How have China's policies affected Japan, and what to they mean for the U.S.?
The recently-released Tankan survey is consistent with the negative trends in Japan noted in yesterday's post.
Though the manufacturing sector index rose from +1 to +8, the forward looking measures deteriorated. Capital spending intentions of large corporations were +2.4%, down from +4.4% in the prior quarterly Tankan. The message is somewhat more negative because the September survey tends to seasonally show slightly higher capital spending intentions versus the June survey. More importantly, manufacturing optimism went from +3 in the June survey to -1 in the September survey.
The odds are that Japan may already be rolling into recession. Consumption has been buoyed by spending incentives; they expire this month. The Kan government is preparing a new round of such incentives, but the experience of other economies shows that a second round of such incentives has much less impact.
Most ominous is the trend in exports. Exports have led the Japanese economy over the last decade or so. It was almost a 50% decline in exports that took Japanese GDP down by a huge 8.9% from peak to trough in this latest recession. The rise in exports has accounted for 80% of the recovery since that trough which still has GDP 4.2% below the prior cyclical peak. The export data now shows a possibly significant outright downturn in exports already. This is striking because the world economy had still been recovering fairly strongly and Asia, led by 10% economic growth in China was still growing robustly.
Worse yet, the deterioration we are now seeing in Japanese exports do not reflect the strength in the yen this year. THE LAGS IN TRADE ARE LONG. The threat to Japan from the rising yen is that Japanese corporations are forced by the strong yen to move their production platforms to lower cost economies and thereby hollow out Japan. It takes a long time to make these business investment decisions and act on them. To the extent that "hollowing out" is now hurting Japanese exports, it reflects 95 to 100 yen to the dollar and not 83 yen to the dollar. A further adverse impact on Japanese exports and industrial production from recent yen strength could be huge. Already exports are weak and industrial production is rolling over even though Japanese firms report they can live with 95 yen to the dollar. The majority of Japanese industrial firms say they cannot live with 85 yen to the dollar. The deterioration in Japanese exports and industrial production we are seeing now could be much worse, all other things being equal, if the yen stays above 85 to the dollar.
Worse yet, the new China mega-investment boom is ongoing. Only the shortest lead time projects are in production, which are now competing with Japan. But, there is a huge surge in new Chinese production ahead which will compete with and substitute for Japanese exports. Exchange rate considerations aside, the secular trend whereby emerging Asia and especially China are competitively advancing on Japan will undermine Japan's exports and industrial production in the near to intermediate future.
This deterioration is all happening in an overall still-strong global economy. What will happen to Japan if there is considerable global weakness ahead and the yen remains strong? The odds are that Japan will have another severe recession.
Japan truly appears to be the canary in the coal mine in regard to China's overinvestment which, coupled with yen strength, is hollowing out the former. We now have the spectacle of half of all Japanese industrial corporations saying they will have to move their production platforms out of Japan to low cost economies at 85 yen, and yet we see commentaries from Bloomberg's William Pesek "How I Learned to Stop Worrying and Love the Yen", suggesting that an even stronger yen "can be a magnet for the foreign investment that tends to avoid Japan."
It was recently reported that the Band of Japan bought 2.12 trillion yen between August 28 and September 28. Apparently the BOJ continues to drag its feet. We have a market place that expects Helicopter Ben to engage in mega QE and believes a stubborn BOJ will resist intervening in the yen no matter how weak the Japanese economy has been and may be. This brilliant "expectations management" on the part of the BOJ now risks sending Japan into yet another recession while the rest of the world's economy is still growing. And China's ongoing purchases of yen bonds is both irresponsible and exacerbating this trend. This is the type of provocative behavior that could lead to real wars, let alone trade wars.
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The market with the biggest underexposure with the most bearish sentiment attached to it is the Japanese equity market. Eight months ago short the yen was the favorite macro trade of UBS and Goldman which means that all the macro funds were in that trade. Today, there is no bandwagon of yen bulls. So what explains yen strength? There is no manifestation of buying of yen in the balance of payments. Instead you see capital outflows. So who is taking the other side in the short term capital flow account? Have the "quant traders" taken over the market to such an extent that there is some obvious correlation their computers have all picked up and that is the nature of the buying? Or is there something of a more historical nature now enveloping this market?
