A case of need

where the need for markets for its industrial sector is causing Japanese leaders to reconsider a longstanding policy. Nikkei is reporting that the Japanese government has decided to lift its ban on arms exports by domestic companies.

"TOKYO (Nikkei)--The Japanese government decided Saturday to relax its rules on arms exports to allow more joint development and production of weapons with other nations and enable shipments to countries with which Japan co-develops arms. The move is aimed at reducing procurement costs and stimulating the domestic defense industry by promoting joint development and production of key arms, such as next-generation fighter jets, with the U.S. and Europe."

Warships, aircraft, armored personnel carriers, UAV's, missiles...these are all things that Japan's excess industrial capacity could be reconfigured to produce relatively quickly. As economic conditions remain difficult, we can expect to see changes in long-held attitudes as national leaders search for alternative markets for idle production capacity.

According to Wikipedia's entry on the Defense Industry of Japan, the country's "indigenous suppliers [have] developed and produced an almost complete range of modern equipment, including aircraft, tanks, artillery, and major surface and underwater naval combatants". The same source indicates that historically "Nearly 60 % of Japanese defense contracts were awarded to five large corporations: Mitsubishi Heavy Industries, Toshiba Corporation, Mitsubishi Electric Corporation, Kawasaki Heavy Industries, and Ishikawajima-Harima Heavy Industries Corporation. "

As an indicator of the potential for growth, the Wikipedia source references "A secret memorandum circulating among defense contractors in 1988 estimated that lifting the export ban would result in Japan's capturing 45 % of the world tank and self-propelled artillery market, 40 % of military electronic sales, and 60 % of naval ship construction".

In particular, the Mitsubishi F-2 has been put into service as a successor to the F-16. This aircraft might make inroads in the international market if the manufacturer was allowed to make foreign sales.

The need for new markets will likely overcome domestic political opposition to foreign arms sales.

Japan's Economy Contracts At An Annualised 15.2% In The First Three Months Of 2009

Japan’s economy shrank at a record rate last quarter as exports collapsed and businesses drastically cut back on investment spending. Gross domestic product fell by an annualized 15.2 percent in the three months ended March 31, following a revised fourth- quarter drop of 14.4 percent, according to the Japanese Cabinet Office. The economy contracted 3.5 percent in the year ended March 31, the most since records began in 1955.



Japan's economy is exports dependent, and exports fell by an unprecedented 26 percent during the last quarter, forcing most companies to drastically cut production. In fact industrial output was down 18.1% on the previos quarter and 34.5% year on year.



GDP fell 4 percent on a seasonally adjusted basis, more than double the 1.6 percent drop in the US, and well above Europe’s record 2.5 percent contraction. Due to the impact of deflation, without adjusting for price changes Japan's economy actually shrank 2.9 percent in nominal (current price) terms in the quarter.



Weaker domestic demand was the biggest contributor to the decline, reducing GDP by 2.6 percentage points, the most since 1974. But this was unevenly distributed between consumer demand and investment. Consumer spending held up reasonably well - and only dropped by 1.1 percent (see chart above) while business investment was down a record annual 10.4 percent, and a massive 35.5% over the last quarter. And companies are likely to keep cutting spending because the decline in external demand has left factories operating well below capacity level, and semi idle workforces can only be retained for so long.

“There is a huge problem of over-capacity,” said Hiromichi Shirakawa, chief economist at Credit Suisse Group AG in Tokyo. “That means capital spending is not likely to pick up.”

The slump in housebuilding has also deepened, and home construction was down by 25% quarter on quarter.




Shrinking More Slowly?

A number of reports over the past month suggest that the contraction in what is still the world’s second-largest economy may slow (second derivative decrease) for the first time in a year this quarter) as exports begin to stabilise (albeit at a low level) and Prime Minister Taro Aso’s 15.4 trillion yen stimulus plan, announced in April, has some effect.

The most recent Nomura/JMMA Japan Manufacturing Purchasing Managers Index reading rose to a seasonally adjusted 41.4 in April from 33.8 in March, the steepest gain since data were first compiled in October 2001. However the index remained below the 50 threshold that separates contraction from expansion for the 14th straight month.




