Japan: Business Cycle Disappears

Japan's politicians and the Bank of Japan appear unable or unwilling to get a grip on their economic problems despite Prime Minister Shinzo Abe’s vaunted quiver of economic arrows, the most potent of which – restructuring – remains sheathed.

In effect, the country has broken its Economic Clock®, with crazy investment implications. A broken clock tells the time twice a day. Policy is characterized by an excess supply of money and an excess supply of goods – a condition in place for many moons already.

Japan’s politicians have refused structurally to reform the economy, to put some power behind Abe's third arrow. We see this clearly in the continuation of Japan's closed labor and goods markets, not to forget the enormous power exercised by Japan's farmers, lack of immigration, lack of openness to foreign direct investment and that crucial reform: to allow failed business actually to fail. Thus, Japan simply no longer has a business cycle at all.

The Financial Times in early February reported that the Bank of Japan “now combines negative shorter-term interest rates with annual asset purchases of ¥80 trillion (US$670 billion), equivalent to 16 percent of gross domestic product, driving down interest rates across the yield curve. A lack of demand from borrowers means it has not stimulated much growth in credit, however."

So there is no business cycle! Nevertheless, BoJ Governor Haruhiko Kuroda doggedly insists that there is no limit to monetary easing "...as he vowed to slash interest rates deeper into negative territory if necessary."

This reminds one of ECB chief Draghi;'s "whatever it takes" comment. How does Haruhiko Draghi sound to you?

There have been two policy errors: the focus on inflation and the attempt to generate inflation via negative interest rates. The focus on inflation has been misguided. The business cycle works only if the economy is firing on all pistons, e.g. on demand-pull inflation ("inflation") and competition, to name two crucial ones.

Thus, without structural reform, inflation cannot return. If structural reforms allow for inflation, then the lack of reforms disallows inflation. It is logical. We just now have asserted that Japan's politicians are disallowing structural reforms, thereby killing Japan's inflation and thus business cycle. So why focus on inflation at all, when structural reforms should be the focus?

Neither can negative interest rates work. All of us know that the BoJ introduced -0.1 percent (by a slim majority of 5 to 4 on Jan . 29 on banks' new excess reserves held at the central bank. This was hard on the heels of Switzerland's -0.75 percent, Sweden's -1.1 percent, Denmark's and the Eurozone's introductions of negative rates. Indeed, on Feb. 9, Japan's 10-year government bond "yielded" -0.05 percent. Negative rates have been introduced in order to stimulate trade as well as consumption, cheapen lending and enhance banks' profitability. Can these results possibly be achieved?

Theoretically, negative rates must lead to currency depreciation: after all, why hold the yen if you are paying for the honor? In practice, the yen (along with the Swiss franc) have risen in value.

As Jamie Chisolm pens in the FT's Trading Post of Feb. 10: "The BoJ is likely to be most put out that the currency is stronger than it was at the time when the central bank surprised the market with a negative deposit rate."

Theoretically, a cheaper exchange rate is meant to stimulate exports. In practice, this does not work on a macro scale for highly-developed economics (see my more recent e-book, Trade Myths, for more).

Theoretically, a cheaper exchange rate is meant to result in "imported inflation". In practice, this is not working: Japan's excess supply of goods means that her importers cannot pass higher purchasing costs on to the end-consumer.

Theoretically, if the proverbial Mrs. Watanabe is not getting anything on her bank deposits, she will blow the money on shopping, on private consumption. In practice, private consumption already has been dealt that blow of a consumption tax. And another one is on its way. Add to this Mrs. Watanabe's job-insecurity, and you have the perfect brew for NO spending by her.

Instead, Mrs. Watanabe wants to patch-up her tawdry household balance sheet. Thus, don't expect negative interest rates to propel consumption; instead, Japan's family treasurers, her women, want to redress their own tattered balance sheets on account of old age.

Cheaper Lending

In a truly competitive market, lower funding costs should lead to lower borrowing costs, which should lead to increased loan demand. This theory errs as follows: Lower funding costs are not passed-on fully to the borrower. More importantly, however: with Japan's excess supply of money, companies are by definition cash-rich. So why need they borrow? This means that should lower borrowing costs happen, they cannot stimulate demand for loans.

Negative short-term rates mean that Japan's yield curve steepens: if the bank borrows at the short end of the curve and lends at the long end of the curve, its profits - theoretically - must rise. In practice, however, nobody except the true wretches want to borrow, so out goes the turnover, obviating any effects of "margin improvement".

Investment Advice

Average dollar costs into Japan over the next six months. Crazy as this advice sounds, any "excess supply of money" has to go into asset markets, and Japan's stock market is relatively speaking the most accessible and attractive one around, especially after recent market plunges, which have cheapened stocks. However, within this, be selective of course: avoid banks (see above), instead opting for high dividend yielders such as utilities.

Enzio Von Pfeil is a Hong Kong-based independent financial advisor who blogs at Private Capital Ltd.