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Just recently, we saw China overtake Japan as the number two biggest economy in the world. The change in the world rankings was more than just result of China’s robust economic growth as Japan’s poor performance made them surrender their spot over to the Chinese. I have come up with, not one, not two… but FOUR main reasons why the Japanese economy is in trouble.

1. Deflation is putting a snag on Japanese demand

You heard me talk about this here before. Let me remind you of those wide words of wisdom.

Deflation occurs when the annual inflation rate drops below zero. As I’ve explained in the past, falling prices may sound nice but it isn’t really good for the economy. When consumers expect prices to fall, they tend to keep their money in their wallets, which leads to deflationary spiral of low demand and production. This is exactly what’s been happening in Japan. Prices have been steadily falling during this recession. With CPI data coming out later this week, we can probably book Japan into the Deflation Hotel for a 9th straight month. Oh and before I forget, did I mention that the BOJ expects prices to slide for THREE MORE YEARS?

In order to combat this, the Bank of Japan has resorted to spending money and cutting rates… which brings me to my next two points.

2. Japan is a walking debt time bomb

Just yesterday, global credit rating agency Standard & Poor decided that they had enough of Japan’s debt follies and placed country’s debt outlook from “stable” to “negative” and threatened to downgrade its debt rating if the government does not enact something to fix its soaring deficit. In case you didn’t know, Japan’s public debt currently stands at a whopping $10 trillion dollars! A rate downgrade will put the country’s sovereign credit rating at AA, just a notch lower from its western counterparts like US, Britain and Germany.

To say that a downgrade of Japan’s credit rating will be disastrous is an understatement. An actual downgrade will cause their borrowing costs to skyrocket, which will eventually make repayment even more difficult. Ahh, another one of those vicious cycles, eh?

3. Japan offers a very attractive return on its debt… Not!

It’s no secret that the Bank of Japan has the lowest interest rate among its peers. How low? Well, the BOJ’s benchmark interest rate currently stands at 0.10%. While having a low interest rate encourages lending and spending, it also has a bad side effect of limiting foreign investments because of its very low return. Imagine shoring up ¥1,000,000 on a vehicle that pays out 0.10% per annum. After a year, you’ll end up with a gain of only ¥1,000! The recent sovereign debt downgrade all the more makes investments in Japanese bonds less attractive.

Investments are a major part of a country’s GDP. For Japan, it takes up about 24% of its total output. So having a limited investment flow, resulting from its low interest rate, would curb the nation’s total income as well as stunting further its growth.

4. Japan’s recovery fails to impress

The recent BOJ statement revealed that the central bank is not so confident with the country’s growth prospects. BOJ officials left the growth forecasts unchanged, saying that the economy has yet to pick up pace. According to them, there isn’t sufficient momentum to support strong domestic demand and sustainable economic growth.

I looked back at Japan’s latest GDP report and was surprised to find out that third quarter growth suffered a huge downward revision from 1.2% to 0.3%. In fact, the reported 1.6% increase in business investment during that period turned out to be just an illusion. It was revised to show a massive 2.8% drop, accounting for much of the overall downward change in GDP. Well, fourth quarter GDP figures aren’t due until the second week of February but after seeing two consecutive quarters of downward GDP revisions, I wouldn’t count on strong economic growth just yet!

Generally, an economy’s economic standing is also reflected on its currency since it would attract more investments, causing the demand for the local currency to rise as well. This means that strong fundamentals translate to a stronger currency and weak fundamentals lead to a weaker currency. Well, with the four reasons I mentioned above, the Japanese Yen should be at the bottom of the Pacific right now! Ever heard of Mickey Mouse money?!

But that’s not what we’re seeing lately. In fact, despite the Japan’s weak fundamentals, the Yen has been strongly rallying against most of its major counterparts. Thanks to good ole risk aversion, the Yen still has some value. For now, weak economic reports are causing investors to flee back to the safe-haven currencies, which are, as we all know, the US dollar and the Yen.

How much longer this will last, I can’t tell. All I know is that, time and again, the markets have been switching gears between risk sentiment and fundamentals as the major driver of price action. And if we see a shift back to fundamentals, well, the yen could just go SPLAT!