Consider the recent fishing dispute between Japan and China: it is part of a longstanding rivalry between the two countries, predicated on a century of ill will. Perhaps the Chinese are buying far more yen than they have shown in their accounts. They only show the cash positions, not the forward positions. Could it be that they are buying huge quantities of yen in the forward market, which are then arbed to the short term capital account? The motive here would not just be to price a competitor out of the market, but to settle grievances from the Second World War, such as the Rape of Nanking. Most countries tend to bury these longstanding historical grievances in their diplomacy, but this fishing boat incident and Beijing's handling of it has to at least leave one with the impression that this newly emergent economy, now ranked number 2 in the world, is in a position to get revenge for the past. The best means of avenging the nation for historical slights and grievance, and making oneself the dominant power in Asia (whilst mitigating the influence of the US through its levers on Japan) is very simple: just buy yen and force the Japanese corporations to hollow out Japan.
Could this be the source of the mysterious strength of the yen? If so, then we have the makings of a real renegade nation on our hands. It is apparent that the post-bubble trauma in Japan has become so great that the body politic in Japan is near a breaking point. It appears to be only a matter of time before the Kan government, forced by the political tides, will simply steamroll the Bank of Japan and try to match the QE zeal of Helicopter Ben. However, if it does not act soon on a scale advocated by Ben Bernanke, Japan may already enter recession before the global economy approaches a double dip, and it may wind up with an economic and fiscal deficit and fiscal debt disaster if one or more major economies like the U.S. or Europe go into a double dip, even if it is a mild one.
More to the point, is Japan the lead indicator as to why could happen to the rest of the world, as a resurgent China continues on its current mercantilist course? The west coast port data for the US on outbound containers (exports) and inbound containers (imports) points to significant ongoing trade deterioration in the US in the months ahead. Because the second quarter reported U.S. trade deterioration was so great, it may have undershot a declining trend, so such trade deterioration may not surface in the next trade report. But it is there. Fiscal support to offset the declines in trade is non-existent (and likely to remain so given the likely future political configuration in Congress). We have gone from a very rapid pace of expansion in exports on a sequential and year on year basis to small declines in exports on a year on year basis and more severe declines on a sequential basis.
Why is U.S. trade deteriorating? In part because the rest of the world might be slowing. However, the more significant cause may well be China's over investment in industrial tradeables and consequent pressures for greater Chinese exports and a greater degree of Chinese import substitution. In that regard, Japan is proving to be the lead indicator.
There is a curiously perverse but symbiotic relationship that exists between China's mercantilists and America's finance capitalism. The whole "Bretton Woods II" process contributes to the financialization of our economy, as it continues to hollow out our manufacturing base. It represents an unholy alliance between Wall Street and China's military, which is driving much of the investment in China because they are reaping so many material benefits. The problem, however, is that at some point Chinese credit expansion has no place to put its money. All of the targets have been saturated, which means that there will be overinvestment in all industries and to an incredible degree. This may well kill industry after industry. It appears to be happening already in Japan.
How can there be an encore? To avoid recession you have to keep the investment ratio up. But capex as a percentage of GDP in China is already off the charts - it is in excess of 50% of GDP. So the Chinese can build an additional round of capacity, which may be equal to ten times annual demand by next year, and fifteen times by the year after, in Of course, this process has its limits. When the ratio is this high it is very hard to keep it this high. There is a tendency for it to fall and it will fall faster if there is a trade war. But if it falls there will be a recession in China, so perhaps China is far more recession prone than anyone thinks. It may ultimately be recreating Japanese-like bubble conditions in its own country.
And what does this mean for Japan, which is the canary in the coal mine? With this kind of investment going on in China, the Japanese firms haven't a chance to compete with the yen prevailing at this level. And China knows this so it continues to buy Japanese yen bonds, which keeps the currency high and basically destroys its main Asian competitor. It represents the ultimate revenge for Manchukuo and the Rape of Nanking. And this is a development that could move very fast because the excesses of investment in China are currently so great.
As Chris Dialynas and I have pointed out before, there is no question that China's mercantilism is a product of our ham-handed approach to Asia during the 1997/98 crisis, Less appreciated, however, is Beijing's role in creating that crisis via its cumulative 60% devaluation against the dollar from 1992-94. Very few people are looking at the direct impact of China's trade policies and how it is beginning to hollow out other countries' manufacturing bases. It's not just the US. The Japanese economy is now at the cutting edge of this threat.
Can the US be far behind?
Marshall Auerback is a Senior Fellow at the Roosevelt Institute, and a market analyst and commentator.