasing government spending as a direct consequence of having raised taxes in order to reduce the deficit, NipponMarketBlog is left in a state of not knowing whether to laugh or cry, but we are frankly leaning quite heavily towards the latter.
Yet another indicator of bond market apathy in the face of the overwhelming force of the monetary Shock-and-Awe tactics of the BoJ, is the level of participation in the bond market on the part of large institutional investors. An easy way to measure this is by looking at trading volume in the bond market. If trading volume is high, it tends to indicate that the market is functioning as intended and lots of investors are trying to use it to position themselves according to what they believe is the outlook for the market (and ultimately government finances) in both the short term and the long term across the entire yield curve. Low trading volume indicates the exact opposite, i.e. a dysfunctional market where there is little to no ability of the market to arrive at a meaningful price, because the entire market is completely dominated by just one player – the BoJ.
The Japan Securities Dealers Association has released its latest data for bond market volume, and it makes for some interesting reading. Below is a chart showing the total monthly trading volume (buys) of government bonds by city banks, regional banks, trust banks and all others, going back to early 2004.
From this we can see how bond market activity is near the lows for the period in question, despite there being enough to be either excited or concerned about for the average bond market investor. One can only wonder what this lack of order flow has done to the bond trading departments of major investment banks. NipponMarketBlog predicts lower bond trading revenues for investment banks for some time to come.
From the Japanese government’s perspective it might seem like a good thing that the bond market is so subdued, and that the BoJ effectively owns most of the government’s new debt, which is predominantly what prices the already existing debt stock.
However, there are (at least) two major problems with this.
Firstly, this dysfunctional bond market with its lack of accurate pricing of return versus risk, represents a sort of coiled spring in the sense that when the market finally breaks and investors properly lose faith in the Abenomics program, the reaction will be that much more violent.
Secondly, the fact that the JGB markets is artificially held in check by the massive influence from the BoJ’s buying, where it would otherwise have been much more active, volatile and with upwards pressure on interest rates, means that the government itself is likely to mistake this lack of activity and upward pressure on interest rates for an indication that things are going well and that there is no need to do anything too rash too quickly. In other words, it may encourage complacency and remove the urgency from the political process when it comes to implementing the much needed structural reforms that this and many previous governments have long struggled to get under way. Unless Shinzo Abe’s government gets serious about these structural reforms, Abenomics will – as we have said many times in the past – fall flat on its face, and once that has happened there will be no option left but to default on the government debt.
As we have mentioned in the past, Japan is very much between a rock and a hard place, and there is no easy solution to the problems facing the country.
NipponMarketBlog can not help feel that there is excessive focus on taxation and monetary policy, and far too little attention on finding ways to permanently reduce government expenditure. The declining birthrate, the shrinking workforce and the growing number of elderly simply dictates that the current expenditure level (and by implication the current level of overall public service) is entirely unsustainable, and raising taxes with its negative impact on economic growth is not a solution, just as monetizing government debt and thereby effectively robbing the average citizen of his or her private wealth through rampant inflation, simply does not represent a long term solution.
We very much fear that the Japanese government has begun to believe its own hype, and that complacency with regards to serious (and probably painful) public finance and service reform is beginning to creep in. With the government’s deficit running at 10% of GDP every year, and the bond market that sustains it becoming ever more fragile, there really is no time to lose. Sadly, if history is anything to go by, humans in general, and the Japanese political class in particular, are re-active as opposed to pro-active, and will only react in a meaningful way to a problem after it has blown up in their faces.
NipponMarketBlog would like to be optimistic, but we continue to feel compelled to be ‘realistically pessimistic’…
On the 27th of September, the Ministry of Internal Affairs and Communications published the Consumer Price Index figures for August. The headline figure was 0.9% YoY, and CPI excluding Fresh Food was 0.8% YoY.
These are obviously a set of much watched figures, since many (the Japanese government included) use them as a sort of barometer for the extent to which Abenomics is working. The idea is that rising inflation will push consumers to spend more, because goods will be more expensive in six months or a year. It should be obvious to most people that even if this logic is valid, it is unlikely to have any meaningful effect if inflation goes from -0.5% to 0.5%. One could imagine it working if inflation moved from 1% to 8%, but the very small absolute changes that are currently materializing in Japan are unlikely to cause the fundamental shift in consumption behavior that the government is hoping for.
We here at NipponMarketBlog have argued several times that the idea that higher inflation by itself is a success criterion for Abenomics is misguided (see here and here), primarily because the success or failure of Abenomics rests on the nascent recovery becoming self-sustained, and this in turn requires a sustained increase in corporate investment and private consumption. But of course, if prices are rising faster than wages, leading to a reduction in real wages, consumer will likely be less inclined to part with their hard-earned cash. Unfortunately, it seems that Japanese companies are less than likely to raise wages for their employees just because Shinzo Abe would like them to, and a recent survey of companies demonstrates this trend very clearly. We have commented on the survey here.
Equally, in an environment where inflation is accelerating thus leading to a smaller real return on savings, consumers will be especially wary of increasing their expenditure. The assumption that the so-called ‘wealth effect’ arising from a rising stock market thus enriching the average consumer, is also misguided, especially in Japan where equity ownership on an individual basis is very low. Not even in the US where stock ownership for individuals is much more wide spread is this effect meaningful, simply because the vast majority of wealth increase falls to only the top 5% of the population.
Even if one was prepared to accept the premise that (at least for now) inflation is positive for the economy, it is becoming increasingly clear that the vast majority of the ‘improvement’ in inflation is happening for the wrong reasons. Lets look at the details of the CPI figures for August.
