Japan may be the world’s biggest surprise in 2018
Japan had a stellar 2017. But could the world’s third biggest economy be a source of global chaos in the year ahead?
Looking at investment-surprise lists for 2018, it’s intriguing to see how many have Japan serving up negative shocks. One of the most closely-watched annual what-could-go-wrong lists comes from Danish-based Saxo Bank. Its analysts predict 2018 as the year the Bank of Japan (BoJ) finally loses control of its monetary policy. “As inflation rises,” they write, “yields, too, will spike, and the result will be a fantastical plunge in the yen. Ultimately, Saxo says, the central bank may resort to fresh quantitative easing-style measures, but not before the yen hits 150 to the US dollar (from 113 now).
Long-time Japanophile Jesper Koll of WisdomTree also predicts the yen plummeting to 150 as monetary policy cycles in Tokyo and Washington diverge. After all, BoJ governor Haruhiko Kuroda has dismissed talk of an exit from the crisis-mode easing of recent years. Odds are, the central bank will ease again before it throttles back on stimulus.
The real circuit breaker that should worry markets, Koll explains, is China. “Japan and China now compete head-to-head in many markets, including high-tech and bullet trains; so yen depreciation is now more of a worry for China’s factories than for US ones,” Koll writes. “The weaker the yen gets, the greater the risks of a Chinese yuan devaluation. When the yen slips past Y140/$, I fear a 30% Chinese yuan devaluation more so than a potential backlash from the US.”
A Donald Trump backlash would be no small thing, of course. The US leader is already miffed that Japanese Prime Minister Shinzo Abe, his closest ally, voted for a United Nations rebuke of Trump recognizing Jerusalem as Israel’s capital. A sudden yen drop that imperils exports would surely set Trump off. “The risk of increased US protectionism and trade retaliation still exists,” says Ken Maeda of Schroders in Tokyo. This could easily return to the political agenda if the US administration continues to struggle to deliver on other elements of its growth strategy.”
Japan faces two other vulnerabilities: bubbles in bond and stock markets. Tokyo is at the centre of an unprecedented asset build-up on the part of central banks. From 2008 to 2017, the assets amassed by the US, euro zone and Japan swelled by $8.3 trillion, according to the Bank for International Settlements. That, estimates Yale University’s Stephen Roach, has “distorted asset prices around the world”. With nominal gross domestic product (GDP) in those three regions increasing by just over $2.1 trillion, the remaining $6.2 trillion of excess liquidity also has fed epic complacency on the part of governments.
Take Japan, where the 10-year government bonds yield is just 0.05%. That’s irrationally low, considering Japan has the biggest debt burden in the developed world and one of the fastest-aging populations and lowest birthrate anywhere—and the same credit rating as Bermuda and Slovenia. Deflationary pressures offer a modest explanation, but Japan’s debt market is one of the globe’s most obvious asset imbalances.
The BoJ’s government debt holdings topped 40% earlier this year, threatening the smooth functioning of the market. Its role in equities also is raising red flags. As of the end of June, the central bank owned roughly 71% of all shares in Japan-listed exchange-traded funds. The Nikkei Stock Average’s 129% surge on Abe’s watch isn’t all BoJ buying. Some of the rally is indeed based on rising corporate profits. Yet the recent parade of quality-control scandals at Kobe Steel Ltd, Mitsubishi Materials Corp., Nissan Motor Co. Ltd and others belie the argument that the Nikkei is riding high on improving corporate governance.
At some point, BoJ will lose control of history’s biggest quantitative easing (QE) experiment. The more it thrusts its tentacles into new asset classes, the more susceptible Japan’s economic pillars become to froth. Might 2018 be that year? That’s anyone’s guess, but the variance of Japan predictions suggests a uniquely uncertain year for North Asia, South-East Asia and South Asia.
While many think BoJ will be biased toward easing, others, including economists at Pictet Group in Geneva, expect surprises in Japan ranging from inflation to a geopolitical flare-up with China over disputed islands.
Not so fast, say strategists of BlackRock Inc. in New York. Spare capacity in Japan is their chief concern—and why they expect BoJ to “keep policy loose”. Sure, the synchronized nature of the global recovery is benefiting Japan. But as Abenomics enters its sixth year, growth is being driven by duelling bubbles in bonds and stocks. The former ignores a collision between demographics and debt. The latter ignores that household wages have barely budged on Abe’s watch. Markets, it follows, are racing ahead of improvements in the real economy.
Whether things end badly for Japan and/or China in 2018 is highly debatable. What’s not is that Asia’s two superpowers are heading into a uniquely uncertain year.
William Pesek, based in Tokyo, is a former columnist for Barron’s and Bloomberg and author of Japanization: What the World Can Learn from Japan’s Lost Decades.
His Twitter handle is @williampesek
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