Japanese Economic Hard Landing Forecast for 2008

By: Dr_Krassimir_Petrov

While investment powerhouses like UBS barely lowered their 2008 growth forecast for Japan in late January down to 1.2%, their forecast is likely to prove overly optimistic. Even in late January, Morgan Stanley's respective forecast is 1.1%. IMF's forecast is 1.5%. So far, only Goldman Sacs has suggested that there is a probability that the Japanese economy may have slipped into a recession at the beginning of 2008. I believe that the Japanese economy will surprise on the downside with a recession during 2008 that may likely extend into 2009.

The Big Picture – the Japanese Macroeconomy

Investors should not lose sight of Japan's big picture. The boom is characterized by a wild real estate and stock market bubble during the roaring 1980s. The peak was in 1990. The bust has been going on for 17 years now, and still counting. It was interrupted a few times with anemic growth driven by the government's attempt to reflate the economy. Each short recovery triggered a wave of optimism that the Japanese malaise is over and the stock market rallied. 

As a result of this protracted macroeconomic malaise, the Nikkei is in a 17 year secular bear market that was interrupted by a few short-lived cyclical bull markets. Each bull market gave way to the bear as the economy slipped again into recession. Each bear drove the market to lower lows. For the last 17 years, the Nikkei rode down the proverbial “slope of hope”.

The Nikkei is once again in bear mode. Since mid July 2007, the Nikkei traded above 18,000. Only 6 months later, in late January 2008, it traded below 13,000. The anemic rally in February has fizzled, so that by March 7th, the index is trading once again below 13,000. That is a sustained drop of about 30% - a bear market by any meaningful definition. Confirming the bear, the index is trading below its 200-day and 50-day moving averages, and both are in sustained downtrends. Cleary, the bear is telling us that the economy is once again on its way to recession.

An Austrian analysis of the big picture suggests that the Japanese economy never really recovered from its 1990 post-bubble hangover. In order for the economy to be fully recovered from the 1980s bubble binge, previous malinvestments of the boom must be liquidated. This readjustment is necessary to cleanse the system, to shift scarce resources back to their most productive uses, and to realign capital prices to consumer prices.

This means that a number of conditions must be properly satisfied to declare the bust over.

• Condition 1. Bad loans made during the boom years must be written off as losses during the bust. This cleanses the banking system from the toxins of the boom. 
• Condition 2. Weak businesses should be liquidated during the bust, rather than propped up by the government or the banks. These bankruptcies and liquidations shift scarce resources to more productive uses 
• Condition 3. Finally, Interest rates must rise sufficiently to restore proper valuations in the capital markets, and therefore allow stocks and bonds to fall in value relative to consumer goods. This realigns properly the price ratio of capital goods to consumer goods.

In other words, if the economy is to restore its health, it must swallow the bitter medicine. The basic problem with the Japanese economy is that none of these necessary conditions has been satisfied during the last 17 years. It is true that the stock market has fallen substantially during these years, roughly by 70%. It is also true that real estate prices in Japan have fallen by roughly the same amount. Notwithstanding these significant market corrections, the Bank of Japan has kept interest rates on Japanese Government Bonds artificially low in the 1-2% range over many years. This guarantees that when interest rates eventually normalize, stocks and bonds must necessarily fall a lot more. It is true that nominal interest rates may not rise for many years, but it is mathematically impossible for nominal rates to go negative. The Bank of Japan cannot hold these artificially low interest rates forever. Sooner or later they must rise; by the law of discounting, bond and stock prices will fall. The point is that the necessary conditions are not well satisfied; so as Freddie Mercury might have put it, “the bust must go on”.

While there may be a possible economic revival in 2009-2010 accompanied by another tradable rally in the Nikkei, in my opinion the long-term investor should stay out of the Japanese stock and bond markets. 

The Yen Carry Trade

Nevertheless, investors should pay constantly special attention to the Japanese Yen. The Yen carry trade remains The Big Unknown . Japanese and foreigners alike have borrowed in Yen at artificially low interest rates, have sold the yen, and have bought higher-yielding non-Yen-denominated assets to exploit the interest-rate differential. This effectively creates a (synthetic) short position in the Yen that pushes its exchange rate artificially lower. 

While estimates of the size of the Yen carry trade vary from $500 billion to $1 trillion, it is obvious and undisputed that its size is huge relative to Japan's GDP or money supply. Just like the rise of Yen interest rates is certain, so is the unwinding of the Yen carry trade. The accumulated Yen carry trade positions artificially devalue the Yen; the unwinding of the Yen carry trade will restore its value to a higher, more market-driven value. 
Unfortunately, the timing of rising interest rates and the timing of unwinding of the Yen carry trade is uncertain. Interest rates are effectively controlled by the Japanese government. The carry trade is encouraged or discouraged via policy. To a great extent, both are determined not by market forces, but by the will of policy makers.

The Japanese Yen has the potential to rise dramatically. Three factors determine the fundamental strength of the Japanese Yen:

• High savings rate . This accelerates the accumulation of capital and the productivity of the economy. 
• Sustained current account surpluses . This increases the accumulation of foreign assets. This in turn creates a built-in demand for Yen when these foreign assets are eventually sold and converted back to Yen. 
• Unwinding of the Yen carry trade . The is the most powerful factor. It provides a built-in demand for Yen when the carry trade is no longer profitable or tenable.

The unwinding of the Yen carry trade will result in a rush of trillions of Yen back into the Japanese economy. Given that these Yen are borrowed, most of then will be used to pay back debt; some will end up in the stock market and little will end up in the bond market. Thus, the unwinding of the carry trade has the potential to drive a powerful rally in the stock market, although this is far from sure. 

Indeed, we should be very careful about concluding that the unwinding carry trade will drive higher the stock market. They Yen put in a cyclical bottom in June 2007, and has been steadily rising since. Some unwinding of the carry trade is already evident. At the same time, the Nikkei has put in a cyclical top and has been steadily falling since. In other words, a strengthening Yen through partial unwinding of the carry trade over the last eight months has actually coincided with a falling stock market. 

For the moment, unwinding of the carry trade has had negative implications for the stock market, so one must be very careful in drawing conclusions. Moreover, one can make a good argument that the unwinding of the carry trade will drive the stock market lower, not higher. For example, the nature of the unwinding process is that of deleveraging, which in turn implies trouble for both foreign and domestic markets.

Summary and Investment Advice

To summarize my expectations about the Japanese economy in 2008, the macroeconomy and the stock market should perform poorly, while the Yen has a strong potential to rise. The long-term strategic investor should stay out of the Japanese stock and bond markets. However, I recommend speculating on a rising Yen, preferably with LEAPS or other instruments that limit losses from potential government intervention in the currency markets. 

Krassimir Petrov ( Krassimir_Petrov@hotmail.com ) has received his Ph. D. in economics from the Ohio State University and currently teaches Macroeconomics, International Finance, and Econometrics at the American University in Bulgaria. He is looking for a career in Dubai or the U. A. E.

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