Headline inflation is clearly rising, but excluding Food (which is rising very slowly) and Energy(which is rising uncomfortably fast), the overall inflation rate is actually still negative to the tune of -0.1%. In other words, the inflation rate is rising slowly, not because the economy is improving (although that is certainly the case to some extent), but almost exclusively because energy prices have shot up, which in turn is a result of the significantly weaker Yen caused by the BoJ’s massive quantitative easing program. This rise in input costs artificially boosts inflation (and causes the illusion that Abenomics is already working), but it is putting pressure on corporate profits and making everyday life more expensive for Japanese consumers.
The following charts illustrates the extent to which energy prices are rising.
This is very worrying indeed for the Japanese government, and frankly for the Japanese people who have entrusted the management of the country’s public finances with politicians who have consistently added to the financial mismanagement of those finances over many decades now. Abenomics was designed to push Japan out of deflation and spark a self-sustained recovery, all with the single purpose of boosting the economy and thereby tax revenues, and consequently preventing the eventual collapse of public finances and resultant default, caused by decades of ever increasing government debt. We have written extensively on this in the past (see this piece).
Without a sustained change in the spending patterns of consumers (and companies), Abenomics will simply not be successful in turning the economy around, and rising inflation in the absence of rising wages will ultimately result in Abenomics ending up as failure. Apparently, Shinzo Abe last week began meetings with business and trade union leaders to attempt to persuade them to increases wages. NipponMarketBlog can not help seeing this as an almost desperate effort, and we strongly suspect that with soaring energy prices, it will take more than Shinzo Abe asking nicely for them to be persuaded to raise salaries.
On a slightly more philosophical note, NipponMarketBlog observes that human beings have a tendency to believe that for any given problem, there is always an achievable solution. This is a very powerful trait, and probably one that is partly responsible for our species’ evolutionary success in dominating this planet. However, it is sometimes a fact that there simply is not a solution to the problem at hand, the word “solution” being applied here as a way to avoid the negative consequences of the problem in question. Sometimes it simply is not possible to just “fix” a problem.
A few months ago NipponMarketBlog published a piece (see this link) in which we likened the Japanese economy to an aircraft in the middle of a take-off, and pointed out that in terms of application of fiscal and monetary policy, the Japanese government is past the point of no return. They are committed to Abenomics, and there is no way back from this point. Taking that analogy further, imagine if you will that the aircraft eventually manages to take off, but then by some freak accident one of the wings falls off. This is a problem for which there simply is no solution. However much you try to come up with some novel way to make the aircraft fly, it simply can not do so without both wings attached. It will crash, and the only thing you can do at that point is try to deal with that outcome.
NipponMarketBlog strongly suspects that the problem that is Japanese public finances simply is not fixable. Abenomics is a brave attempt to do something – anything – about the problem before it is too late, but it seems to us that the problems are too deep and have persisted for too long for them to simply be ‘fixable’. This of course does not mean that Japan will sink into the Pacific and cease to exits. It just means that Japan will eventually have to suffer the consequences of it’s past fiscal profligacy. This will become a serious burden on future generations, and inevitably lead to significant changes to the fabric and structure of Japanese society.
However, as we have argued before, once this has happened Japan has a great opportunity to relaunch itself as a much healthier, leaner and more competitive economy (see this piece).
NipponMarketBlog has made the point several times over the past few months (see here and here) that unless wage inflation takes hold in Japan, thus compensating consumers for the loss in purchasing power recently brought about by the prospect of resurgent inflation, Abenomics runs the risk of outright failure.
The reason for this is simple. Abenomics rests on the assumption that both fiscal and especially monetary stimulus can provoke a decisive change in consumer spending and corporate investment behaviors. The latter is proving difficult to make happen, for the simple reason that Japanese companies are often very risk averse, and prefer to “wait and see” before committing to major fixed investment programs. This means that the former, i.e. consumer spending has to carry the Abenomics program forward, at least for the time being. But without sufficient wage increases above the level of inflation resulting in real wage increases, the Japanese consumer will likely begin to tighten his/her belt yet again, and the economy will almost certainly not be able to sustain the momentum it has exhibited lately, especially if global growth slow again.
The pace of economic growth required for the recovery to become self-sustained has been called ‘escape velocity’, and the Japanese economy simply is not there yet.
Significantly, this point was made by Bank of Japan policy board member Koji Ishida, in a speech earlier this month, where he was quoted as saying:
“Unless income rises in tandem with prices, economic growth will be temporary and not sustainable”.
We could not have said it better ourselves. The fact that a member on the BoJ policy board is making this statement makes it plain that the BoJ is genuinely concerned about whether wage inflation is taking place or indeed will be taking place in the future. For all its bravado about how well the economy is responding to monetary stimulus, and how it will be able to handle an increase in the consumption tax, the BoJ knows as well as anyone that without wage inflation, Abenomics will be dead in the water.
However, not only is the government proposing increasing the consumption tax (see this piece), but indications are now emerging that the hoped for wage inflation could be more difficult to achieve than the government initially hoped.
A recent Reuters Corporate Survey shows that companies remain averse to raising base pay, preferring instead to raise bonuses which can easily be scaled back later. In other words, the most important component for consumer confidence, i.e. base pay, remains stubbornly where it is.
266 companies were asked if they would raise wages if the government eventually raises taxes, and around half responded that they would not raise wages thereby helping to preserve consumer purchasing power. Only 13% are planning to offset the tax hike with any pay increases, while 37% do not yet know. The same survey indicated that around 60% of companies were expecting higher profits in fiscal year 2013/2014.
With regard to upcoming salary negotiations, the stance of 60% of companies is currently to only raise bonuses but not base salary, and 24% have already ruled out any pay increase at all.
This makes for quite worrying reading for Prime Minister Abe and BoJ governor Kuroda, who have more or less bet everything on wage increases and corporate investment kicking in and resulting in a self-sustained economic recovery as a result of aggressive fiscal and monetary stimulus.
