Deflation? Investors shouldn't worry
Although Japan has long been regarded as the sick man of Asia, a trip to Tokyo finds a city that is efficient, modern, well run and filled with people who show no particular sign of distress despite all of the conventional warning signals.
In fact, Japan is actually arguably the healthy man of Asia, according to a new contrarian report issued by the Hong Kong-based independent financial research firm Asianomics. With most of the world’s economists pointing out that Japan’s years of steady deflation have to be stopped, Asianomics says it’s not a worry.
“Under current policy settings Japan looks to us like one of the safest places on the planet to have your money,” the report says, noting that unlike the continuing quantitative easings in the west, the yen is underpinned by the Bank of Japan’s refusal to print money as fast as other central banks and by the continued existence of a current account surplus.
And, while public debt, which crested at 200 percent of gross domestic product, has terrified investors for years, actually the problem is in the process of being addressed by incremental policy changes that will raise government revenues and cut government spending.
“With these decisions Japan is pushing further into the future any domestic public financing crisis,” according to the report, which was sent to private clients. In particular, the report flies in the face of conventional wisdom in that it points out that Japan is wrongly accused of succumbing to deflation.
“Deflation is the modern world’s ‘immense collective fantasy, the hobgoblin of supposedly great minds. Central bankers, politicians, the media and academics (no Popes as far as we know) denounce and attack this most normal of economic phenomena,” the report notes.
Most conventional analyses single out deflation as a major source of Japan’s growth problems. However, stripping out the effects of aging, Japan’s growth record was solid until the global credit crisis hit in 2007-2008. During the 2000s, per capita growth was at a par with the US and total factor productivity growth was comparatively higher and at similar levels as in Germany.”
In other words, Japan’s growth problems, according to the econometric analysis undertaken by the IMF, can all be explained by its ageing population. Aside from that, Japan’s growth performance in the last decade is actually one of the best in the OECD.
Studies show that deflation in Japan actually has been largely driven by technological progress and productivity, both of which are real income and wealth enhancing. Japan actually has deregulated a wide range of areas during the late 1990s and early 2000s including zoning laws for large retailers, which may have contributed to slashing domestic-foreign price differences by reducing margins and/or improving productivity in the distribution chain.
Although liberalization and deregulation have further boosted productivity and real incomes, mainstream commentators from the IMF to the Bank of Japan to the media and most stockbroking economists, urge the adoption of monetary policies that would negate these highly positive effects of declining prices.
In fact, the report argues: “Everywhere you turn the deflation hysteria results in recommendations that would undermine private sector wealth, reduce real incomes and, potentially, undermine the currency as well as the largest asset holdings of the banking and household sector in Japan, i.e., government bonds.”
When the mainstream talks about ‘deflation’, it specifically refers to falling consumer prices. However, Japan’s deflation over the years has been more associated with falling investment goods’ prices than consumer prices.
It is certainly true that the private sector has not been borrowing over most of the last 20 years. In fact, there has been only one year since 1994 that private non-financial corporations have run a deficit – have borrowed more than their income – and that was in 1997. The private-sector’s balance sheet position has improved dramatically over the last 20-plus years, reflecting post-bubble prudence.
“In fact,” Asianomics says, “it has resulted in such an improvement in Japanese corporate fundamentals that the Japanese equity market boasts some of the best financial health scores in Asia and some of the cheapest valuations.”
To the contention that Japan has been disadvantaged by too-high real interest rates, the report notes, that is another non sequitur from the conventional wisdom.
“Japan’s growth rate and productivity performance are one of the best in the OECD once its demographic change is taken into account. Our own company financials analysis shows that balance sheets and cash flows have rarely been in better shape. Even the corporate earnings track record is stellar for a low growth trajectory economy.”
For most of the last decade Japanese real lending rates have been below those of the United States, the report continues. “Even today, in the easiest money period ever in the history of US monetary policy, Japanese real lending rates are at almost exactly the same levels as US rates. And here is the rub: as a percentage of nominal GDP, since the Bernanke influence of 2002 was exercised, nominal private investment in Japan has been greater than in the US in precisely 10 years out of 10.”
Japan’s investment ratio is higher than in the US – the world’s No. 1 free-market economy – and its private sector has been able to pay down debt despite “deflation” in 17 of the last 20 years. Japan’s average growth rates and average total factor productivity rates, adjusted for population aging, have both been better than in the United States. Most worrying of all, mainstream economists continue to rail against deflation in Japan as if it were the cause of all the country’s problems whereas the conclusions of this report – looking at company finances and the true inflation and real interest rate experience – is that there is very little wrong with the Japanese economy at all. This in an economy where, according to econometric studies, inflation expectations are not negative and where the appreciating exchange rate over the last 30 years has yet to result in a current account deficit.
There is little disagreement that the BoJ’s policies have produced ample liquidity to the domestic financial system. The experience of Japanese banks during the financial crisis was instructive in this respect. Apart from some temporary concerns over the successor banks to two legacy credit banks, no Japanese financial institution suffered from any significant stress.
According to the financial metrics collected for the banking system, the total capital ratio in the system was a healthy 14.1 percent as at end 2011 and the loan: deposit ratio stood at a conservative 70.6 percent.
Where there is disappointment is in the transmission of this liquidity into real economic activity.
“It is our view that the Bank of Japan, when it talks of an ‘inflation’ target, is really using the term as a proxy for ‘economic growth’. It would be delighted to see its efforts result in faster nominal GDP growth in particular. However, it is faced with the same problems as all central banks: it can create the domestic liquidity but it cannot make the private sector horse drink it. This is, in part, the legacy of Japan’s credit bubble. Companies and households have spent years adjusting their balance sheets to the point at which they are comfortable with debt loads.”
Company balance sheets reached a comfortable level was reached some years ago. There is no concerted deleveraging effort going on in corporate Japan at this point but neither is there a desire to gear-up again. The result of this ‘steady state’ is that Japan poses a neither threat nor a convincing solution to global growth problems. But domestically, they’re doing pretty well.
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