Is Japan’s ‘happy depression’ about to turn unhappy?

Jim O'Neill

February 23, 2012

With the new Greek restructuring deal agreed, the question is whether fears about the sovereign debt crisis will abate or will the markets simply start looking elsewhere for other troubled waters?

In this regard, Japan increasingly looks like the real stand out. A variety of famous investors have come to the conclusion over the past two decades that Japan was on the verge of a major sovereign debt crisis, only to retreat quietly after it becomes clear that domestic deflationary pressures and strong domestic bond demand are continuing to keep Japanese bond yields remarkably low.

Japan has somehow managed to creep by with its problems untouched, or as some of us have described it, seemingly enjoying a happy depression. But the fact is that Japan’s outstanding debt to gross domestic product stands at a whopping 230 per cent and makes Greece’s latest 120 per cent by 2020 target seem like a picnic by comparison.

Late last year I repeatedly found myself asking Japanese investors why they were joining the rush to sell 10-year Italian bonds at seven per cent yields when their own 10-year bond yielded one per cent. With the exchange rate against the euro below Y100, shouldn’t they in fact be doing the opposite? Even though Italian yields are now back down to 5.5 per cent and the exchange rate has risen above Y106, it still strikes me as odd that Japanese investors are ignoring such an attractive relative investment.

Some of the investors I spoke to replied that Japan has external surpluses whereas Italy, like the rest of Club Med Europe, has external deficits. They could have said this then, but the argument weakened after Japan reported its first full calendar year trade deficit for decades. Moreover, given high energy prices and the fall in Japan’s industrial competitiveness, such deficits could well persist. It would raise the possibility that Japan’s days as an inveterate current account surplus country are coming to an end.

From a global perspective, this is not a bad thing as it is another sign along of global rebalancing. But it raises the thorny question as to who is going to be the marginal buyer for Japanese bonds?

Unless the yen is going to get much weaker and 10-year yields much higher, it seems exceptionally unlikely that there will be international investors.
So what should Japanese policymakers do to avoid a crisis?

They need to do two things. In the medium term, Japan has to find a creative strategy to deliver a reduction in its long term debt.

It must control public spending better, adapt its tax system, and combine this with a plan to raise its pitiful real growth potential. If the government is not going to encourage mass immigration, it will also need to introduce dramatic service sector reform.

Strong productivity gains are essential if the growth rate is to rise beyond that implied by the country’s weak demographic profile. These issues are not dissimilar to those previously ignored by many of the Club Med countries. Now, forced by the crisis, the likes of Greece and Portugal are finally trying to make reforms.

In the nearer term, Japan simply has to announce a Swiss National Bank-style commitment to halting further yen appreciation. The currency’s strength is compounding Japan’s competitiveness problems as many of its leading multinationals struggle to cope with challenges from overseas rivals. Due to Japan’s persistent low inflation, some models suggests that the yen is close to a reasonable level. Other models that adjust for productivity rates suggest something closer to an exchange rate of Y110 against the dollar and Y130 against the euro would be more sensible. This would put it in a better position to deal with the mounting long term challenges. Without that, it looks as though Japan’s “happy depression of the past 20 years is set to become less happy and more depressed.

The writer is chairman of the asset management division of Goldman Sachs and its former chief economist

Beyond the edge

Whatever happens to Greece, the failings of the euro zone have not been addressed

Feb 18th 2012

BILL HICKS, a comedian, used to joke that there must be a “ledge beyond the edge”. How else could the survival of Keith Richards be explained? What goes for rock stars also appears to go for Greece, which has been on the brink of a second bail-out package for weeks.

Deadlines have already been missed. A meeting of the Eurogroup of finance ministers, scheduled for February 15th, at which the terms of a deal were supposed to have been endorsed, was postponed the day before. Euro-zone ministers wanted more details of proposed spending cuts as well as written assurances that Greek politicians won’t renege on the deal once a general election, pencilled in for April 8th, is over. Greece has consistently missed its targets to date; trust among its troika of rescuerseuro-zone governments, the IMF and the European Central Bank (ECB)—that it will stick to a new agreement is low.

The way financial markets shrugged off news of the cancelled summit suggests that investors are confident that a deal can still be reached when the Eurogroup next meets on February 20th. There is a deadline that ought to concentrate minds: Greece has a €14.4 billion ($18.8 billion) bond that falls due on March 20th.

A scheme under which private investors would “voluntarilytake losses, by swapping their Greek bonds for longer-dated ones with half the face value, has to be completed before then. Around €30 billion of the second bail-out pot is set aside for guaranteed euro-zone bonds to sweeten the swap deal. The process may have to start before that money is in place, which will make some bondholders reluctant to take part. The deal could easily unravel.