As we discussed here, now that Japan has gone down the ‘all-or’nothing’ route of massive quantitative easing, there is no realistic way back for the government and the BoJ. Just look at what happens to US (and indeed global) markets whenever the US Federal Reserve even mentions eventually tapering off its own QE program.
So if wage inflation in Japan is not happening to a degree that is sufficient to keep up with rising inflation, and if this in turn is choking off the crucial increase in consumer spending, could the government consider raising wages for public servants to well above inflation rate levels? This could potentially compensate for the private sector’s reluctance to increase wages, and it would certainly make Abenomics play out closer to what was intended, but of course it would also entail an increased burden on public finances and debt, which are exactly what the government is trying to reduce.
On October 1st, the government will make its final decision about whether to raise the consumption tax from 5% to 8% (and eventually to 10% next year), in an effort to try to mend the frankly catastrophic public deficit and debt situation that Japan finds itself in, and that we have written about in some detail here).
Later that month, it is expected that Abe will flesh out further details about the so-called ‘Third Arrow’ in the Abenomics program, i.e. structural reform which has been attempted several times in the past without success. This could potentially have a significant impact on the health of the economy going forward. However, the Japanese bureaucracy is famously entrenched in its old ways (and they have been blamed for derailing more than one government’s economic initiatives), and so it will be interesting to see what the government believes it can roll out now that is has control of both chambers of parliament.
It seems to NipponMarketBlog that Abenomics has proceeded along a path that probably seemed wide and easily navigable to the government a few months ago, but reality is now beginning to sink in and the path is narrowing, and only one thing is certain. The further down the path Abenomics brings the economy, the fewer options there will be for changing direction. And turning back is certainly now no longer possible.
The tension between Japan and China has been increasing in tandem with China’s economic rise. China is increasingly asserting itself on the global stage, rapidly modernizing its military and being more belligerent in its behavior towards its neighbours. The most public examples of this are the various disputes over islands in the South China Sea, where China disputes the sovereignty of various Japanese, Vietnamese and Indonesian islands, among others.
The strained relations are being exploited in both China and Japan for domestic political purposes, and are spilling over into companies’ ability to carry out cross-border trade and business.
Much of the antagonism between Japan and China (and indeed between Japan and several other South-East Asian nations) stems from unresolved historical issues, mainly relating to the Second World War. In the case of China, the most widely known incident (and the one which has become emblematic for China’s attitude towards Japan), was probably the so-called ‘Nanking Massacre’.
Historians estimate that Japanese troops killed between 250.000 and 300.000 people in the city of Nanking during a six week period after its capture in 1937 during the Second Sino-Japanese War. Records of beheading ‘contests’ using Samurai swords, mass rape and other even more shocking and reprehensible behavior on an enormous scale makes this an extremely thorny issue in Sino-Japanese relations, even today close to a century later. The Chinese state, never missing an opportunity to bash Japan, makes sure that memories of this are kept fresh in the Chinese national psyche through the education system, where these historical events are re-visited in what is called ‘Patriotic Education’.
There is also the issue of so-called ‘comfort women’ in several South-East Asian countries during late stages of the Second World War, where Japanese soldiers sexually exploited local women from occupied countries in a very organized manner, and one which makes it difficult not to conclude that the Japanese at the time viewed the inhabitants of these occupied countries as lesser human beings.
The sense that this attitude still prevails in Japan today, continues to linger in much of the rest of South-East Asia.
Modern day Gunboat Diplomacy
The term ‘Gunboat Diplomacy’ stems from the mainly colonial 19th century practise of forcing countries to open up trade using sea-going military vessels. In Japan’s case this was exemplified by the arrival of Commodore Matthew C. Perry’s four-ship squadron in Tokyo Bay in July 1853, subsequent bombardment and thus demonstration of superior military technological capabilities, and ultimate forcing of a trade agreement with Japan in 1854.
More recently, something similar has been occurring in the sea between Japan and China, although no shots have been fired in anger. Specifically, the Senkaku islands as they are called in Japanese, or alternative the Diaoyu islands as they are called in Chinese. The island cluster is 76 miles from Taiwan, 92 miles from the closest Japanese island, also a part of Okinawa prefecture, and 100 miles from the coast of China.
The islands have never been inhabited, and the Japanese government cites a survey from 1885 mentioning “no trace of having been under the control of China.” The government of Japan in January 1895 decided to incorporate the islands and to place a marker on one of them declaring them to be part of Japan. When the islands (governed by the Okinawa prefecture) were put under US administrative control after the San Fransisco Peace Treaty in 1951, neither the mainland Chinese government, nor the “nationalist” Chinese government in what is now Taiwan, objected.
The islands went back to Japanese control when the Okinawa prefecture reverted to Japan in 1972. They have been officially owned by various business entities, but have been leased by the Japanese government, who have in turn ‘lent’ one of the islands to the US military for live fire bombing exercises. The islands have not been used in this capacity for several decades now.
In September 2012 they were nationalized by the Japanese government, ostensibly to prevent them from being acquired by the nationalistic governor of Tokyo who had been considering using municipal funds to purchase them in a deliberate, populist and no doubt vote-winning snub of China. Rather predictably this action still angered China and resulted in increased Chinese naval activity in the surrounding area, which in turn caused Japan’s airforce to scramble F15′s, which then prompted the United States to urge both parties to remain calm.
Whilst the dispute over the islands is obviously a stage for the two nations to conducts nationalistic posturing, mainly designed for domestic political purposes, there is also a deeper economic aspect to the issue. There is likely to be significant oil and/or gas reserves in the seabed in the disputed territory, and so both countries have a very real economic incentive to keep the pressure up and not simply roll over.
