Are we seeing the end of Japan’s 30-year investment collapse?
Japan’s “Great Exodus”
The below graph reflects “The Great Exodus” of capital leaving Japan since 1990. When the Japanese bubble economy burst in 1990, Japan ceased to attract investment at the rate it had historically attracted investment capital post-WWII. Japan’s bubble economy came to a frothy head during 1986 and 1990, while short-term interest rates lowered from 5% to 2.5%. The subsequent rise of short-term interest rates from 2.5% to 6% by 1991 brought an end to a great run for the Japanese economy.
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As reflected above, the Sun began to set on Japan the day the Bank of Japan began to raise interest rates in 1990. More than 30 years have passed without a single cycle of monetary policy tightening in Japan. Short-term interest rates have remained near 0% since 1996. The above graph reflects what has happened with regard to the decline in investment in Japan since 1990. This series explains why this decline happened and what might happen in the future under “Abenomics.”
Japan’s “lost decade”
Economists have referred to the 1990s as Japan’s “lost decade.” This expression captured Japan’s overall decline, as explained by a decade of lost opportunity in terms of implementing meaningful structural reform in a declining economy. If only bad economics came discreetly packed in decade-long increments. As the yellow line above reflects, Japan saw its last investment hurrah between 1986 and 1990, and things have gone downhill ever since. The question remains: what can Japan do about growing investment? Japan’s new Prime Minister, Shinzo Abe, has some radical ideas that have rattled Japan’s slumbering equity markets and drastically weakened Japan’s currency since his election in November 2012.
“Abenomics”: Larger budget deficits and aggressive monetary policy
As we noted in the first part of an earlier series, Japan’s new Prime Minister, Shinzo Abe, in conjunction with Bank of Japan Governor Haruhiko Kuroda, will attempt to end the post-1990 deflationary spiral that has gripped the Japanese economy. These policies, known as “Abenomics,” will attempt to encourage private investment through a more aggressive mix of monetary and fiscal policy. “Abenomics” aims to end deflation by targeting a 2% inflation rate, as well as to increase fiscal spending by 2% of gross domestic product, or GDP. This level of government spending is expected to raise the 2013 deficit to a whopping 11.5% of GDP in 2013—higher than that of the US budget deficit after the 2008 crisis, as well as present-day Greece’s deficit (with approximately 10.0% budget deficits).
China ate my lunch
As the above graph reflects, China’s entry onto the global economic stage of free market capitalism has led to a “Great Exodus” of capital formation. Foreign direct investment began to pour into China post-1976, as Deng Xiaoping’s Open Door Policy began to develop. China began to suck in capital from around the world, as manufacturers such as Toyota rushed to mothball factories in high-cost G7 countries such as Japan and built new state-of-the-art manufacturing centers in China’s new Special Economic Zones.
The Great Wall of cheap land, labor, and capital
The Japanese manufacturing economy, which had slowly worked its way up the value-added food chain from low-end manufacturing post–World War II, had run into a wall—the Great Chinese Wall of cheap labor, land, and capital. This increase in manufacturing competition for Japan was somewhat mitigated by the post-Regan Era of consumerism in the United States, characterized by high trade deficits—especially with Japan.
Japanese exports of products, such as vehicles, were also sustained during the W. Bush years, as the wealth effect of the housing bubble fueled consumption in the United States—pushing personal savings in the United States from the historical average rate of 6.85% to a record low of less than 1% in April 2005. However, since 2008, Japan, like China, may struggle to find strong buyers in the United States and Europe. As a result, there has been about as much interest in building new auto plants in Japan as there has been in Detroit.
A crack in the Great Wall?
The above graph reflects investment capital flows as a percent of GDP declining in both Japan and the United States post-2008, while capital flows have continued to explode in China. However, it’s important to note that some very important things have changed.
- China attracted capital at a high rate from 1990 to 2008, while the Japanese yen went on a massive secular (long-term) appreciation from nearly 160 yen to the dollar in 1990 to 75 yen to the dollar in 2011. Not only did ultra low-cost China go into capitalism as a competitor to Japan (ouch for Japan), but China also pegged its currency to the dollar, which went on a long-term weakening against the yen (double ouch for Japan). Ultra-cheap China made Japan appear increasingly expensive, as Japanese trade surpluses pushed the yen higher and higher. It appears that Japan may have finally cried “uncle” and is now in the process of a whole new makeover to turn around this ongoing deterioration in the economy. Enter “Abenomics.”
- “Abenomics”: The election of Japan’s new Prime Minister, Shinzo Abe, has brought with it the promise of ending deflation in Japan, which has caused the country’s currency to depreciate against the dollar by 33% in less than a year. Finally, a reprieve for Japan!
- Note the Graph of Capital Formation in China since 2008: 47% of GDP is still an astronomical rate of capital formation, though the growth rate has finally flatlined. Perhaps this rate will decline, as the Chinese yuan remains linked to the solid US dollar, while the Japanese yen continues to weaken. Plus, it might appear that China is reaching diminishing returns on its debt-financed growth in recent years, suggesting that capital formation could indeed be poised for a significant slowdown—just as Japan experienced post-1990. These trends in investment and exchange rates merit watching very closely.
What to watch for
Should the yen continue to weaken against the US dollar and Chinese yuan, the cost base differential between Japan and China could continue to decrease, leading to an improvement in Japan’s terms of trade vis-à-vis China. It’s important to note that Japan’s wages have remained stagnant while its currency has dramatically appreciated over the last few decades. Contrary to these trends, China has experienced dramatic wage inflation, while its currency has remained largely unchanged against the yen since 1996.
Why the bull market in Japan could go into overtime
This decades-long relationship shows early signs of reversing itself under “Abenomics.” The Japanese Yen has a long way to go before reaching its Regan Era levels of 260 to the dollar, just before the Plaza Accord led to the yen’s secular strengthening to date. However, should Abenomics inflationary scare tactics steer the yen back on course for Regan-era levels of weakness versus the dollar, investors could see major changes for Japan, and the Japanese equity markets would very likely head deep into bull market territory for a long time.
As 2013 progresses, investors could see a continued outperformance of Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan ETF (EWJ) versus China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further clarification as to why DXJ could outperform both EWJ and other Asian equity indices, please see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.” Plus, as Japan pursues unprecedented monetary expansion, and the US Fed ponders monetary tightening, Japanese equities could also outperform broad US equity indices, as reflected in the State Street Global Advisors S&P 500 SPDR (SPY), State Street Global Advisors Dow Jones Index SPDR (DIA), and Blackrock iShares S&P 500 Index (IVV).
For related analysis, please see the following articles.