This is a follow up to my previous article on Japan, “The Current Japanese Debt Situation And What We Can Learn From It”. No doubt, I am not the first advocating a macro trade on Japan’s cornelian debt dilemma. Actually, I would think that every single macro hedge fund out there has had this trade on in one form or the other at some point in time. Nevertheless, I will make the case that this time is different.
To understand why, one must first address a few misconceptions about Japan, which go a long way in explaining why these trades have endlessly lost money and why the timing is so difficult to get right. Japan is like no other western country, and to understand its system one has to switch from our neoliberal western culture of guilt and assess Japan with the eyes of a culture that rests on shame. Japanese culture puts a premium on maintaining “face” which leads to constant misinterpretation by the west on what they have achieved and what they are seeking. Its actions must be understood in the context of a centrally planned capitalist economy totally devoid of mineral resources and with, at its head, the bureaucrats of the Ministry of Finance (MOF). The MOF controls the Japanese economy at its roots by controlling the pinnacle of the system, banking. By doing so, Japan has managed to circumvent a few of the most salient flaws of neo-liberalism, namely, growing wealth disparity, short term horizon economic decision making and the structural monopoly of the banks in the capitalist system.
To summarize briefly, the Japanese have understood that a strong economy rests on production and investment and that these will necessitate savings. To achieve the needed level of savings, the government has focused its policies on restraining consumption by reducing the ability of households taking on debt via zoning policies that reduce the size of Japanese houses. The result is that, unlike anywhere else, housing is considered as a durable consumer good that loses all its value after 15 years (Richard Koo estimates that this policy alone costs Japanese households every year some 20-30 trillion JPY in unrealized wealth should housing be valued as it is in the US). In a second step, the government deliberately makes it extremely difficult for Japanese households to keep their savings anywhere else but in a limited number of banks controlled by the government. And finally, by controlling the supply of capital to businesses through their control of the banks, the government keeps a tight rein on the means of production and may decide which industries should receive loans and which should not.
It is also well known that by a complex cobweb of cross-shareholding (Keiretsu), corporations all own each other with banks, controlled by the MOF, largely owning the corporate capital. In doing so, corporations have essentially relegated private ownership as a no-vote passenger of the system enabling most of the wealth generated by corporate Japan to flow either to the workers (in the form of wealth and lifetime employment) or to the company itself in the form of investment.
These interlocking business relationships have enabled Japan to protect large monopolies that are the pillars of Japan’s industrial might and enabled it to safeguard the highly competitive position of its high-tech industries without enduring the risks of bidding wars and fratricide competition. Instead, the alignment of interest of all players has enabled them to scale their R&D programs as well as adapt their pricing in times of recession to avoid the bankruptcy of weaker firms.
The system basically rests on the belief that such a structure can avoid the flaw of businesses being incentivized by short-term rewards, and instead leaves the bureaucrats to figure out the long-term projects that will yield lasting competitive advantages for society as a whole. In addition, instead of only using money as a means of motivation, which ultimately exacerbates income disparity as you move up the income scale, Japanese society is built around a sophisticated tradition of respect.
Now that I have laid out the (oversimplified) picture of the Japanese centrally planned economy, it is interesting to connect the dots of where they are and where I believe they may be heading. It is obvious that with a culture resting on shame, a default on government bonds is simply out of the question.
Over the past twenty years, Japanese bureaucrats have focused essentially on safeguarding social cohesion and protecting its leading industries whilst it recovers from its massive excess investment and overcapacity. The only way to achieve this, after the gigantic financial bubble of the Nineties, was to have the government bear all the costs of these excesses and ensuing losses of the deleveraging era to impact corporations and households.
The natural buyer of this transfer of wealth from the public sector to the private sector in the form of numerous JGB issuance have been the banks who in the absence of any loan demand have invested domestic savings in government debt. This recycling can continue for as long as there are sufficient savings to finance new issuance of government debt. But here lies the problem. The savings of the private sector are dwindling fast. Domestic savings have fallen from 16% in 1980 to around 2% of GDP today. This number will only worsen and turn negative as Japan's population declines and compares with a deficit that was already 8.1% of GDP in 2010 (source: Ministry of Finance) . This gap must be either filled by external capital or by monetization by the Bank of Japan.