.The pressures on Greece are even more acute. Its economy shrank by 7% in the year to the fourth quarter of 2011. The fall in GDP in the final three months of 2011 was around 5%, according to Haver Analytics, compared with an average fall of 0.3% across the whole euro area. That made the Greek economy the worst of a sorry bunch (see chart). Uncertainty is the economy’s biggest problem. Businesses will not invest until Greece’s future in the euro is secure; nor will suppliers extend Greek firms credit, worsening a savage liquidity shortage.

Greece has missed its fiscal targets, in part because of the deepening recession. The budget deficit in 2011 was probably close to 10% of GDP, barely changed from 2010. But European leaders agreed on €130 billion for Greece in October and are loth to ask their parliaments to approve a bigger sum now.

The ECB will have to forgo the profits on the Greek bonds it bought at a discount if Greece is to have a chance of cutting its debt burden to 120% of GDP by 2020. More immediately, Greece has been asked to make €3.3 billion of extra cuts this year. That will prolong the recession. Private-sector wage cuts needed to restore Greece’s competitiveness will make things worse in the short term.

The growing social tensions in Greece mean its politicians cannot embrace yet more cuts with much enthusiasm. But Greece’s official creditors have their own reasons to get cold feet about another rescue package. Most of the new bail-out money will be disbursed this year to cover Greece’s big budget deficit; to enhance the bond-swap deal; and to inject capital into Greek banks after they have taken losses when privately held Greek bonds are restructured. Once this rescue money is paid, euro-zone governments will have fewer means of taking Greece to task.

What’s more, from 2013 Greece is supposed to sustain a series of “primarybudget surpluses (ie, excluding interest payments) so as to cut its debt burden. But once the state has eliminated its primary deficit, it will not need external finance to fund its day-to-day operations. If Greece then refuses to run big surpluses, a second round of debt restructuring would beckon. That would hurt official creditors, as well as the remaining private bondholders.

One way to keep Greece in line would be to stagger the bulkier bail-out payments. The money required to get private bondholders to take losses cannot be delayed if Greece is to avoid default. The troika could, however, withhold the funds reserved to recapitalise Greek banks. That would give them leverage over the government that is formed after Greece’s elections, which would have to use promissory notes in lieu of capital. But it would also spur a fresh round of deposit flight from banks, worsening the liquidity shortage that has made the recession so harsh.

Greece’s euro-zone creditors might be willing to live with that outcome. They have been emboldened by the success of the ECB’s three-year bank loans in pushing down bond yields for troubled-but-solvent countries like Italy and Spain. Germany’s finance minister, Wolfgang Schäuble, said on February 13th that Europe is “better prepared” for a Greek default than it was two years ago. Perhaps, but without continuing external support in the event of default, Greece might also be forced to leave the euro.

There remain large gaps in the euro zone’s defences against contagion should that happen. The euro-zone rescue fund, capped at €500 billion, is designed to rescue only small countries. Its size is limited by its structure: the more countries that have to be bailed out, the fewer there are to take on the burden of rescuer. It could not credibly bail out Italy, for instance, were that necessary.

A jointly issued Eurobond would allow burden-sharing across all countries but would also require governments to give up some control over their tax-and-spending decisions. The reaction in Greece to impositions by its creditors shows how hard that would be.

The failings of the euro as a currency zone have barely been addressed. The lack of a co-ordinated fiscal policy, and the loss of competitiveness (and banking troubles) at its periphery, help explain why it has tipped into recession, says Laurence Boone of Bank of America.

The chosen remedies are fiscal austerity, structural reform and deleveraging by banks. Given enough time, these measures might restore the zone to health. But they might first push some countries off the ledge.

Markets Insight

February 22, 2012 4:12 pm

Japan’s policy will spur high debt economies

By Peter Tasker

Has the last samurai of the hard money clan finally hung up his sword? That’s the way it looks.

The Bank of Japan’s recent decision to adopt an inflation target and double its bond purchase programme completes the global flight to soft money. The implications are likely to be profound.

The biggest surprise was the timing. In late January Bank of Japan governor Masaaki Shirakawa was in London repeating the standard BoJ mantraJapanese deflation was structural and nothing could be done about it. A few weeks later he was joining the ranks of the monetary activists.


Why the sudden volte face? Political reality, is the likely answer. The Bank of Japan’s isolation had become increasingly untenable.

In the aftermath of the Lehman’s shock in 2008, the US Federal Reserve and the Bank of England embarked on aggressive programmes of quantitative easing, which involved buying massive amounts of government bonds. By linking their currencies to the US dollar, many of the emerging economies were effectivelyimportingsuper-easy US monetary policy.