The Economy Watchers index, a survey of barbers, taxi drivers and others who deal with consumers, climbed to 28.4 in March from 19.4 in February, the second-biggest jump on record, according to the Japanese Cabinet Office.



Japan’s consumer sentiment alos rose - to a five-month high - in March, and the confidence index climbed to 28.9 from 26.7 in February. The index has now advanced for three consecutive months since after plunging to 26.2 in December, its lowest level since the government began compiling the figures in 1982.



Exports also increased in March from a month earlier, as firms across the globe who had run down stocks started to rebuild them.



Still, the failure of export demand to do more than simply stabilize will probably limit the scope of Japan’s recovery. Toyota, Hitachi, and Panasonic have all recently forecast continued production and job losses in the current business year. Panasonic said only last week it plans to close about 20 factories this year and proceed with the 15,000 job cuts announced in February.


Paul Krugman, speaking as far as I can see at a seminar in Ho Chi Minh city, had the following to say, which I pretty much agree with.

“Just about all of the economic indicators out there are suggesting that the free-fall has come to an end, that we’ve stabilized,”

“Probably the worst in terms of shocks to the system is over.....The acute stress that we had last fall after the failure of Lehman has been reduced,” he said. “Interest-rate spreads on commercial paper are way down, interest-rate spreads on corporate debt are down a little bit. The spread on interbank lending is down....“I don’t think we’ve hit bottom, but the bottom is not too much further below us,” he said. “My big concern is that we don’t hit the bottom and bounce, we hit the bottom and stay there. It’s not obvious where recovery comes from.”

It's like someone hit a very sensitive mechanical device with a large sledgehammer, this sent the device reeling under the impact smashing a lot of the works in the process, and now the shock absorbers have done their work and the vibrations are slowing we will be able to assess the true extent of the damage.

He also seems to be warning the US dollar can experience a "Japan-style carry" effect.

“The U.S. dollar is going to fall quite a lot, or at least significantly,” he said. “The demand for dollars has been temporarily inflated by the crisis. Good news is actually bad news for the dollar. If things stabilize, then the safe-haven demand for dollars falls off.”

So the second derivitive is falling. We should not see more 15.2% annual contractions in Japan, but this does not mean GDP will not keep on falling -for how long? This is the part we still don't know.

Japan's loss of AAA rating

The quote from Moody's is

"Japan's credit profile is Aa2

The unified rating of Aa2 reflects Japan's considerable strengths. These include Japan's large domestic savings, a strong home bias on the part of its domestic financial institutions and institutional investors, relatively low holdings of government debt by foreign investors, and Japan's $1 trillion of official foreign exchange holdings. Moody's believes the domestic market will absorb the record level of bond issuance this year to fund the government's economic stimulus program. However, the rating also reflects the risks of Japan's high level of debt, which leaves the country's fiscal position vulnerable to shocks or imbalances that would cause a sharp rise in interest rates. The ratings also reflect the sizable but temporary increase in the government's budget deficit caused by the severe effects of the global collapse in trade and recession on the Japan's economy. Further, Japan's large foreign exchange reserves, although large compared to those of most other countries, are only a small fraction of its liabilities and could not alone eliminate refinancing risk at a time of severe stress."

Here is a look at the trend in Japan's government debt(courtesy of Edward Hugh):

That net debt number is likely to exceed 100% of GDP in 2009. Moody's noted that very little of this debt is held by non-Japanese. Of course, one of the primary causes of this is the fact that much of this debt was issued at extremely low interest rates. So it was relatively unattractive to foreign investors. Japan's government debt amounts to the country's citizens avoiding taxation now with the expectation that the country's future productivity will be great enough support repayment of the debt in the future without ruinous taxation levels.

The Bank of Japan holds over $600 billion in US Treasury debt. In theory, the proceeds from these holdings as they mature could be used to reduce the outstanding domestic debt over time. Of course, that would put upward pressure on the yen versus the dollar and thereby weaken the country's export sector. The decision that faces Japan's leadership today is whether to continue to depend on exports, or shift policy to supporting the domestic sector more and thereby increasing the proportion of GDP generated domestically. Such a shift would result in short term difficulties, but in the long run would serve the Japanese public best.

Other weaknesses of Japan include the fact that it has no meaningful defense forces, and its agricultural sector cannot produce enough to feed the country's population for any meaningful length of time. Also, Japan relies on imported fuels for over 80% of it's energy needs.