Both countries now claim the islands as their sovereign territory, and there are regular incidents of war ships maneuvering precariously close to each other in the waters surrounding the islands. NipponMarketBlog has found reports that Chinese Coast Guard ships entered Japanese waters around the islands on the 2nd of August, thus violating what the Japanese perceive to be their sovereign territory for the second time in just two weeks.
Clearly, a permanent peaceful resolution seems unlikely at this point, and very recently an unidentified Chinese official told the state-run China Daily that any Japanese speculation about high-level talks to resolve the dispute were “not true and is fabricated, based on the needs of Japan’s domestic politics.”
However, this also does not mean that a military confrontation is likely. In fact, NipponMarketBlog considers it highly unlikely that this dispute will lead to a military confrontation, for reasons we will go into in more detail below. But the issue is likely to fester and continue to poison the relationship between the two countries, until such time as a permanent resolution is found, either as a consequence of a discovery that the area does in fact not contain oil and gas in commercially viable quantities, or through some sort of Sino-Japanese quasi-governmental joint venture company to extract the oil and gas.
This would at least be to the benefit of both countries, rather than continuing with a situation where none of the two countries can benefit from what natural resources the area might contain.
Populism and insular attitudes
It is peculiar how (mainly conservative) politicians in Japan regularly find themselves embroiled in controversy surrounding the relationship with China, paying regular public visits to shrines for the war dead, including those of alleged perpetrators of war crimes throughout Asia. One of the most famous shrines is the Yasukuni Shrine in Tokyo, where virtually all Japanese Prime Ministers go to pay their respect sooner or later. 14 Class A war criminals are buried there, and the shrine is a constant source of contention.
On the face of it, these actions appear merely clumsy and insensitive, and one would have thought that the advisors of these politicians would ensure that they steer clear of this controversy. But of course, things are more complex than that.
It would appear that there is still significant political capital to be gained in Japan from being seen to be patriotic in the sense of paying respect to soldiers who died in the Second World War, even if those same soldiers are widely accepted as being war criminals. This in itself in an interesting observation about the Japanese electorate, although it probably relates mainly to the older generations.
At any rate, for these politicians (including current Prime Minister Shinzo Abe) there is a very clear trade-off between pandering to nationalistic sentiment at home, versus risking public derision and even condemnation abroad, and it would appear that in that trade-off, the emphasis is very often on wooing of the domestic electorate.
This is very much in keeping with the extremely insular mentality of most Japanese, including also many Japanese companies. One often gets the sense that they behave as if the rest of the world is ‘optional’, and if they just ignore it then it will not affect them. This is of course a serious miscalculation, but it can be found in many places, including in corporate Japan.
NipponMarketBlog has experienced this rather disconcerting mentality in the context of meetings with several companies in Japan. For example, we were meeting with a company involved in the Basic Materials industry, which it seemed to us was perfectly placed for exploiting the fast growing Chinese electronics manufacturing industry. The investor relations team however, made it quite clear that the company was very reluctant to bet too heavily on China, since they were concerned about “not being paid”.
This concern may well have been valid, but to simply refrain from entering a market for this reason was quite shocking to us. This is a remarkable example of how some companies behave as if they have a choice between engaging in the biggest growth market in the world, or simply staying away, and how they very much think of the rest of the world as ‘optional’. This despite Japan’s overwhelming dependence on trade with other countries. Even in this extremely integrated modern world of free-flowing digital information and open international trade, this mentality seems to prevail. Something that is very obviously not in the country’s own best interest.
Interestingly, Prime Minister Abe decided not to attend in person on this year’s anniversary of the end of World War Two on August 15th 2013, instead asking an aide to make an offering at the Shrine on his behalf. However, a delegation from the government, including two cabinet ministers, did visit the shrine. Perhaps more upsetting for Japan’s neighbours, Abe omitted the usual reference to “profound remorse” or “sincere mourning” that has been included in the Prime Minster’s speech for around two decades now, at the annual memorial ceremony for Japan’s war dead. This is another indication of Abe’s tougher stance on foreign relations than that of many of his predecessors. Needless to say China and South Korea were less than impressed.
Parallels with post World War Two Germany
For decades after the Second World War, Germany was incessantly reminded of its transgressions against other European nations, and like Japan it adopted a pacifist attitude to foreign policy, maintaining only a self-defense force within the NATO frame-work and it was throughout the Cold War effectively governed by US military forces stationed at several bases in what was then West Germany.
Now, more than half a century later, Germany is no longer vilified for its past history, except by elements on the political fringes in countries currently suffering severe economic problems of their own making. Germany is seen as an equal player along-side countries such as the UK and France, even to the point of sending troops to Afghanistan to help fight the Taliban. In global politics as well as economic and financial affairs, Germany is at least on par with its European neighbours, and indeed often seen as a leading example of efficiency, discipline and economic flexibility (especially in its labour market), allowing for continued growth when much of the rest of the world is struggling. This allows Germany to play by far the biggest role in the continued evolution of the European Union, with all the consequences that this has for other countries.
The same can not be said for Japan, which is still viewed with significant mistrust, especially in China. Any talk of changing Article 9 immediately sparks vehement reactions from China and several other countries, reminding Japan of its history in Asia.
Clearly, Germany has managed to move beyond the Second World War, whereas Japan has not, and the reason is simply that whereas Germany is perceived to have genuinely repented (and having also paid significant war reparations), Japan is not perceived to have genuinely repented. In fact, it is probably fair to say that the perception in Asia seems to be that the only thing Japan regrets, is losing the war. Whether this is fair or not, perception is often reality, and the reality Japan has to deal with is that it is still dragging its feet on a final acceptance of guilt as far as the Second World War is concerned.
This issue will thus remain unresolved until Japan is perceived to have repented sufficiently, but of course this becomes less and less likely as time goes on, just as it becomes less and less clear precisely how this repentance could happen.
