Japan Gets Three D’s on Its Report Card

It looks like Japan will be heading to summer school again, as it recently got three D’s on its latest report card! What are Japan’s problems now? Deflation, debt, and disastrous politics!

Deflation

For the nth summer in a row, Japan will be taking Inflation 101. As I’ve pointed out in the past, deflation has been a persistent problem for Japan and could derail recovery. Remember, if prices are expected to fall, consumers would be less willing to spend. With consumer consumption making up a big chunk of potential growth, declining demand would hurt the economy.

This past April, the consumer price index revealed that consumer prices fell by 1.5% from the previous year. On a monthly basis, this marked the 14th straight month that core prices have fallen! In fact, the only thing that went up in the past year was tuition costs!

This is a cause for concern, because the only thing that the quantitative easing measures that the Japanese government has implemented, domestic demand remains to be subdued. Could we hear more cat calls from the government asking BOJ Governor Masaaki Shirakawa for more stimulus measures via monetary policy?

Debt

Now, the problem with even more quantitative easing measures is that it would add to country’s debt, which is already a sumo-sized problem on its own!

According to estimates, Japan’s huge fiscal stimulus spending will eventual take the country’s budget deficit to almost 7.8% of its GDP this year. Meanwhile, its debt-to-GDP ratio is predicted to hit 200%! As of the moment, debt servicing already makes up almost… wait for it, 40% of the Japanese government’s revenues!

Japan’s debt is simply not sustainable. Remember, Japan’s aging population is mostly made up of grandpas and grandmas, which means that the overall income level is declining and health care expenses are rising. As a result, the amount of money saved also falls.

The only way for Japan to stabilize and service its debt is for tax revenues to increase, which is terribly hard in a deflationary situation. Interest rates are at record low levels, so the Japan really has very little options to stimulate growth.

I wonder if those rising tuition costs include paying for lessons on how to save!

Disastrous Politics

Aside from struggling with economics, Japan’s other problem subject is politics. Pip Diddy has been telling me about the ongoing conflict on the removal of the US air base from Okinawa island. Apparently, Prime Minister Yukio Hatoyama vowed to remove this air base from Japanese soil but failed to fulfill his promise. Instead, the air base would simply be relocated to the northern side of the island, much to the disapproval of the residents in Okinawa.

With so many protests and harsh accusations to deal with, Hatoyama felt pressured to drop out of office. His failure to come up with an alternative solution to the Okinawa base problem earned him an incomplete mark in his report card, forcing him to withdraw from the political arena after a brief eight-month term.

Because of Hatoyama’s resignation, the Democratic Party of Japan is left with no leader to guide them through the upcoming parliamentary elections. And with barely one month left before the upper house elections, the DPJ just has a few weeks to get its act together. Otherwise, they’d find it nearly impossible to do a repeat performance of their landslide victory in last year’s lower house elections.

If this happens, Japan could be in for more political instability if opposing parties take hold of parliament. Hmm, this reminds me of all that political drama in the UK, when the possibility of a hung parliament weighed heavily on the pound. Of course, like the UK, Japan is also facing a bulging public deficit…

Headmaster’s Comments

The yen has been holding up, thanks to the risk aversion that is flowing through the markets. While not being a natural safe-haven currency, the yen tends to gain when traders become risk averse. Traders use the yen as a funding source thanks to its low interest rates, so when they have to unwind their positions in risky assets, they begin covering their yen positions as well.

Yesterday reminded us, however, that fundamentals do play a role. A currency can’t get a pass just because it’s part of the safety patrol! Even with concerns that the European banks are flunking credit rating tests, the yen was unable to sustain its gains thanks to all political turmoil that hit the markets.

So while risk aversion continues to be the prevailing theme in the markets, we may not see the yen gain too much as its GPA gets weighed down by all those D’s! Time for summer school? Japan better not let those D’s turn into F’s!