Another issue is that somehow the fact that Japan has been running inflationary policies for 18 years now is easy to miss when their nominal numbers all are so flat. It was easy to see the inflation get exported to the US and the rest of the world through the carry trade mechanism. The question that doesn't seem to be asked is where all of those yen went after the carry trades were unwound. At some point the BoJ has to remove the excess yen, which would obviously be deflationary, or we should expect a collapse in the yen.

(A cross post by Scott Peterson from Wasatch Economics)

Japanese Housewives Back in the Game?

By Claus Vistesen

I am sure all investors, analysts, and commentators have been tracking a wide range of indicators to gauge whether the shoots of green would continue to spark or whether it was merely a blip on the way down. Clearly, this has been and is a little more than a blip I think and for my own part, decisive evidence came today that things might have changed. I am of course talking about the Bloomberg report (also here) that Japanese housewives are once again making their presence felt in currency markets playing the carry wheel.

Individual investors in Japan increased bets to the most in six months that the yen will weaken as the economy stabilizes, jumping back into a trade that was all but wiped out last year.

Businessmen, housewives and pensioners held 153,326 margin contracts at the end of last month that will make money if the yen declines against currencies ranging from the euro to the Australian and New Zealand dollars, according to the Tokyo Financial Exchange. All told, they may have as much as $125 billion in yen so-called short positions, RBC Capital Markets strategists said. “Investors believe the worst of the global recession is over and higher-yielding currencies are bottoming out,” said Yoshisada Ishide, who oversees $1.8 billion as a Tokyo-based fund manager at Daiwa SB Investments Ltd., a unit of Japan’s second-biggest investment bank.

Now, I have had my eyes on the Japanese housewives on more than one occasion (especially here) because I think that the tendency of Japanese retail investors to scour the global economy for yield runs a bit deeper than a simple carry trade play. Well, it is of course a carry trade but the underlying impetus for Japanese retail investors to act as they do also has something to do with a decline in home bias due to a low domestic interest rate environment as a result of demographics and subsequent sluggish domestic demand. The point is simply that one of the only ways Japan can achieve sustained is to mobilize its large stock of savings and, more importantly, to mobilize it abroad (e.g. through the purchase of samurais) in order to get the yield which is not obtainable in the domestic capital markets.

In the current environment of financial crises, great depressions, and credit crunches Ms Watanabe et al. have of course, in line with most other risky asset punters, been pulling back their fangs. However, with the recent narrative of green shoots and second derivatives it was also always going to be the question of when, if at all, carry trading would return as per function of declining volatility and appreciation of risky assets. As I have suggested lately, tentative signs have emerged that carry trading activity has slowly been coming back.

Now, it can be debated whether the apparent return of the Japanese housewives to the carry trough represents evidence of a solidification of the green shoots or, as a friend suggested to me, a contrarian indicator that things will soon hit the fan again. This particular friend of mine is an investor, so you are probably better off listening to him than me. There is also the small question of the targets for Ms. Watanabe's allure in the form of the usual, OECD, suspects such as the Kiwi, the Aussie, and the Euro.

Looking at the chart to the right the recent three months which have been marked heavily by the green shoots discouse, it is quite obvious to see that the JPY has depreciated accross the board against the usual suspects. It is difficult to say whether MS. Watanabe has had a hand in this, but more interestingly is also the fundamental question of where the carry trade activity is going to be conducted in the future?

Specifically, it will be interesting to see whether there is going to be a change in the game whereby the OECD economies currently engaged in QE and with subsequent credible commitments by the central bank to keep rates low become funding for a carry trade to exploit the potentially "low volatility" growth (yield) in places such as India, Brazil and Turkey. Clearly, the BOJ has the mother of all credible commitments here in the sense that nominal interest rates have hardly budged the zero bound for more than a decade even in the midst of booms. This last point need careful watching I think as well as of course we might as well get another bout of volatility which could fold the, after all, fragile green shoots.

So, it does indeed seem as if the Japanese housewives are back in the game, but another fundamental question is whether the housewives ever left the game. This is to say that we need to look at structural long term outflows as well as more short term punting in order to really understand the what drives MS Watanabe and her fellow Japanese retail investors.