In 2011 the European and Swiss central banks, traditionally bastions of hard money orthodoxy, defected to the reflationist camp. In both cases the decisions were rooted in political pragmatism, rather than ideological conviction. The Swiss problem was the suffocating effect on economic activity of the soaraway swiss franc. The European Central Bank’s pressing need was to backstop the banking system’s exposure to the dodgy debts of the eurozone periphery.

These were symptoms of a larger malaise – the stresses and strains endemic to a world of high debt and low or no growth. In the developed world the balance of social and political risk is driving policy one way – to reflation, by any means possible. In the emerging world the policymakers – often in politically fragile positions themselves – have gone with the flow in order to protect export sector jobs.

Earlier this month Mr Shirakawa was given a rough ride when he appeared before the Diet, Japan’s parliament. There were strident protests from corporate Japan at the surge in the yen. Such great names of Japanese industry as Sony, Sharp and Panasonic were haemorrhaging red ink while South Korea’s Samsung chalked up record profits. The doubling in the yen-won cross rate since 2007 was not the only factor, but it didn’t help.

On most objective measures, there is plenty of ground for the central bank to make up. Japan’s gross domestic product deflator has been declining at 1-2 per cent per year for the last twelve years, but the BoJ’s balance sheet is smaller now than in 2006.

Compared with the ballooning ECB balance sheet, the BoJ’s ten trillion yen of new asset purchases are little more than “the tears of a sparrow”. To make an impact, it will have to do more. In the end it will, like it or not. Politically the bank has put itself in play.

The first effect will be on financial markets. If a central bank accumulates assets that would have otherwise been bought by private investors, those investors have to find something else to do with their money. The experience of the past few years is that artificial reduction of the supply of risk-free assets ignites demand for risky assets.

The effect on the real economy is trickier to assess. Even the Bank of England, which has hoovered up 25 per cent of the gilts market, has not succeeded in raising inflationary expectations beyond pre-crisis levels. In a deleveraging world, the effect of higher stock prices has limited impact.

One way – for Japan and the world as a whole – to raise inflationary expectations would to be to generate such a powerful rise in stock prices that investors started to diversify into hard assets such as real estate and commodities. A rise in the price of “things” is the essence of inflation.

Just as it was a long time after the inflationary peaks of the mid-seventies before inflation was definitively vanquished, so it may take several cycles before the threat of debt and deflation can be laid to rest.

Interestingly, it was the countries with the worst inflation problems – such as the UK and the US – that benefited most from the struggle to tame inflation. Japan, which already had low inflation in the early 1980s, ended up in deflation.

If the world follows the same template this time, it would be the countries with serious deflation problems that benefit the most, while high-growth countries could end up with serious inflation.

The notion that the debt-raddled economies of Japan and core Europe could prove better investments than the stars of the emerging world seems preposterous. But is it any more preposterous than the notion in 1974 that the best performing stock market of the coming decades would belong to the inflation-plagued, strike-bound UK?

Peter Tasker is a Tokyo-based analyst with Arcus Research

Copyright The Financial Times Limited 2012.


FEBRUARY 23, 2012, 3:18 P.M. ET

Banking on Another ECB Liquidity Fix


There is nothing like a shot of liquidity to set the market's pulse racing. The first European Central Bank offer of cheap, unlimited three-year loans to banks pumped €198 billion ($262.3 billion) of new money into the economy net of funds used to roll over existing ECB facilitiesenough to fuel a substantial rally across asset classes.

But as with any artificially induced high, the euphoria is liable to wear off unless the dosage is increased. On that basis, next weekend's second Long-Term Refinancing Operation risks being a disappointment.

Estimates of what banks might borrow vary from another €200 billion of net new money up to €1 trillion. The size of the range reflects uncertainty over what banks will do with the funds. Some banks will have no option but to take ECB loans to finance existing lending since they are cut off from other sources of funding.

Peripheral country banks clearly fall into this category. Italian and Spanish banks used the first LTRO to take care of their funding needs until the second half of this year and may use the second to secure their funding until well into 2013. Some French and Austrian banks may also need funds for these purposes, judging by the decision to ease local collateral requirements.

But banks may be wary of using the LTRO to fund ordinary lending if they can avoid it, no matter how cheap, since the loans must be repaid after three years. That is less than the maturity of a typical corporate loan, let alone a mortgage. The LTRO also requires collateral at a time when banks are already heavily reliant on other forms of secured funding, such as covered bonds. A shortage of unencumbered assets could restrict future access to senior unsecured bond markets. That is why banks such as UniCredit have raised money in private markets even when the cost is well above the LTRO.

