Henry,
Some interesting correlations and insights into Japans continuing financial restructuring.
"The Postal Savings Fund is now insolvent...."
"The near-term trend continues to warn that the yen will rise sharply to new highs against the Euro."
The Japan Contraction
By Martin A. Armstrong
Princeton Economic Institute
© Copyright April 15th, 1999
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Fiscal year-end has now come and gone and the dark clouds that have plagued Japan are also refusing to go away. April 1st has marked yet another milestone in the ongoing process of Japanese Big Bang and the impact upon the global economy is still silently pressing forward. The most significant factor that has now entered the scene comes in the form of "consolidated" accounting requirements ahead of next year's mark-to-mark. The consolidated reporting is already starting to make its presence felt as institutions and corporates in Japan must now reveal all entities on one balance sheet. The hidden losses in offshore subsidiaries, like that of Yamaichi, will soon be on a mark-to-market basis. This is causing some pressure to liquidate overseas assets to simplify the accounting. Nonetheless, the coming mark-to-market system is also having an impact upon institutions that have taken sizable losses in overseas bond markets due to recent foreign exchange fluctuations.
Some of the Japanese big life insurance companies will substantially decrease new investments in foreign bonds. For the current fiscal year, the life companies have put their top priority on "safety" admitting their inability to manage foreign exchange risk. The Japanese big life insurance companies are planning to decrease new investment in foreign bonds include Nippon Life, Daiichi Life, Sumitomo Life, Meiji Life and Asahi Life. According to their press announcements, the total amount of increase in their investment into foreign bonds will be only about JPY90 billion (US$7.5 billion), which is HALF of the new investment program set up at the beginning of fiscal 1998 term.
The inability to offer professional global funds management by the life companies in Japan is starting to impact the own ability to attract funds in Japan, to some extent, thanks to Big Bang. Raising the white flag, the life companies will shift the weight of fund management into products such as domestic bonds, where there is no foreign exchange risk while accepting a lower credit rating. Of the big five life insurance companies, their budget for foreign bond investment during the previous fiscal year was established at JPY1,800 billion (US$15 billion). Thanks to the Russian Crisis and the hedge fund panic liquidation of the dollar that drove the yen sharply higher, the actual amount of intended investment fell short of that budget coming in at only JPY1,500 billion for foreign bonds. Those markets most likely to come under the most pressure are Euro, Canada and Australia. The collapse in the Euro has marked this new currency as the worst performing bond from the Japanese perspective. Of the foreign bond investments, the US dollar will still remain as the bulk of overseas investment for most Japanese institutions.
While the net effect of this change in policy on the part of the Japanese Life Companies does NOT constitute a capital repatriation, it does warn that the volatility in general is now starting to introduce huge risk even for basic bond markets. A continued rise in overall volatility will raise the risk SUBSTANTIALLY for a MAJOR capital investment contraction over the next two years. This is starting to provide a precursor of warning that despite optimists on Wall Street, it is simply impossible to expect that there will be no recession whatsoever for the next three years. The warning signs are starting to appear on the horizon and they are not tidings of utopia forever. There is NO WAY we can avoid a recession as capital begins to pause and take notice of the increasing volatility.
Recent pressure downward on the dollar via the yen is also being caused to some degree by the liquidation of overseas assets by Japanese brokerage houses. Rumors prevail that Nomura is about to dump ALL its British Real Estate holdings to Buffett in a deal that could be in the amount of US$6 billion. This rumor alone has had some negative impact upon sterling. Japanese banks continue to remain in a contracting mode as the close down overseas operations because BIS (Bank International Settlements) requirements call for 8% reserves compared to 4% for domestic assets. The insane and stupid regulations from the BIS are also causing a natural contraction in global economic activity – another precursor to a recession.
The Japanese brokers are under SEVERE pressure also due to changes in Big Bang that introduced the "segregated account" system as of April 1st, 1999. Previously, client's money in Japan was commingled and brokers could borrow from those funds if they chose. However, the adoption of the segregated account system may on the surface appear to be an excellent reform, it still has the mad touch of bureaucratic bumbling.
The new Japanese segregated account system is perhaps the most bearish development we have ever seen for a share market. If a client opens an account, then funds are placed in a trust bank under the new segregated account system. The broker must then use his own capital for margin requirements. If the broker executes a trade through another broker, he must then place margin with the counter-party brokerage firm. In turn, the counter-party must place that margin in another segregated account and post his own capital. The net effect of the Japanese version of a segregated account is in reality making margin business extremely expensive and high risk to any broker. Combine this trend with the trouble in the banking system where credit facilities have been curtailed to all brokers, and the net effect is anything but bullish. While the Nikkei has been quite strong, the buying is coming from overseas while domestic investors are taking advantage of the liquidation opportunity.
