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The bug waiting to be squashed

Low immigration rates, high sovereign debt, imminent US rate rises and declining exports could write an obituary of the Japanese economy

The bug waiting to be squashed

Japan is often described as a bug on a car windshield, waiting to be quashed by the wipers. The point is that such an ill-fated bug is pressed down by the winds flowing around a fast-moving car, forcing the bug to do exactly what is not in the interest of its own survival, i.e., stay on the windshield, where the wipers will squash it.

Japan is forced down on this suicidal windshield by multiple forces. One, its homogeneous culture, the strength of its TQM-oriented companies, can only survive if it remains an insular society. This prevents Japan from assimilating immigrants. Its language and culture are complex and nuanced, making it very difficult for outsiders to integrate into the Japanese society. This is a strength when you want mass obedience, even co-ordinated innovation (explaining Japan's leadership in artificial intelligence and robotics, for example) but is a weakness when you are looking for individual innovation and diversity of thought. The biggest consequence of this has been that an ageing society is unable to shore up its demographics with immigration.

Economically, this means that Japan is unable to reduce its rising dependency ratio, the number of non-working adults that are dependent on its working population. Some 35 per cent of Japanese are now above 65 years of age.

Japan is weighed down by a bankrupt government that is paying for its past sins. The highways to Hokkaido, where nobody lives any more, have been funded with public debt. So also the huge bank bailouts in the early 90s, leaving behind zombie banks with evergeen debt held by the government in turn financed by the savings of the ever-parsimonious Mrs Watanabe. Government expenditure accounts for 42 per cent of the GDP. The government also holds about 223 per cent of GDP as debt, not counting private debt. In a slow economy with hardly any growth, the government runs a fiscal deficit of 6-7 per cent, with no room for any revenue buoyancy.

Now in this no-hope situation comes a sudden game-changer. The clearance of the glide path towards higher/normal interest rates in the US is going to impact the global NIRP (negative interest rate policy) virus that is now infecting some 30 per cent of global bonds. With the US clearly in a normal territory, no NIRP country can come into the normal world to borrow to fund its fiscal deficits. Japan is caught with its guns in its pocket, while its hands are cut off; hence, the metaphor of the bug on the windshield, waiting for the wipers to squash it.

There are only two communities in Japan that are positive economic players. One, its famed private, corporate, exporting sector and the other is Mrs Watanabe, its famous, hard-working, saving grandmother, who holds the world's largest stock of unproductive (now negative-yielding) assets. And the same country, perhaps logically, has the world's most bankrupt functioning government (not counting Zimbabwe/Venezuela as functional governments) and its most uncompetitive domestic sector, mainly non-tradeable services. The complex interplay of this set-up is now coming to its logical conclusion.

The steady weakening of its export competitiveness, thanks to (the political impact of) its large trading surpluses has caught the attention of its major trading partners. This is going to put a cap on Japan's ability to export away its woes. It needs a domestic market, which it does not and cannot have, thanks to its ageing population. And the inability of its government to either increase revenues in a slowing economy or to reduce expenditure (for the same reason) is leaving it a sitting duck, waiting for the day its savings turns negative. This is inevitable, given the ageing Mrs Watanabe.

On that day, the government must monetise its debt -service obligations because there will be no foreign money, at least at negative interest rates. And nobody is going to be lending money to a government running deficits at 10 per cent of GDP. So the only option is to print the yen to oblivion.
How does an investor play it? There are two components to the risk: the risk of yen appreciation (against the dollar) and the risk of rupee depreciation (which comes in regular episodes). The former happens when there are global cycles of risk aversion, when one of the big under-currents is that the world's largest creditor country pulls back money into Japan from its various overseas investments. This is usually a retail rush. With Mrs Watanabe clutching at her purse strings, it's really a withdrawal from the higher-yielding overseas-invested funds in Japan, and a rush back into the zero-yield Japanese government bonds. And second is the reversal of the classic emerging-market trade, the best example of which was the 'taper tantrum, which saw India among the Fragile Five and the rupee crashed over 30 per cent.

Looking forward, the cycles of global risk aversion can be anticipated by tracking the CBoE VIX, the DXY and its second-biggest (and most volatile) component, the dollar-yen exchange rate. And the cycles of rupee depreciation follow very predictably the kind of rupee appreciation that we are seeing just now. The latter is easy to study: you will find a spike in the current account deficit, an undisciplined increase in 'bad' imports like gold/electronics from China - basically the overvalued rupee frittered away in conspicuous consumption. Obviously, the two can happen together or against each other, which you should mathematically work out to get the pace and aggression that you will use to trade the yen-rupee pair.

Like just now, there are twin irrationalities that are cancelling themselves out. While interest rates in the US are clearly rising, Japan's simply cannot rise. The yen has appreciated against the dollar as money gets pulled back into Japan by the crazy Mrs Watanabe, who is terrified that either Mr Trump or Korea will blow each other up in their neighbourhood and at least break their windows if not burn their house. Remember, Japan has vivid memories of the only two bombs ever dropped.
The discontinuous uptick in Indian productivity isn't going to happen. The first effect of this serious rupee appreciation is that imports took a structural uptick of 46 per cent and half the increase in the current account deficit is taken up by gold and Chinese electronics. And this, mind you, in a month of seasonal uptick in exports, being March.

So the only real threat to funding all your borrowings from the yen is that you have to look out to trade down the periodic bursts of terror and the much more predictable bouts of rupee depreciation, which follow the import binges that follow rupee overvaluation. In return for managing this risk, you get a clear, sustainable and perpetual carry of more than 6 per cent plus a huge one-time jackpot when the Japanese government is officially bankrupt. This will happen the day Japanese savings are not sufficient to finance its gigantic deficit. The horse is strong and can carry the weight of the world's most profligate government, but how long can it carry the ever-rising burden of the biggest proportion of old people in the world? One day, the horse will collapse; it's a question of when, not whether.
And you can expect a bumper return from 2 incipient but definitive long-term trends. One, the slow, inexorable (relative) appreciation of the Indian rupee based on the steady increase in Indian productivity, and the steady flows into India as it becomes the growth centre of the world. Two, the steady (relative) decline of Japan, as its savings surpluses reverse and its government monetises its debt to infinity. One day, the yen will drop off a cliff when the world realises that the Japanese government will never be able to service its debt and is really a Greek government hidden inside the world's biggest creditor nation.