The big uncertainty is whether some banks will use the LTRO to fund carry trades, borrowing cheap ECB money to buy higher-yielding sovereign bonds. Spanish banks appear to be doing this already: Madrid has already raised 35% of this year's funding needs, but 65% of issuance has had maturities under five years, compared with less than 35% in normal years, according to Morgan Stanley. That points to heavy buying by banks.

Italy, in contrast, has so far raised just 10% of this year's target, suggesting limited carry trades. What seems certain is that there is limited appetite for cross-border carry trades.

That may point to an LTRO take-up closer to the bottom of the range, similar in size to the last one. That could disappoint those counting on another liquidity rush to support sovereign yields and slow the pace of deleveraging. On the other hand, it could also signal a shrewd awareness of the need to avoid a longer-term destructive addiction.

Will Gold be Paulson's Next "Greatest Trade Ever"?
February 24, 2012
By Peter Krauth, Global Resources Specialist, Money Morning

And it's no wonder.
Paulson made his way into the financial history books thanks to what many now call the "greatest trade ever". 

Paulson & Co. shorted the subprime mortgage market before the collapse banking a $15 billion gain.
So when Paulson went big again by buying gold in 2009 and 2010, investors took notice.

At the time he said, "As an investor, I became very concerned about having my assets denominated in U.S. dollars," Paulson told his audience. "So I looked for another currency in which to denominate my assets in. I feel that gold is the best currency."

In fact, Paulson's holdings in the SPDR Gold Trust (NYSE:
GLD) make his firm the biggest stakeholder in this ETF, with a position currently valued at $2.9 billion.
So that begs the question....

Is Paulson still a gold bull?

In a recent letter to investors he wrote, "By the time inflation becomes evident, gold will probably have moved, which implies that now is the time to build a position in gold." 

And he's not alone.
Recent filings showed that another legendary hedge-fund investor, George Soros, has nearly doubled his stake in GLD to 85,450 shares.

But "Bond King" Bill Gross's latest words and actions may well be the most significant of all.

In his February newsletter, Gross mused "Recent central bank behavior, including that of the U.S. Fed,... may as well induce inflationary distortions that give a rise to commodities and gold as store of value alternatives when there is little value left in paper."

So not only do some of the largest and most successful fund managers all agree on gold, but now even central banks and entire nations are figuring this one out.

Last year global demand for gold hit the highest level since 1997 - 4,067.1 tonnes.

Most of the gains are thanks to a 5% increase in investment demand which largely originates in Asia. 
What's especially eye-catching is the stepped-up buying by central banks.

Last year, they bought 439.7 tonnes, which is six times the level in 2010, and the most since the gold standard ended in 1971.

According to the World Gold Council (WGC), China became the largest gold market in Q4/2011, overtaking India's top seed, and soaking up 770 tons for the year.

Overall for 2011 however, India remained the leader, consuming a total 933 tons.

But China's appetite for gold seems insatiable. Hong Kong imports were 10 times their average levels from January through November

And the World Gold Council expects China's jewelry and investment demand to continue at a frenetic 20% growth pace this year.

Seeking Shelter in Gold

None of this should come as much of a surprise.

China in particular, holds a $1.1 trillion hot potato in U.S. debt. But China's U.S. debt holdings have declined by $73 billion since July. Russia's holdings have also seen a significant decrease to $88 billion from $127 billion last March.

Increasingly, emerging market central banks have been the most aggressive buyers of gold

According to the WGC central banks are wary of the reserves they hold, most of which are denominated in fiat dollars and euros. Ongoing sovereign bond downgrades and low yields have helped push developing nation central bankers to seek shelter in gold.

Large holders of quickly depreciating western debt are becoming apprehensive. They're looking for alternatives that will retain and grow their value.

There are ever more attempts by eastern creditors at buying up hard assets

So I expect stepped-up efforts by developing nations' central banks to acquire and hoard gold. I also expect Asian companies and sovereign wealth funds to buy significant stakes in hard assets like energy, base metals, and especially gold producers.

As the demand for gold continues to climb, its scarcity will become a major factor. Those who want exposure to gold will look progressively toward gold stocks.

Right now, gold equities are trading at levels near the lows of early 2009 relative to the gold price.
Gold Paulson Greatest Trade Ever

At current prices, gold stocks are historically very cheap, and certainly worthy of consideration by all investors who think they are under-allocated in this sector.

That being said, the ultimate safe haven is physical gold itself. In fact, over time, today's price of $1,750/oz. is going to be looked upon as a bargain.
.Here's why...

Even when gold prices do drop significantly, savvy investors refuse to relinquish their holdings.
 . Today, the allure of gold is not only gaining momentum- but it's maintaining its current rise.


The way I see it, now's your chance to grab your piece of the next "Greatest Trade Ever."