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We Are All Japanese Now

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Published in the Financial Times 14/10/2014

When cyber-punk novelist William Gibson declared at the turn of the century that “Japan is still the future,” he probably wasn’t thinking of bond yields. Yet the recent action in world bond markets gives clear warning that the global economy risks following Japan’s 1990s path to stagnation and financial turbulence.

Back then Japan’s super-low interest rates were a unique phenomenon that observers struggled to rationalize. Was it some twisted form of patriotism that led Japanese investors to plough money into government bonds yielding below 4%, 3%, 2% then finally 1%, even as public debt grew to Godzilla-esque proportions? Surely it was only a matter of time before the Japanese bond market imploded and yields soared.

Such beliefs were common not just amongst hedge funds and ratings agencies, but in Japan itself, where ex-bond trader Main Kouda’s novel of financial apocalypse “Japanese Bonds” became a huge best-seller in 2001.

What happened subsequently is the reverse of Ms. Kouda’s scenario. The rest of the world has converged with Japan. Today 10 year bond yields are 0.4% in Switzerland, 0.9% in Germany, 1.0% in Holland and 1.2% in France. Outside the troubled Eurozone, the picture is not much different. The UK and the US are currently the best performing developed economies, but bond yields remain close to multi-century lows at 2.2% and 2.3% respectively. What was once a single market anomaly has become standard.

A few years ago it seemed that Asia’s growth momentum might steer it clear of the deflationary sludge in which the developed world was mired. If the bond markets are any guide, such optimism is no longer warranted. Bond yields are below 3% in Singapore and South Korea and below 2% in Hong Kong and Taiwan. Local currency bonds issued by Thailand, the epicentre of the 1997-8 Asian crisis, yield just 3.3%.

Bonds are pricey by modern standards, but less so in comparison with the deflationary nineteenth century. If there is a bubble anywhere, it is not in government bonds, but biotech stocks, Asian internet IPOs, prime property in London and New York, contemporary art and other collectables. As in Japan since the mid-1990s, declining bond yields have a fundamental explanation – declining growth in nominal GDP almost everywhere.

In Europe consumer prices are already falling not just in Eurozone countries like Belgium, Spain and Italy, but in Sweden and Poland too. This year the UK is expected to grow at 3.5%, the fastest amongst the developed countries, yet the Bank of England recently halved its forecast of wage growth to 1.25% and the current rate is a mere 0.7%. As Societe Generale strategist Albert Edwards points out, US inflationary expectations have declined precipitously since the summer even as the Federal Reserve plots its exit from quantitative easing. Meanwhile the Chinese economy, generator of 40% of world growth between 2008 and 2011, appears to be slowing dramatically and producer prices have been in negative territory for several years.

What has brought us to this unhappy juncture? Factors often cited include globalization, increasing inequality and long-cycle debt dynamics. All are plausible and may have some contributory effect. The new economy itself appears to have a deflationary influence as it destroys intermediaries such as bookshops and concentrates wealth in a limited number of hands. Google has a market capitalization of $380 billion and a workforce of 40,000. Toyota, the world’s most efficient auto manufacturer, is worth $32 billion and employs 340,000 people.

Even so it is worth recalling that the Japan that slid into deflation in the 1990s was not particularly globalized, had a relatively egalitarian distribution of wealth and negligible exposure to internet commerce. As for debt dynamics, on an overall macro basis deleveraging never happened, indeed cannot happen when nominal growth flat-lines.

The paramount factor was the knock-on effect of an unprecedented asset market collapse and consequent financial crisis. Bad policy-making spawned a feedback loop between the asset markets and the real economy that continued for the best part of twenty years. Specifically the Japanese authorities were too slow to clean up the banking system, too cautious in using monetary policy and too scared of Miss Kouda’s fictional bond blow-up to use fiscal policy creatively. Sadly, this last tendency remains. The Abe administration hiked the consumption tax by 3% this spring, thereby delaying the reflationary process by at least a year.

Despite this setback, Japan is one of the few developed countries that is not turning Japanese. Inflationary expectations have risen amongst investors, consumers and businessmen. Job growth has been strong and companies are poised to invest. Denso, one of Japan’s largest auto parts companies, has announced a capacity increase at its domestic plants, thus reversing the industry’s long-established off-shoring trend. Another sign of the super-competitiveness of the yen is Chinese PC maker Lenovo’s plan to shift production at its joint venture with NEC from China to Japan.

The message of the bond markets is clear. There is not a whiff of inflationary risk and governments have the most favourable borrowing terms imaginable for funding targeted tax cuts, infrastructure projects, whatever it takes to prove Mr. Gibson wrong.