A recent poll conducted by the Pew Institute, found that 48% of Japanese believed that they have already apologized enough for the war and that another 15% believed that no apology was necessary in the first place. Unsurprisingly, these views were particularly strong among Japanese between 18 and 29 years old, among whom 73% said that the country has already asked for enough forgiveness or did not need to apologize.
Interestingly, the poll also found that 56% said they were opposed to revising the pacifist Article 9 in the Japanese constitution, however this number is down from 67% in 2006. So on the one hand, Shinzo Abe is actually working against the main-stream popular opinion on the matter of revising Article 9, but on the other hand it seems that the tension with China and the threat of China becoming a steam-rolling economic and military super power in South-East Asia is beginning to cause many Japanese to think twice about the continued viability of Japan maintaining its pacifist stance towards the rest of the world.
In a different poll, carried out jointly by the Japanese think-tank Genron NPO and the newspaper the China Daily covering around 1400 respondents in each country, a staggering 53% of Chinese respondents and 49% of their Japanese counterparts said that there will be a military conflict at some point in the future. On the face of it a very worrying indicator, but perhaps not surprising, given the amount of rhetoric coming out of both governments.
Constitutional reform and Article 9.
On the 19th of July Shinzo Abe’s ruling Liberal Democratic Party won a decisive victory in the Upper House Elections, thus giving the current government a stronger mandate to push ahead with economic reform. However, it also opens the door for more aggressive efforts to amend the Japanese constitution which famously has been pacifist since the Second World War (something that was imposed by the United States after Imperial Japan’s unconditional surrender).
It is well known that this continues to be a major policy goal for Shinzo Abe, and there are even those that suggest that the Three Arrows economic stimulus package and the broader and very public focus on economic growth was initially bolted onto the current Prime Minister’s broader political agenda, simply in order to ensure victory in the Lower House elections, and that economic reform was never actually the main thrust of his push to become Prime Minister.
Either way, the government now has what it probably perceives as a ‘carte blanche’ to press ahead with constitutional reform, which is certain to rile all of Japan’s neighbours.
In fact, even before the recent Upper House election was completed, China was showing its unhappiness about Abe’s impending triumph. A commentator for the official Xinhua News Agency wrote:
“To consolidate power, the prime minister and other Japanese politicians wrongfully chose to indulge a rightist tilt and constantly provoke Japan’s neighbors on sensitive territorial and historical issues.”
The commentator continued:
“If policymakers in Tokyo believe a potential election win could serve as a warrant for further rash behaviors to strain the ties with Japan’s neighbors, challenge the post-WWII world order, or abandon its pacifist commitment, they risk steering the country further down a wrong path.”
The chosen language here is unmistakable antagonistic and even menacing.
Spill-over into business and trade
China is by far Japan’s biggest trading partner. 40% of Japan’s exports go to China, and 24% of its imports come from China. For comparison purposes, only 15% of Japan’s exports go to the United States and just 9% of its imports come from the United States. (Please click on the pie-chart below for a larger version):
This drives home the inter-dependence between the two countries, and the degree to which they simply can not afford the rhetoric moving beyond just rhetoric. Notice also the interesting point that Saudi-Arabia (Oil) and Australia (Metals) are very important trading partners for Japan, since Japan has virtually no natural resources itself.
However, the increasing antagonism between Japan and China is now naturally spilling over into trade and cross-border corporate activities in a very real way, and it is having a generally negative effect across a wide range of different Japanese businesses that operate in China, either because they have production facilities there or because they are attempting to carve out a market for themselves, supplying either the manufacturing industry or the burgeoning Chinese consumer sector.
Chinese consumers are increasingly boycotting Japanese products, and one even gets the sense that it has become fashionable to be strongly anti-Japanese. Sales of Japanese autos in China has dropped recently in tandem with the ratcheting up of the dispute over the Senkaku/Diaoyu islands. Sales of Japanese cars in China fell in Q1 even as overall car sales in China rose by 17%. Whereas Japanese car manufacturers had a 23% market share in China in 2011, that share has now plummeted to just 15%.
Sino-Japanese trade has been declining for many months now, as illustrated in this chart from the Asahi Shimbun newspaper:
Whereas Japanese companies supplying Chinese manufacturing companies directly with machinery, construction machinery, machine tools or electronic components may not be as adversely affected since the Chinese companies do not necessarily have to publicize these trading relationships, but Japanese companies attempting to sell Japanese branded goods such as cars directly to the Chinese consumers may well continue to experience a significant negative effect of the dispute.
This ongoing contraction in trade between the two countries is no doubt largely due to a wider global economic slow-down, but there is no doubt that the increasingly strained relations between Japan and China have played a role as well.
In a more tangible and also more chilling display of anti-Japanese sentiment in China, the following picture of the entrance to a diner in Wuhan in China, shows a sign which explicitly warns Japanese people that they are not welcome.
Yasuhide Mizuno, the head of Honda’s venture in Wuhan, was quoted as saying that he has “never worked in a more hostile place”. It is apparently not unusual for Japanese to be turned away from local Chinese grocery stores. While it is easy to dismiss this sort of thing as childish behavior with no real consequences, in addition to making life difficult for the thousands of Japanese living and working in China, it also demonstrates the depth of feeling amongst the Chinese people towards Japan in general.
Unfortunately, the Chinese government has proven only too willing to tap into this under-current on anti-Japanese sentiment, often being accused of stoking the fire, or even going as far as arranging anti-Japanese demonstrations outside the local HQ of Japan companies.
Clearly, this is not designed to drive Japanese businesses out, but instead reflects a domestic Chinese politic agenda which we will discuss later.
In the interest of providing a fair and balanced view, NipponMarketBlog should probably also point out that the Japanese are not themselves known for being the most welcoming when it comes to foreigners, especially those not from either the US or Europe. This is evident in Japan’s problematic relationship with importing foreign labour to what is actually a rapidly shrinking labour force in dire need of replenishment. It is also evident on a more annecdotal level in blatant displays of anti-foreigner sentiment, such as this sign on the door of a Tokyo health spa.