The banking crisis continues to spread, while at the same time there is no panic – at least for now. If a panic comes in Japan over the banks, it will not materialize until late 2000 going into early 2001. The reason for such a delay remains the steadfast political guarantee attached to all deposits in a bank right down to a credit union. However, the final phase of Big Bang for April 2001 includes the introduction of a maximum guarantee of only $100,000 similar to the US system. This will have severe implications for the Japanese banks as they will have to face even massive corporate withdrawals. Can companies like Toyota continue to maintain cash deposits of $15 billion within the banking system if they are no longer insured? The same question will be faced by everyone, right down to the housewife. No matter how bad things get in the short-term, a banking panic does not appear to be likely until 2001.
The deregulation of capital investment into mutual fund type products has had less success than initially expected following December 1st of last year. At first, there was a very nice surge of capital rushing into all sorts of foreign fund products involving some of the big names here in the United States. However, the big mutual fund houses in the US have had NO experience in managing investments other than mere dollar funds. They all arrived in Japan with much fanfare but their performance has been an average loss in excess of 20% since their launch. An investor now peers at the listing of fund products in the newspaper and is immediately struck by the sizable losses for about 98% of all products. The problem has been the currency and the lack of professional management in this area. Buying stocks in the US in dollars may look good as the indexes have boomed, but they have not overcome the losses in the value of the dollar against the yen.
The prospect of the coming introduction of the 401K retirement account in Japan as yet another phase of Big Bang still leaves the opportunity for a massive outflow of investment capital in the years ahead. The start, however, has been dampened by the panic selling of dollars by the hedge funds that in turn has created FX losses in just about every sector of the Japanese economy. The strong yen merely perpetuates the deflation and blocks any recovery from taking hold on a sustainable basis. Without a dollar rally back to 130+, the outlook gets worse for Japanese earnings, which translates into rising unemployment and continued pressure upon public confidence. The introduction of the 401K plan in Japan is also likely to cause a drain in capital from the life companies, pension funds and the Postal Savings System and this implies further reductions ahead in professional fund allocations as the decision process shifts toward the individual.
The first quarter GDP numbers for Japan are also at serious risk of showing a further economic contraction. In fact, the first quarter numbers may yet spill over into the second quarter as serious damage has been caused by the government. The Japanese government placed a great deal of pressure upon the banks to write down their bad loans and to meet the BIS requirements. The banks in turn called in loans on the good clients demanding that they "zero out" their loans for March 31st. What we saw going into March was the worst credit crunch perhaps in history. The net effect was significant as corporates scrambled to pay off loans while postponing any spending as much as possible. This has had a sharp contractionary impact short-term upon the Japanese economic as a whole.
To make matters worse, the western press has done perhaps the WORST job of reporting the facts on Japan we have ever seen. The entire issue with the JGB market is a key point. The western press reported that the government was no longer going to support the JGB market and that they only later, following the crash, reversed that decision. The truth lies directly between these two stories. It was the Postal Savings Fund that was used to support the JGB market and just about everything else. Instead of the government using its own cash, it used the deposits of its citizens. The Postal Savings Fund is now insolvent and this is why it backed away from supporting the JGBs. The decision to support the JGBs again involved the Bank of Japan – not the Postal Saving Fund. The entity that supported the JGBs changed! The problem now faced is that the financial minister testified before the Diet that the government would need to come up with the shortfall of cash for next year when redemptions in the Postal Savings Fund come due. In reality, the largest single fund in the world is now insolvent thanks to a failed government policy of intervention.
The next issue of critical importance remains the unwinding of the political crossholdings of shares between banks and corporates. The root cause of the financial troubles in Japan remain the banking crisis. Americans learned this hard lesson during the Great Depression. Banks MUST be prohibited from becoming investors within the economy. The purpose of a bank is to provide credit to the economy – not compete against it. When banks are shareholders and the share market declines, banks lose money along with everyone else. As this process unfolds, banks begin to curtail lending. The more lending contracts, the greater the economic contraction causing the share market to decline even further. This process feeds upon itself and creates a vortex that spirals downward. For this reason, the true recovery will not begin until the cross-holdings have been liquidated. The good news is that everyone admits this fact and the liquidation process in now underway, but again it will take two years.
The near-term trend continues to warn that the yen will rise sharply to new highs against the Euro. Against the dollar, the major resistance stands at the 124 level and breakout above that area will spark a jump to 130. While our long-term models still point to the dollar rising against the yen reaching even 200 as the government is forced to increase the supply of yen dramatically, the contraction unleashed by the new consolidated accounting rules can cause one more dollar decline back to 112-113. The key support continues to lie in the mid 116 zone and only a break of that area would call for such a decline to 112-113 before a reversal in trend back to the upside.
There is little doubt that the long-term prospects for Japan remain very bright. The problems we see are structural in nature but largely short-term and will be resolved over the next two years. Thereafter, the 2002-2007 period appears to be a very strong economic recovery with the Nikkei most likely scoring new record highs in the process.
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