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Japan (W)as Number One

Airbags to protect people in a car crash only work once...

BACK in 1979, the publication of Harvard sociologist Ezra Vogel's international best-selling book Japan as Number 1 signalled the nation's arrival as an economic power, writes Satyajit Das in Dan Denning's Daily Reckoning Australia.

Today, Japan's industrial and economic decline is palpable. But in 2012, Japan's Nikkei 225 stock average rose by around 23%.

Much of the increase reflects faith in the reflation strategy of second time prime minster Shinzo Abe to increase growth through an additional US$120 billion of public spending, create inflation to reduce the debt to GDP ratio, and devalue the Yen.

The strategies, which have all been tried before with limited success, may not restore the health of the Japanese economy.

In the post-war period, Japan enjoyed decades of strong economic growth – around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between1971 and 1990. Since the collapse of the Japanese debt bubble in 1989, Japanese growth has been sluggish, averaging around 0.8% per annum.

Nominal gross domestic product (GDP) has been largely stagnant since 1992. Japan's economy operates far below capacity, with the output gap (the difference between actual and potential GDP) being around 5-7%.

The Japanese stock market is meantime around 70% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It has since traded around 8,000-12,000. Japanese real estate prices are at the same levels as 1981.

Short-term interest rates are still around zero, under the Bank of Japan's Zero Interest Rate policy (ZIRP), which has been in place for over a decade. Ten-year Japanese government bonds yield around 1.00% per annum.

Since 1990, public finances have deteriorated significantly. Government spending to stimulate economic activity has outstripped tax revenues, resulting in a sharp increase in Japanese government gross debt to around 240% of GDP. Net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 135%. For comparison, the US government has gross and net debt of 107% and 84%. Japan's total gross debt (government, non-financial corporation and consumer) is over 450% of GDP, compared to around 280% for the US.

Japan's demographics parallel its economic decline. Japan's population is forecast to decline from its current level of 128 million to around 90 million by 2050 and 47 million by 2100. A frequently repeated joke states that in 600 hundred years based on the present rate of decline there will be 480 Japanese left.

The proportion of Japan's population above 65 years will rise from 12% of the total population to around 23%. Japan's work force is expected to fall from 70% currently by around 15% over the next 20 years. For every two retirees there will be around three working people, down from six in 1990.

According to one forecast, by 2050 Japan will have a median age of 52, the oldest society ever known. Sales of adult diapers already exceed those intended for babies. Japan's problems have been compounded by two major natural disasters – the 1994 Kobe earthquake and the 2011 Tohoku earthquake and tsunami.

In the face of the nation's long term decline, Japanese politics has become increasingly fractious. Frequent changes of leadership, often driven by arcane internal factional politics, have created an unstable environment and a lack of policy continuity.

Japan has had seven prime ministers in six years and six finance ministers in three years. Former Brazilian President Luiz Inácio Lula da Silva once joked that in Japan you say good morning to one prime minister and good afternoon to another.

Japan's post-war economic success, like that in Germany, was based on an export-driven economic model, using low costs and manufacturing competence. An under-valued Yen provided Japanese exporters with a competitive advantage.

The Plaza Accord signed on 22 September 1985 called for France, West Germany, Japan, the United States, and the United Kingdom to devalue the Dollar in relation to the Japanese Yen and German Deutsche Mark by intervening in currency markets. Between 1985 and 1987, the Yen increased in value by 51% against the Dollar.

Japan moved from an era of En'yasu, an inexpensive Yen, to a period of Endaka or Endaka Fukyo, an expensive Yen. The higher Yen adversely affected Japanese exporters. Japanese economic growth fell sharply, from 4.4% in 1985 to 2.9% in 1986.

Desperate to restore growth and offset the stronger Yen, the Japanese authorities eased monetary policy, with the BoJ cutting interest rates from 5% to 2.5% between January 1986 and February 1987.

The lower rates led to a rapid increase in debt funded investment, driving real estate and stock prices higher. At the peak of the 'bubble' economy, the 3.41 square kilometre (1.32 square miles) area of the Tokyo Imperial Palace had a theoretical value greater than all the real estate in the state of California.

Seeking to reverse the unsustainable asset price inflation, the authorities increased interest rates to 6% between 1989 and 1990, triggering the collapse of the boom. As Japan's economic problems worsened rapidly, the government responded with large fiscal stimulus programs. The BoJ cut interest rates to zero. But the policy measures failed to revive the economy, which slid into deflation.

There was a parallel deterioration in public finances. At the time of collapse of the bubble economy, Japan's budget was in surplus and government gross debt was around 20% of GDP. As the Japanese economy stagnated, weak tax revenues and higher government spending to resuscitate growth created substantial budget deficits.