NipponMarketBlog is not suggesting that all Japanese people are necessarily racist, but the examples provided above do hint at a tendency to a more blatant attitude to race and nationality, and a focus on racial differences within South-East Asia, than is perhaps widely appreciated in much of the rest of the world.
Final thoughts on Sino-Japanese relations
In a recent report by the Japanese Defense Ministry, the tone towards China is clear:
“In cases where China’s interests conflict with those of neighboring countries, including Japan, it has taken measures that have been called high-handed, including trying to change the status quo by force”, referring to China’s military build-up and increasingly aggressive stance to territorial disputes.
China in turn responded that:
“Japan has been spreading the so-called ’China threat,’ creating regional tension”, adding that: “Given that some political forces in Japan want more military buildup and frequent military exercises, the international community cannot but feel worried about where Japan is heading. We hope that Japan can correct its attitude and do more to promote peace in the region.”
This is classic political brinkmanship, and it will undoubtedly continue.
Looking at this from a Japanese perspective, and examining the way in which Shinzo Abe seems to have been successful in shifting public focus onto other countries (and by implication the threats that they are perceived to represent), one has to wonder why the Japanese government is prepared to risk its relationship with China (and other South-East Asian countries) over what might seem like history now well in the past.
Similarly, it is worth considering whether China’s position against what it sees as the beginnings of a resurgence of militarist political ideology in Japan is well founded, or mainly designed to distract the Chinese population from domestic troubles such as slowing economic growth and rampant corruption in both local and central government.
It seems to NipponMarketBlog that there is very little basis for believing that there genuinely is a newly militarily activist ideology forming in Japan. Pacifism is now deeply ingrained in modern Japan, and one has to believe that the electorate (especially the younger generations) would ultimately put a stop to any government perceived as going too far towards a re-militarization of Japan’s foreign policy.
Instead, the rhetoric and the obvious resurgence of nationalistic fervour among the current political establishment, rests on the conviction that if the Japanese are to rally around their democracy in the face of an increasingly aggressive China, they must have feelings of national pride rather than shame for those who lost their lives in past wars.
While this latter point seems entirely reasonable, especially for the younger generations of Japanese who had no parts in the events of the early 20th century, Japanese politicians have to realize that they are walking a proverbial tight-rope, and that any mis-steps could potentially turn out to become very costly.
In addition, it should be realized that as time passes, the potential gains in terms of domestic political capital from nationalistic grand-standing on the international stage will invariably wane as the portion of the electorate that it predominantly appeals to, exits the electorate due to natural reasons.
Equally, as time passes, the potential loss from strained relations with neighbours in the region becomes ever greater by virtue of the fact that virtually every other trading partner is growing their economy faster than Japan is growing its own economy, and is thus becoming bigger and bigger relative to Japan.
Ultimately, the two countries need each other in order to grow their respective economies.
Economic growth is now of the utmost importance in Japan, since it is the only thing that can avert a collapse of government finances as we have demonstrated here. Continued economic growth is also paramount to the Chinese government, since this is the only way in which the government can avert civil unrest and maintain its hold on power, in a country where the government is unelected yet the population is increasingly expected to function in a modern pseudo-democratic capitalist economy. This is a potentially fragile state of affairs for the Chinese government, especially if economic growth slows significantly and/or the Chinese fixed investment bubble bursts.
In many ways, the Chinese government is replacing the effectively now defunct ideology of communism as the glue that holds the country together, with the ideology of nationalism. The latter is obviously an inherently much more volatile ‘glue’, but in the absence of outright surrender to a fully fledged capitalist market economy, the Chinese government has clearly elected to use nationalism to hold things together. As such, the Chinese and the Japanese approaches are quite similar in their focus on nationalism in the face of both external and internal pressures.
However, it is clear that both countries have significantly more to lose from an escalation of hostilities, than they have to gain from any derived political capital or national unity in the face of an external (perceived) threat. One can only hope that both governments resist the temptation of escalating the dispute beyond rhetoric in a short-sighted attempt to woo their own populace.
NipponMarketBlog firmly believes that both countries will prove themselves sufficiently pragmatic to maintain a minimum level of cordial relations, so that trade disruptions are kept to a minimum over the long term.
The Japanese economy grew less than expected in the second quarter of 2013 according to the Cabinet Office. Consensus forecasts for Q2 annualized growth were at 3.6% but actual growth came in at 2.6%.
This a rather large miss, but perhaps more than anything reflects that analysts and economists at investment banks are getting slightly carried away with excitement over the improvement in the economy.
There is no doubt that the economy is improving. 2.6% is still a very healthy GDP growth rate, and it far exceeds that of most countries in the world. However, anything less than this would have been disappointing, since the Japanese economy is being stimulated quite aggressively through both fiscal and monetary means via the Abenomics program that we have explained in some detail here.
Using quarterly Cabinet Office data (seasonally adjusted), we have put together a few charts to highlight what we think are the key points from today’s GDP figures.
Firstly, the overall trend in GDP looks reasonably healthy on the face of it:
What is driving the recent growth seems to be mainly private consumption, which is exactly what Abenomics is aiming for, at least as a first stage:
There has been some concern that the observed growth in consumption has been partly the result of consumers moving forward their expenditure in order to avoid the controversial consumption tax hike that we have discussed here.
