China: Caution May Be Warranted | Japan: Real Troubles → Washingtons Blog
China: Caution May Be Warranted | Japan: Real Troubles - Washingtons Blog

Monday, November 2, 2009

China: Caution May Be Warranted | Japan: Real Troubles

As I have repeatedly noted, China has been blowing a bubble with easy credit. MarketWatch's Craig Stephen warns investors to be wary of a potential correction, at least in some sectors:

Policy tightening could soon become the dominant market theme, meaning it's time for a rethink. After recent rate hikes in Australia and Norway, tightening is back on the agenda in many countries, including China. And with the U.S. just clocking up 3.5% annualized GDP growth for the third quarter, dollar bears will have something to think about.

Nomura says its time to get a little more defensive in the face of what they call a "cappuccino recovery" - one-third espresso, one-third milk and one-third froth.

They argue investors face a dilemma on how to discriminate between genuine and sustainable areas of economic growth and the sharp rise in asset prices, often aided by excess liquidity.

The Nomura analysts advise switching out of high beta regional exchanges, which was a recent call.

This change is worth paying attention to, as Nomura's strategists were among the first to link quantitative easing to raising the risk profile of investors and lifting equity markets early this year.

Exchanges and brokerages have been some of the big winners of resuscitated financial markets, while in China, banks and insurers have been a great play on the huge money-supply expansion. Last Friday we saw China's new GEM market launched, with all stocks more than doubling in intraday trading -- will this be a new high-water mark?

Another area where asset prices may have peaked is property...

Runaway prices are not foremost on officials' minds, rather the possibility of a reversal. According to a story in the South China Morning Post quoting an unnamed official, there are no plans to introduce substantial measures to control the surge in the property market. Instead, it said, the government is more worried about a sharp fall in property prices.

Perhaps investors should take note. In Hong Kong, the government effectively controls the price of land. Moreover, property and banking stocks make up more than half of the Hang Seng Index.

If loose money conditions that have been so good to financial and property assets do reverse, Nomura suggests a good place to be positioned is in the under-performing telecom sector, which looks attractive on a yield basis...

Another area that offers similar attributes to those of telecoms and is likely to see continued strong growth is the China Internet sector. A new report from Macquarie on China Internet leader Tencent orecasts growth will remain robust. One statistic that caught my eye was that its QQ instant-messaging services now caters to 448 million active accounts. Tencent is expanding its range of services to this massive user base and is consolidating its first-mover advantage.

In case you haven't been keeping up with Japan, Ambrose-Evans Pritchard does a great job of summing up that nation's dire financial circumstances:

Japan is drifting helplessly towards a dramatic fiscal crisis...

The rocketing cost of insuring against the bankruptcy of the Japanese state is telling us that the model has smashed into the buffers. Credit default swaps (CDS) on five-year Japanese debt have risen from 35 to 63 basis points since early September. Japan has suddenly decoupled from Germany (21), France (22), the US (22), and even Britain (47)...

"Markets are worried that Japan is going to hit a brick wall: the sums are gargantuan," said Albert Edwards, a Japan-veteran at Société Générale.

Simon Johnson, former chief economist of the International Monetary Fund (IMF), told the US Congress last week that the debt path was out of control and raised "a real risk that Japan could end up in a major default"...

"Can these benign conditions be expected to continue in the face of even-larger increases in public debt? Going forward, the markets capacity to absorb debt is likely to diminish as population ageing reduces saving," said the IMF.

The savings rate has crashed from 15pc in 1990 to near 2pc today, half America's rate. Japan's $1.5 trillion state pension fund (the world's biggest) has become a net seller of government bonds this year, as it must to meet pay-out obligations. The demographic crunch has hit. The workforce been contracting since 2005.

Japan Post Bank is balking at further additions to its $1.7 trillion holdings of state debt. The pillars of the government debt market are crumbling. Little wonder that the Ministry of Finance has begun advertising bonds in Tokyo taxis, featuring Koyuki from The Last Samurai. If Japan's bond rates rise to global levels of 3pc to 4pc, interest costs will shatter state finances.

No one knows exactly when a country tips into a debt compound trap. But Japan must be close, even allowing for the fact that liabilities of the state Loan Programme (FILP) have fallen by 40pc of GDP since 2000.

"The debt situation is irrecoverable," said Carl Weinberg from High Frequency Economics. "I don't see any orderly way out of this. They will not be able to fund their deficit. There will be a fiscal shutdown, a pension haircut, and bank failures that will rock the world. It is criminally negligent that rating agencies are not blowing the whistle on this."

Mr Hatoyama inherited a country that was already hurtling into sovereign "Chapter 11". The Great Recession has eaten up 27pc in tax revenues. Industrial output is down 19pc, even after the summer rebound; exports are down 31pc; the economy is 10pc smaller today in "nominal" terms than a year ago – and nominal is what matters for debt.

Tokyo's price index fell 2.4pc in October, the deepest deflation in modern Japanese history. Real interest rates have risen 300 basis points in a year. It reads like a page from Irving Fisher's 1933 paper, Debt Deflation Causes of Great Depressions...

"This is incredibly dangerous," said Russell Jones from the RBC Capital Markets. "The rate of deflation is shocking. The debt dynamics are horrible and there is the risk of a downward spiral."

We're not talking about Iceland or Latvia here. Japan is the world's second biggest economy. If Japan tanked, it would dramatically affect the world economy.

For more on Japan's lousy age demographics, see this.

Note: I am not an investment advisor and this should not be taken as investment advice.

1 comment:

  1. We are a long way from the edge of the woods yet in the unwinding of this credit cycle. The Fed and US government are (rightly) congratulating themselves on avoiding financial Armageddon last year when the credit system froze. But since then, very little delevering has taken place and other bubbles have been blown in high risk areas owing to moral hazard. Regular explosions are still detonating in the financial sector, with bank failures rising every Friday without an end in sight and big players are still blowing up (CIT).

    The question is, what and where is the next Lehman? It's not necessarily going to be in the US and Japan is a good candidate. Many people are also looking to Eastern Europe as the likely implosion point, threatening EU finances.

    A real problem lies in the neoliberal meme of "fiscal responsibility." Governments and CB's are under pressure to end stimulus and raise rates to "prevent inflation from developing" when the world is still facing debt deflation, real economies are stagnant, the global output gap huge, and social unrest is stirring. Tightening anytime soon would be fatal. This is going to test the EU's Economic and Monetary Union (EMU), for example.

    All its going to take is one butterfly flapping its wings to set the process in motion again.


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