Japan is aiming to further weaken its currency and help its biggest companies sell more goods abroad.
The Asian nation, by doing so, is exporting its problems, threatening a trade war that likely would turn ugly and claim financial victims across the world.
Shinzo Abe, who was elected prime minister in December, is frustrated by an economy that has grown an average of only 0.9 percent a quarter in the past 20 years and a stock market whose value is one-third of its peak in 1989. He said six months ago that he will “implement bold monetary policy, flexible fiscal policy and a growth strategy that encourages private investment.”
Add to Japan’s woes high debt (the equivalent of $9.8 trillion), a wave of retirees (the official retirement age is 60) and a shrinking population (one of the lowest birth rates, at 1.4 babies per woman), and you can see that Abe is in an almost no-win situation.
That’s why weakening the Japanese yen might be the country’s only recourse. By lowering the currency against the dollar and the euro, exporters such as Sony and Toyota bring home more profits and bolster the economy.
|Weakening the yen might be Japan’s only recourse. But at whose expense?|
But here’s what it does to the rest of the world: It forces other countries, as a defensive measure, to follow suit. Investing expert John Mauldin says Japan has “fired the first shot in what will be the first real currency war of our lives. There is no historical analogy (of this magnitude).”
Berkeley economics professor Christina Romer, former chair of the president’s Council of Economic Advisors, says: “This is the most serious and radical economic experiment undertaken in my lifetime by a major economic power.”
The Damage Has Already Started
The trade-weighted yen is already down 20 percent from its peak, and has tumbled 33 percent against the dollar. Still, inflation, which usually signals a growing economy, has barely budged. One study concluded that to sustain inflation of 2 percent, the trade-weighted currency would have to decline 15 percent to 20 percent a year for the next five years.
A painful truth for Japan is that the size of its economy recently was surpassed by China, which now ranks behind only the U.S. (China is projected to have more millionaire households than Japan by the end of 2013, according to Boston Consulting Group.) Despite economic stagnation, Japan remains a powerful export engine, and a lower yen is an easy way to generate growth.
A drop of one yen against the dollar produces a $2.7 billion profit increase for the 30 largest Japanese exporters, Japan’s Nikkei newspaper reported. Based on a 25-yen decline in the exchange rate, those companies gain an extra $67 billion.
But the crucial question is: At whose expense? Why, the rest of the world’s. First, other Asian countries, especially South Korea and China. And then Germany and the U.S.
What if the yen falls for the next four years? No one has answered that. But that’s the key concern of our time — not the end of the Federal Reserve’s bond-buying program, not Europe’s fiscal woes and not China’s cooling economy.
Here’s How This Might Play Out …
First, Japan has discovered that it has little wiggle room. Japanese government bond yields rose 50 basis points two weeks ago, leading to a one-day decline of 7 percent in the Japanese stock market. Investors sent a message: The country’s massive debt is unsustainable with a rise in carrying costs. If government bond interest rates rise by 2 percent, the government would be spending almost 80 percent of its revenue to service its debt.
So, as in the U.S., Japanese yields must be held down through direct central bank purchases. That would further stimulate the Japanese stock market as “QE forever” has done in the U.S.
Second, other countries might respond with their own attempts at currency manipulation. It has already begun with South Korea. Europe would be put to the test. Would Germany relent and permit the European Central Bank to launch its own program of asset purchases?
Third, if Germany does take part, all the big players would be doing the same thing: Pushing their monetary pedals to the floor. Then what? That would be the moment of inflation or deflation truth — perhaps one followed by the other. That would likely mark the peak in this global equity cycle.
There would seem to be three investment stages to this end-game scenario
The first stage, the one we’re in today, favors paper financial assets, namely stocks, that benefit from deflation imposed by central banks.
The second stage, which would occur when all major central banks coordinate their aggressive monetary policy via bond purchases, could usher in an asset-driven inflation cycle. At that time, investors would want to hold hard assets (income-producing real estate and gold, and, depending on supply and demand, oil and natural resources); and shares of the highest-quality global companies that control their own destiny.
The third, and final, stage begins when interest rates begin to rise as central banks defend currencies against money flows, possibly combined with capital controls. Bonds and stocks would collapse, with only cash offering the best combination of stability and increasing relative value — that is, the opportunity to buy risk assets out of the rubble.
History shows that it’s difficult to preserve wealth in financial assets, as values are eroded by inflation, depression or war. Get ready because, coming soon, you could be hurt or helped by central banks’ attempts to prop up their economies. Japan has already set things in motion.
In the short run, I recommend you review your personal situation — because this isn’t a one-size-fits-all market environment — and if you can assume some risk, you should remain fully invested in high-quality stocks. The first stage, which favors paper financial assets, should continue for at least the next several months.
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