However, it does appear that there is more to the story than that. Notice how consumption seemed to roll over in early/mid 2012, only to pick up again in late 2012 and early 2013. This seems to hint at consumers reacting to Abenomics even before the results became evident. In other words, the average Japanese consumer clearly bought into the idea that Japan was capable of turning the corner through implementation of Abenomics, and this in conjunction with the rapidly rising equity market in late 2012 (caused by largely speculative foreign investor inflows, as well as the dramatic effect on corporate profits caused by the falling Yen, which in turn was a result of the BoJ aggressive QE program), clearly caused consumers to loosen their purse strings. Finally, there was (and still is) a quite concerted effort in most of the Japanese media to encourage the idea that Japan is turning the corner, and with that message being drummed home every day to the average consumer through TV and newspapers, there is no doubt that this would have had a positive impact on people’s spending patterns.
This is all very positive, but as NipponMarketBlog has pointed out in the past, unless wage inflation takes hold now that consumer price inflation seems to be turning positive (see our piece here), there is a real risk that the bounce in consumption that we have observed so far, may well fizzle out.
In the absence of further growth in consumption, the other two major components of GDP that have the potential to take over and thus maintain positive growth for the economy as a whole, are government spending and private investment (particularly corporate investment). Unfortunately, given the Japanese government’s dismal fiscal situation (see our piece here), continuing with public sector spending (and thus also deficits to the tune currently 10% of GDP) is simply not sustainable for more than a couple of years. In other words, private investment has to take over as the driver of continued growth. There is also the risk of so-called ‘moral hazard’ from too much public spending (see out piece here).
Sadly, for the moment at least, there seems to be limited scope for an increase in corporate spending. The Q2 GDP figures reveal that private non-residential investment actually fell 4.5% YoY, which is quite an unpleasant surprise, especially considering the very large jump in corporate profits being reported at the moment (in the order of 100% YoY across the companies listed on the TSE).
Clearly, the fall in the Yen and the resultant increase in corporate profits has not yet persuaded companies to invest in new equipment. The government is mulling over a plan to incentivise companies to increase investments through tax breaks, but one has to wonder how effective that is going to be, for the simple reason that corporate Japan has been flush with cash for years and so presumably would already have increased their investment spending if they had deemed it necessary or beneficial to do so. The fact that this has not happened, seems to indicate to NipponMarketBlog that from a business management point of view there simply is not currently a perceived requirement to increase investment, and no amount of tax breaks are going to change that – at least not in a meaningful way.
So why have companies not invested more given that the Japanese economy is picking up? There could be several reasons for this. Firstly, corporate Japan is inherently very conservative, and one does not usually see large scale investments unless there is an obvious opportunity presenting itself. Secondly, corporate Japan has suffered from overcapacity in many sub-sectors (which is partly the reason for the prolonged period of deflation), and so the economic rationale for further investments is tenuous at best. Secondly, could it be that corporate Japan as a whole is still not buying in to Abenomics, possibly because they realize that they growth in profits that they have already experienced is to a large extent the result of the accounting effect of a weaker yen?
Either way, it is NipponMarketBlog’s view that the government will struggle to materially affect any meaningful change in corporate capital spending behavior, especially if they now begin to find themselves under pressure to increase employee salaries and bonuses because of inflation beginning to turn positive.
Any decision on the part of corporate Japan to increase spending has to come from within, and it has to be the result of decisions about returns on invested capital, which in turn will be based on confidence in the sustainability of the domestic recovery and the strength of the global economy. Time will tell whether corporate Japan eventually steps up and starts investing again, but there is no doubt that without an increase in investment, Japan’s apparent revitalization could be at risk of failing.
Finally, we present the view of the level-headed HSBC strategist Garry Evans, who appeared on Bloomberg TV and among other things discusses the idea of a very incremental increase in the consumption tax, which NipponMarketBlog finds an infinitely more sensible idea than the currently proposed two-stage doubling next year from 5% to 10%. The last thing the government would want at this point in time is to risk derailing the recovery in consumption by slapping the consumers with a higher sales tax that may well decrease their propensity to spend, especially if wages do not keep up with increases in prices.
This piece is a somewhat lighthearted attempt at throwing light on a serious issue; Japan’s enormous government debt.
On the 9th of August 2013, the Ministry of Finance announced that Japan’s public sector debt exceeded one quadrillion Yen on June 30th. The debt stood at 1,0086 quadrillion Yen to be precise (or 10.46 trillion USD), which is more than the economies of the UK, Germany and France combined.
So how much is a quadrillion exactly? Well, one quadrillion is equal to one thousand trillion, which in turn is equal to one thousand billion, which in turn is equal to one thousand million. Below we present the numbers using zeros:
So one quadrillion is equal to one million billion. Confused? These number can be tricky to get one’s head around, so allow us to attempt to illustrate:
The US government’s on-balance sheet debt is around 16 trillion USD (around 60% higher than that of Japan), but this is for an economy that is almost 3 times bigger than the Japanese economy.
Worked out on a per capita basis, the average man, woman and child in Japan is theoretically significantly more indebted (through their government) than their US counterparts. The average citizen in the US is indebted to the tune of around $50.000 due to government debt, whereas the average citizen in Japan ‘owes’ around $80.000.
This of course is in addition to any personal debt each individual may have built up.
The Bank of Japan helpfully has a picture on its website of a package containing 100 million Yen in 10.000 Yen notes. The package is 38cm by 32cm, about 10cm thick and it weighs about 10 kilograms.
You would need to acquire 10 million of these packages to end up with a quadrillion. Stacked on top of each other, your quadrillion Yen ‘tower’ would reach a dizzying 1.000km into space and weigh in at 100.000 tons, or about the same as a herd of 14.000 African elephants.
Imagine a man standing in the middle of Tokyo handing out 1.000 Yen notes to people for 8 hours a day, every day of the week.
Assuming he hands someone a 1.000 Yen note every 5 seconds, it would take him 475.000 years to hand out one quadrillion Yen, or roughly the amount of time that has passed since the earliest Neanderthals roamed Europe:
What we have done here is to attempt to provide our readers with a grasp of the scale of the numbers involved in this ultimately very serious issue.
