How Keynes failed JapanMarch 17, 2011: 12:29 PM ET
It's obvious that growth will continue to slow in Japan. What's only now becoming clear to many is just how inept the country's fiscal and monetary policy was before the earthquake.
By Darius Dale, Hedgeye
It goes without saying that the situation in Japan is frighteningly tragic and our thoughts and prayers go out to the victims of this crisis, both surviving and deceased.
With that said, the critical risk management task to focus on is determining what to buy and what to sell, and at what levels. To do that, one must have a proactive risk management strategy that understands full well that risk is always on. As Rahm Emanuel famously said in the wake of the collapse of Lehman Brothers, "You never want a serious crisis to go to waste."
The seesaw in the Nikkei during the past few days is largely driven by hysteria surrounding warnings of a possible nuclear disaster just 137 miles north of Tokyo. While we agree with that premise to an extent, we don't think these moves are something to be written off as "panic selling"; nor do we think it's wise to "buy the dips" here. Some dips are not meant to be bought.
There will be a throng of investors trying to get ahead of the Japanese recovery story, some that will buy the dip on valuation, and a few others that will buy them on the global growth story -- which the data now suggests is increasingly eroding. We'll need to see the prices confirm over the next few days or so before we feel comfortable shorting Japanese equities.
We think this most recent natural disaster serves as a wakeup call to the global investment community regarding the state of Japan's finances. While certainly not new news to our Hedgeye readers or to investors such as Kyle Bass and Marc Faber, we do think the broad-based weakness across Japanese asset classes suggests that, on the margin at least, the world now understands that Japan is on the fast track to what we've termed the Keynesian Endgame.
To be clear, the Keynesian Endgame is a scenario whereby big government intervention (known in academic circles as "countercyclical government stimulus") in the form deficit spending, debt buildup, and cheap money monetary policy fail to produce the desired results. Instead, it produces depressed growth rates, which we have seen from Japan over the past two decades.
It's important to highlight Japan's fiscal and monetary policy response to this recent natural disaster and thus its latest contributions to its debt and deficit crisis:
- Japan, which has yet to pass financing legislation for the government's record 92.4 trillion yen ($1.1 trillion) budget, currently has roughly 1.3 trillion yen in discretionary funds from the current budget that can be allocated to the recovery efforts;
- By comparison, the 1.3 trillion is less than half of the 2.7 trillion the government pulled together in the wake of the 1995 Kobe earthquake. Normalizing for the different JPY/USD exchange rates, current on-hand funding is roughly (-42.5%) smaller than it was sixteen years ago;
- Going back to the budget specifically, which will take effect in two weeks, proposed measures to finance the budget, including a proposal to raise the consumption tax, were largely the source of recent political tension and the cause of a rift within the Development Bank of Japan, as well as a growing divide between Japan's central government with its local government officials;
- The current natural disaster combined with severely depressed approval ratings for Prime Minister Kan and the ruling DPJ (81% of voters and 75% of local government heads disapprove of the current leadership) all but guarantee there will be no tax and fee hikes to help finance the budget;
- Much like the US, the Japanese government will potentially face a shut down as early as July once all revenues are exhausted and potentially 20 trillion yen worth of short-term JGB debt is issued via a special provision to cover expenses; and
- While we don't think the Japanese government will stop functioning given the need to respond to this latest disaster, we do think its growing inability to pay for what it spends will result in an serious acceleration of JGB supply growth over the intermediate-term. This will likely push Japan's Debt/GDP ratio above 210% in FY11, from the current 208.2% using the most current debt balance and GDP figures.
Monetary Policy Response
- Given the Japanese government's inability to adequately fund the relief efforts, the Bank of Japan did exactly what they've been doing for years after having been encouraged by the likes of Paul Krugman and many other Keynesian academics (including Ben Bernanke) to print lots of money;
- In 48 hours alone, the BOJ created 42 trillion yen (~$520 billion) in newfound liquidity and BOJ Governor Masaaki Shirakawa pledged more "aid" should financial conditions warrant it;
- This latest round of government intervention in attempt to fuel a publicly-levered stock market rally is on top of the BOJ currently monetizing JGB debt at a rate of 21.6 trillion ($267.2B) annually.
It's clear that Japan, much like the US, cannot afford to finance event risk -- which includes things like recovery from natural disasters and war. That shifts much of the burden to the central bank to print money. It's worth noting that this concept is near the core of our bearish long-term thesis on the yen -- this recent earthquake and tsunami merely inches Japan closer to a demographic fueled JGB supply/demand imbalance.
Further, one has to wonder how much yen the Bank of Japan can shower the financial system with before people stop bending over to pick them up. To this point, it comes as no surprise to us that only 8.9 trillion of the 42 trillion yen offered by the BOJ was actually met with demand from financial institutions. Japan has been in a classic liquidity trap for many years and we don't expect the BOJ's latest attempts at printing money to be met with a commensurate pick-up in private sector growth.
Our view is in sharp contrast to current consensus expectations, as many Japanese investors have been trained to beg for stimulus at the first sign of a market crack after many years of government intervention.
We can foresee a scenario whereby the yen continues to appreciate over the intermediate term even in the face of accelerated easing out of the BOJ. For this reason, we think the Japanese yen will continue to strengthen over the intermediate-term trend. Understanding full well that consensus will likely continue using the same one-factor model of yen up/Japanese stocks down, we remain bearish on Japanese equities over that same duration.
All told, it's obvious that growth will continue to slow on the island economy and that the fiscal and monetary levers that Japan can pull in the event of further crises continues to grow increasingly inadequate by the day.
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