Japan's End Game
The following is an excerpt from John Mauldin and Jonathan Tepper's new book, Endgame. The book may be purchased through Amazon by clicking here.
A major debt and currency crisis in Japan is a case of when, not if. Forecasting when it might happen, though, is difficult. We can't remember who said it, but the old line is true. "You can't call yourself a real macro trader until you have lost money shorting Japanese bonds." But when the crisis of confidence in Japanese bonds happens, it is likely to be swift, and the lucky traders who are short will become legends.
The realization that crises happen suddenly and unexpectedly is not lost on Japanese politicians. Recently Prime Minister Naoto Kan stated, "Our public finances have become the worst of any developed country. Like the confusion in the Eurozone triggered by Greece, there is a risk of collapse if we leave the increase of the public debt untouched andthen lose the trust of the bond markets."
Japan has two options. Either it engages in extremely painful contraction of government spending, or it prints money and gets rid of the deficit via monetization. There is simply no way to pay back Japanese debts. Japan's government is running one of the largest structural budget deficits in the world at more than 7.2 percent of GDP every year until at least 2015, according to IMF calculations. By that stage, Japan will be in the range of 230 percent debt-to-GDP ratio. Cutting the deficit significantly will be extremely difficult. Governments print money rather than doom the economy to a severe
recession or a depression induced by economic contraction. When this happens, the yen is likely to fall dramatically in value, Japanese interest
rates will go up, and Japanese bonds will sell off.
Such an abrupt change for Japan would be nothing new. Japan has a history of making 180-degree turns. In 1868, during the Meiji Restoration, Japan went from being an inward-looking country to a rising economic and military power. In the 1950s, under the Yoshida doctrine, Japan abandoned militarism and instead embraced pacifism. Both of these moments marked a dramatic turn in Japanese society. Even in 1990, after the bubble burst, Japan turned overnight from high
consumption and ostentation to frugality and sobriety. What will happen if Japan makes a 180-degree turn, and Japanese savers decide to
abandon the yen and Japanese government bonds?
Can we hear a bid for 100 yen to the dollar? 125? 150? 200? 250? 300? It seems unthinkable now, but it is quite possible unless the Japanese
willingly embrace a contractionary, severely deflationary depression. Not a good set of choices.
We have said before that Japan is a bug in search of a windshield. The only question is when the bug will be crushed. But it does have consequences for the rest of the world. Japan matters. Japan matters a lot. Not only is it the third largest economy in the world (depending on how you measure size) but also it is a major export power.
What happens if the yen starts to lose value? What happens when you can buy a Honda, Toyota, or Lexus cheaper than you can buy a Kia or a Hyundai? Or any of a number of European cars? Now take that same analogy and apply it to scores of industries that compete with Asia, the United States, and Europe. How does Korea deal with a real loss of competitiveness? In the past, they have devalued their currency. But can they really keep up with a hyperinflating Japan? And that goes for all of their neighbors, not to mention Germany and the emerging market countries.
Yes, the cost of Japanese inputs (like steel) go up, but not their labor or engineering or the infrastructure and factories they already have. For a while, in the early stages of endgame, it is a very dicey atmosphere in world trade and currency markets.
Then, what if you are Mrs. Watanabe and the cost of everything you buy from overseas is going up rapidly? And you are on a fixed income? Your savings are not inflation indexed. First, you end up buying less. But you also figure out (because the Mrs. Watanabes of the world are very smart and currency savvy) you need to move your savings into other currencies. And since the Japanese are serious currency traders from their homes, they can do it with a click of a mouse.
So there is even more pressure on the yen.
Yes, we know that the Japanese have huge hoards of foreign currencies, especially dollars. But that is not their salvation as they spend yen at home.
Once they start down the endgame path, it is difficult to get off it. It goes back to our chapter on This Time Is Different. It is a BaBang! moment. And because it is Japan, it is a BIG BANG! moment.
Note: Endgame was completed well before the recent earthquake in Japan. The authors granted RCM permission to publish an excerpt and I chose this section. The recovery facing Japan will be extraordinarily difficult and their existing economic condition will not make the job any easier. Our thoughts and prayers are with the Japanese people.
I read Endgame last weekend and will publish a review next week. For now, I'll just say that I highly recommend you click on that link above and get a copy of your own. - Joe Calhoun, Real Clear Markets