The debt burden in Japan is clearly enormous, and very obviously needs to be dealt with. The central government is already spending a quarter of its tax revenue just on paying the interest on its debt, and this is with very low interest rates. NipponMarketBlog has done the math on what will happen if and when interest rates start to rise, and it is truly frightening (see our piece here).
Shinzo Abe’s cabinet along with the BoJ’s Kuroda are attempting to turn the corner with its Abenomics program (see our piece here), but the challenge is very significant, and the jury is still very much out as to whether the attempt will prove successful in the long term.
On August 8th Prime Minister Abe ordered the creation of a panel of so-called experts to ‘analyze the impact on the economy of a higher consumption tax’, which is widely seen as the first step to help reduce the deficit which is currently running at around 10% of GDP.
However, NipponMarketBlog finds it interesting that two of the members of the panel will be Bank of Japan governor Kuroda and Finance Minister Aso, both of whom have obviously already expressed their support for the consumption tax being raised (See our piece here). One suspect that this panel of experts is being put together simply to rubber-stamp the government’s plan to raise the consumption tax, thus providing perceived expert backing for government policy in the eyes of the electorate.
Bank of Japan governor Kuroda has entered the debate about the controversial increase in sales tax (or ‘consumption tax’ as it is also known) that the government is mulling over at the moment. He seemed to be attempting to drive home the rather obvious point that unless public finances are repaired, bond yields are bound to move higher, which will topple the proverbial house of cards, since this will cause government debt repayments to explode beyond what can possible be financed by the government through tax revenues.
He is quoted as saying that:
“Ending deflation and raising the sales tax are achievable at the same time.”
“Generally speaking, as a result of the continuance of large budget deficits, the government’s debt levels are already at extremely high levels. Considering that issue, it is extremely important for the government to clarify the path of fiscal rehabilitation and to move ahead with fiscal and structural reforms. The Bank of Japan is strongly hoping it will steadily implement them.”
As NipponMarketBlog has mentioned several times, Japanese public finances are in such dire straits that urgent action is needed, which is why both fiscal and monetary stimulus in the shape of Abenomics has been launched.
The idea behind Abenomics (see our piece here) is to kick-start the economy and propel it onto a self-sustained growth track that can then carry the tax increases necessary to mend public finances and eventually reduce government debt (at least as a percentage of GDP). However, the key word here is ‘self-sustained’. Simply raising nominal growth by using fiscal stimulus (to create the accounting effect of higher GDP numbers), and monetary stimulus to weaken the Yen and thereby boosting corporate profits in the short-term (whilst wage inflation lags behind), is not a sustainable strategy. It does not increase the long-term capacity of the economy to create wealth, and consequently it does not provide the tax foundation required to decisively mend public finances.
We make three observations about governor Kuroda’s statements:
1. Kuroda is in charge of monetary policy, not fiscal policy. But of course the distinction between the two is becoming ever more blurred. As we mentioned in this piece, the Bank of japan has effectively ceased to exits and has been replaced by what is just an extension of the Ministry of Finance.
2. The comments quoted above appear to NipponMarketBlog as a display of overconfidence in the extent to which Abenomics is working, specifically the permanent effects that the policy is expected to have. This is especially the case since past increases in the consumption tax has been widely blamed for derailing nascent economic recoveries in Japan at least once in recent history.
3. Kuroda’s meddling in law makers’ decisions about the tax code also seems to demonstrate a level of perceived urgency on the part of the BoJ, which is not necessarily conducive to creating the impression that the BoJ is in control of the situation. At the same time however, one can not help suspect that perhaps Prime Minister Shinzo Abe and Finance Minister Taro Aso have asked Kuroda to issue these statements, in order to put pressure of law makers to ensure that the sales tax hike goes through parliament.
At any rate, in NipponMarketBlog’s opinion there are certainly signs of higher growth and higher levels of economic activity in general at the moment, but it is still very tenuous and far from sufficient to start increasing taxes. We believe the hike in sales tax is very much premature. A surging equity market (partly due to the BoJ’s QE and higher inflation expectations) and rising corporate profits (largely due to the weakening Yen), along with positive CPI numbers (almost exclusively due to the weakening Yen and resultant higher energy prices) does not constitute a sustainable recovery. At least not to the point where tax increases should be considered.
The focus in Kuroda’s comments on deflation as a problem rather than a symptom is also quite worrying. Kuroda’s statements underline the idea that deflation is perceived as a problem in itself, rather than a symptom of a dysfunctional economy. This brings with it the risk that officialdom in Japan are treating the symptom and not the illness. This approach historically never ends well.
NipponMarketBlog is reminded of a quote from a well known investor, who once (perhaps slightly harshly) remarked that:
“Japan has never missed an opportunity to miss an opportunity”.
We are concerned that history might be repeating itself. It is too early to tell, but the impatience with which the consumption tax hike is being treated is certainly worrying.
The whole situation is of course very much characterized by a sort of ‘Catch 22”, where taxes have to be raised for public finances to be repaired, but in order for that to happen growth has to be encouraged, and the only way for a government to do this quickly is to increase fiscal and possibly also monetary stimulus, which worsens the fiscal balance and creates doubt about the long term solvency of the government respectively (the latter due to the risk of rising bond yields).
It is tempting to think that Abenomics is actually just a short-term measure to create a nominal growth spurt that can buy the country some time, but as we have made the case for before, Japan is effectively already insolvent (see our piece here), and eventually some sort of default and/or debt restructuring has to be implemented.
However, we also believe that if and when this default or debt restructuring occurs, Japan as a whole (and corporate Japan in particular) has a golden opportunity to re-invent itself and again emerge as a dynamic center of growth in the global economy (see our piece here).