The relative performance of asset and currency prices could lead one to think that, after years of economic distress, Japan is on the mend while European reforms have stalled amid political resistance to Anglo-American capitalism. But this seems to be the exact opposite of what is really happening.
Many observers, often with their own axes to grind, have focused on recent developments in Europe, especially Germany. The
resistance to a foreign hostile takeover, use of state largess to bail out a large construction firm and threats of unilateral action to institute a withholding tax on savings invested abroad have all been cited to support the bearish attitude toward the euro.
There are, however, significant changes taking place, and the fact that they are overlooked may be offering savvy investors attractive investment opportunities.
Part of the euro's weakness is a reflection of the restructuring that is taking place. European companies have gone on huge shopping sprees, snapping up foreign companies. Not only has this direct investment offset the lion's share of both U.S. and U.K. current-account deficits, but recently released data suggest European companies led the investment into Japan as well.
European companies accounted for a full three quarters of the record $13 billion in foreign direct investment in Japan during the first half of the fiscal year that ended Sept. 30. Through these purchases, European companies are thought to be acquiring cutting-edge management and technology and fortifying their presence in the large markets.
The currency flow that results from these transactions appears to be having a more significant impact on the foreign-exchange market this year because other flows seem to have diminished. After being frustrated last year and earlier this year, the large hedge funds have reportedly pulled back from the foreign-exchange market this year.
The reorganization of corporate assets is encouraging an even more profound change in Europe: the development of broader capital markets. In particular, the corporate bond market in Europe has exploded with activity this year. Volume has nearly tripled from 1998. Especially noteworthy is a 26% increase in high-yield European corporate bonds, which is facilitating the reorganization of corporate assets.
European corporations increasingly are freeing themselves from their historic overreliance on bank lending as a means for working and investment capital. In 1997, bank lending in Europe accounted for nearly 90% of European corporations' financing needs. According to
Morgan Stanley Dean Witter
, this proportion is set to fall toward 70% this year. By comparison, U.S. companies rely on capital markets for roughly 80% of their funding needs. But what is key is the direction of change in Europe.
On the other side of the equation, the single currency in Europe has freed up a whole class of investors. European insurance companies and pension funds are deterred from taking on currency risk, so traditionally they have invested primarily in domestic markets. This contrasts with Japan, where the life-insurance companies and trust banks are often among the largest investors overseas. With the introduction of the euro, European life insurers and pension funds can more easily invest throughout the common currency zone.
The incredible number of jobs the U.S. has created over the last 10 years is not simply a function of flexible U.S. labor markets. On the contrary, a good deal of evidence suggests that the bulk of the job creation is in small and midsize businesses which have access to capital that they didn't have when they relied more on bank lending. Yes, Europe needs to have more flexible labor markets, but reform of the capital markets will help facilitate this change. In addition, one of the implications of capital-markets reform is that it brings with it shareholder values.
Many observers scoff at the French
plans to legislate a 35-hour workweek. They cite this as proof of the lack of commitment to reform. But look at what's happening: Job creation, excluding the state sector, in France in the third quarter was the fastest in a full decade. As of October, French unemployment stood at 11%, a 7-year low. It is set to fall further in the coming months. In fact, the French economy is likely to be among the strongest in the
Group of Seven
next year and may even nudge above U.S. growth.
Japan is a different kettle of fish. The fact that the Japanese economy appears to be on the mend is significant, but this should not be exaggerated. The government has spent nearly 25% of
in recent years trying to reflate the economy. Once the government's spending slows, the economy falters. After strong January-March growth, the Japanese economy has stagnated from April-September (expanding 1% in the second quarter and contracting 1% in the third quarter).
Many market participants and officials may be underestimating the challenge of fixing the deep fiscal hole that Japan has dug. The
Organization of Economic Cooperation and Development
estimates that, to stabilize its debt as a percentage of GDP, servicing costs could amount to 2%-4% of GDP. It suggests Japan cuts spending and boosts taxes. Of particular note, the OECD suggested that the 5% retail sales tax might have to be tripled. Japan's fiscal morass represents an obstacle to substantive reform.
Bank of Japan's
survey of business sentiment will be released early Monday morning in Tokyo. The market expects it to show continued improvement. This may be used as an excuse to push the dollar through the bottom of its 5- to 6-day trading ranges against the yen, which is around 102 yen. BoJ Governor Masaru Hayami said on Nov. 3 that a dollar near 102-103 yen was not problematic. The market will continue to fish for a more serious pain threshold, now believed to be near 100 yen. Keep in mind when you see the tankan results that the report has not been positive (meaning more optimists than pessimists) since September 1997.
Marc Chandler is the chief currency strategist for Mellon Bank. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at