The argument often made that households are sitting on a mountain of accumulated savings of some 1,400 trillion yen (17 trillion dollars) versus only a little under 1,000 trillion in outstanding long-term government bonds does not hold the test of scrutiny. It is a striking example of double counting because this large pool of household cash has already been used to finance the sovereign debt. All these savings have already made their way into JGB’s through intermediation.
An even more frightening aspect is that the $1.2 trillion Government Pension Investment Fund (GPIF), the largest owner of JGB’s in the world, was unable last year, for the first time ever, to invest any new money in government bonds because of rising pension benefits and is expecting to become a net seller this year (source: Bloomberg). So wherever one looks, it appears that the Japanese savings capacity has dried up.
There is clearly a sense of denial, but this denial in the face of an unmanageable debt load could very well hide a simple observation. The only variable that can really pull them out of this downward spiral is a significant weakening of the yen, which would in turn finally give a sizable and lasting competitive advantage to their large industrial base. The main problem Japan has had ever since it has entered its lost decades of no growth and falling prices is the same as any mercantilist country that produces and sells much more than it consumes. As the demand increases for exports so does the demand for the currency. Unless this is countered by strong domestic growth leading to strong imports, the JPY will relentlessly strengthen under the weight of foreign demand, causing torturous headaches to the MOF bureaucrats.
The Japanese government has two options to weaken its currency. The first option is to impose monetization of the debt. As I often insist, sovereign currency nations do not have to call on households to finance debt issuance. They can simply call on their central bank, in this case the Bank of Japan, to purchase the new issuance and monetize the debt. Given their current debt load, this behaviour would trigger a fall in confidence and cause the JPY to plummet. Although this option could cause an abrupt spiral in the value of the JPY, it is likely that the fall would be cushioned by the large foreign currency reserves. Although the Bank of Japan has continually opposed the calls made on it to monetize the debt I suspect it has done so to keep “face”, but knowing that it would ultimately need to intervene.
But this is only the first option. The second option is to intervene in the foreign exchange. There are two rules for currency interventions to be effective. They must be sterilized and multilateral. This time around both boxes are checked and an implicit free put option has been granted under the dollar/yen price.
The recent tragic events have just opened the door to what would have been considered an unacceptable beggar-thy-neighbor attitude by Japan just a few weeks ago. Not only can the central bank implement a large wave of quantitative easing without losing "face", but in addition, it can intervene directly on the currency flows. Once you put aside the repatriation myth one can focus again on the real flows.
In fact, Japan rushed to seek an agreement on a concerted intervention to weaken the yen. This time around both boxes are checked and an implicit free put option has been granted on the dollar/yen price. The timing is ideal.
Between the Europeans that have started their tightening cycle (although a short one I believe) and the Fed which will soon be ending its quantitative easing strategy, this free put under the yen is as close to a free lunch as you can get and is going to seed a gigantic carry trade. As hedge funds, money managers and all the hot money around rushes to borrow yen and invest the proceeds in other higher yielding investments, the yen will only accelerate its descent. We are in the very early stages of what might be remembered as the “great devaluation”. I strongly believe the time to go short the yen is now.
On the technical side, wave V of the long term Elliott Wave count ended at 76.25, considering that wave count started in 1980 around 280, the new wave count could bring us a long way. In the short-term, if the yen crosses above the 55 weeks EMA at 85.60, the next target is 95.00 (38.2% retracement of 124 to 76.25).
There are a few different ways to play the yen weakness. The easiest is to simply buy a short yen ETF like the ProShares UltraShort Yen (YCS) which seeks to replicate twice the inverse of the daily performance of the U.S. dollar price of the Japanese yen. So if the yen weakens by 10% versus the dollar this ETF should appreciate close to 20% (a little less because of the fees it charges).
Another trade I find interesting, but only if you are familiar with options, is the purchase of a long-term put option on the yen. Long-term options are often undervalued because the simplifying assumption behind the Black-Scholes model that is used to price them assumes that security prices follow a strict stationary lognormal process. As we all now, little if anything in finance is log-normally distributed! I believe a 3-year (June 30th 2013) USD call JPY put with a 140 strike will cost about 0.3% in premium (only 3,000 dollars for every 1 million dollar of underlying). At that price, if the dollar/yen rate reaches 160, your 3,000 dollar premium will be worth over 120,000 dollars. A pretty attractive asymmetric reward if you ask me. You should be able to implement this trade by calling your broker but these are clearly some constraints on size so you might want to stick to the ETF.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.