Japan's total tax revenue is currently at a 24 year low. Corporate tax receipts have fallen to 50 year lows. Japan now spends more than ¥200 for every ¥100 of tax revenue received.

The period of Japanese economic decline was known as the Lost Decade, or Ushinawareta J?nen. As the economy failed to recover and the problems extended beyond 2000, it has come to be referred to as the Lost Two Decades or the Lost 20 Years (Ushinawareta Nij?nen).

Japan's large pool of savings, low interest rates and a large current account surplus has allowed the build-up of government debt. Japan has a large pool of savings, estimated at around US$19 trillion, built up through legendary frugality and thrift during the nation's rise to prosperity after World War II.

High savings rates also reflected the country's young age structure especially until the 1980s, the low level of public pension benefits, the growth of income levels through to the late 1980s, the bonus system of compensation, the lack of availability of consumer credit and incentives for saving.

In recent years, household savings were complemented by strong corporate savings, around 8% of GDP. This reflects slow growth, excess capacity, lack of investment opportunities and caution driven by economic uncertainty. Much of these savings are invested domestically. A significant amount of the savings is held as bank deposits, including large amounts with the Japanese Postal System.

In the absence of demand for credit from borrowers, the banks hold large quantities of government bonds to match the deposits, helping finance the government. Japanese banks hold around 65-75% of all Japanese government bonds (JGBs) with the Japanese Postal System being the largest holder. Around 90% of all JGBs are held domestically.

The high levels of debt are sustainable because of low interest rates, driven by the BoJ's ZIRP and successive rounds of JGB purchases as part of quantitative easing (QE) programs since 2001.

The BoJ balance sheet is now around US$2 trillion, an increase from around 10% of Japan's GDP to 30% since the mid-1990s. BoJ holdings of JGBs are some US$1.2 trillion, around 11% of the total outstanding.

Low interest rates perversely have not discouraged investment in bank deposits or government bonds. This reflects the poor performance of other investments, such as equity and property, during this period. The strong Yen has increased the risk of foreign investments.

Although nominal returns are low, Japanese investors have received high real rates of return, because of falling prices, otherwise known as deflation.

Over the last 50 years, Japan has also run large current account surpluses, other than in 1973-1975 and 1979-1980 when high oil prices led to large falls in the trade balances. The current account surplus has resulted in Japan accumulating foreign assets of around US$4 trillion or a net foreign investment position of approximately 50 % of GDP.

This helped Japan avoid the need to finance its budget deficit overseas and also boosted domestic resources, increasing demand for JGBs. Since the global financial crisis and more recent European debt crisis, Japan has been viewed as a 'safe haven'.

Investors have purchased Yen and JGBs, pushing rates to their lowest levels in almost a decade and increasing foreign ownership of JGBs to around 9%, the highest level since 1979, the first year for which comparable data is available. These factors have assisted Japan to finance its budget deficit.

But airbags designed to protect occupants of a car from injury in a crash only work once. Similarly, the factors which allowed Japan to increase its government debt levels are unlikely to continue.

Following the collapse of the bubble, policymakers implemented a variety of economic stimulus programs. Japan's budget surplus of 2.4% in 1991 has become a chronic budget deficit, increasing from 2.5% in 1993 to about 8% by the end of the 1990s. It has remained high during the 2000s.

The BoJ has tried unsuccessfully to increase inflation to reduce debt. Japanese inflation has averaged minus 0.2% in the 2000s, a decline from levels of 2.5% in the 1980s and 1.2% in the 1990s. The policies have failed to restore economic growth, trapping Japan in a period of economic stagnation.

Nomura economist Richard Koo argues that Japan is experiencing a 'balance sheet recession', triggered by the collapse of financial asset prices. Financially insolvent firms are reducing debt – deleveraging – despite low interest rates. This is evidenced by a sharp fall in investment (currently around 22% of GDP, down from 32% in 1990) and corporations becoming net savers from net borrowers.

Private consumption is weak, falling to about 57% of GDP, further reducing domestic demand. This reflects weak employment, lack of growth in income and the aging population. Strong exports and a current account surplus have partially offset the lack of domestic demand, as firms focused on overseas markets.

With investment and consumption weak, large budget deficits have supported economic activity, avoiding an even larger downturn in economic activity.
In a balance sheet recession, monetary policy is ineffective with limited demand for credit. GDP tends to decline by the amount of debt repayment and un-borrowed individual savings. Government stimulus spending is the primary driver of growth.

Given that the strategies have been tried unsuccessfully before, the Prime Minster Shinzo Abe's policies have a desperate quality. Although the measures will provide a short term lift in economic activity, it is unlikely to create a sustainable recovery. They will increase the budget deficit and government debt levels.

Continued economic weakness, a decline in savings rates and a reversal of the current account surplus make the Japanese government debt burden increasingly unsustainable.

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

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