Japan is not a country whose bureaucrats are known for speaking blunt truths. So when its finance minister last week said the country's finances were approaching catastrophe, investors were seriously rattled.
It wasn't the first time Japan has unnerved investors, of course, but after a decade of economic pain the situation has worsened. Government debt has continued to tick upward, with some estimates predicting it will reach 130% of economic output by the end of this month.
Standard & Poor's
recently cut Japan's once-sterling credit rating. Amid widespread consumer fears, deflation has taken hold, with prices dropping 1.1% last year. And now there's another worry unsettling Japanese markets: the possibility of recession in the U.S. Against this messy backdrop, the benchmark
dropped to a 16-year low Monday.
We talked to
, president of
and the manager of the
Matthews Japan fund, to help us figure out the significance of the latest turn of events.
TSC: Can you put the events of the last couple of weeks in perspective? Given that Japan's economy has been in trouble for such a long time, how worried should we be when the finance minister says its finances are near collapse?
I think what's really been hurt is whatever credibility the central bank of Japan and the
Liberal Democratic Party
had a month or two ago has pretty much evaporated. Deflation remains rampant, which is even worse than inflation being rampant. The central bank's interest rate policies were obviously, though symbolic, harmful
in raising the rate from 0% to as high as 0.25% earlier. To say we were in a sustainable recovery was obviously erroneous. They were taking the exact wrong direction.
So what they really need is to present policies that convince people that some help is on the way -- the central bank buying bonds and pumping liquidity into the economy and producing some expectation of Japan escaping from its deflationary trap, and at the same time the government presenting policies which convince people that a lot of the tough long-standing issues of deregulation and the restructuring of the domestic economy will be dealt with aggressively. There has been positive change in Japan in the last few years, but there's no sense that the government has truly supported those changes.
TSC: In the short term, people have been talking about problems for the market associated with corporate year-end book closings at the end of March -- basically, that companies are selling off some of their investments that have lost value, and that's making things worse.
There is current selling pressure as companies dump some of their cross-holdings before the fiscal year ends. There's a certain amount of artificial selling pressure. We should get some letup in the selling of cross-holdings after the end of the month.
Also, the Nikkei is lower than it would be because right at the peak of the tech-boom peak, they rejiggered it and added a bunch of tech names. It's a couple of thousand points
below where it would be if they hadn't rejiggered it. Those are a couple of things that make the Nikkei look worse than it could be, from a technical standpoint.
TSC: Why should people who are not directly invested in Japan care about what happens there? The economy's been stagnant for a long time, so why should its problems matter now?
It's particularly important given that one of the only policies the
Bank of Japan
left is to weaken the yen. That's not a good policy at a time the U.S. may be sliding into recession. We have not had a crisis in Japan at the same time
there's been a crisis in the U.S..
TSC: And by weakening the yen, Japan would basically be trying to export their way out of their problem?
They'd try to export their way out of it: There would be less imports from the U.S. and the rest of Asia -- Japan sells more and the rest of the world sells less. So
you'd have devaluation without a clear policy and commitment to reform and restructuring.
TSC: Do you think that will happen?
It's absolutely up in the air. We need a new prime minister, but that's not going to happen for six weeks. And we need the LDP to appoint someone who can articulate a vision of the future, not a vision of the past.
TSC: What might be the impact of Japan's problems on the U.S. market? Obviously the bulk of concerns there are domestic, but it seems like Japan's problems could act as an additional burden on the US economy. Do you think investors view this as an additional worry, and why?
A recovering Japanese economy would buy U.S. goods. A slumping Japan economy is going to hurt, and it will likely lead to continued yen weakness as we are currently seeing. This hurts the U.S. in global competition as well as all other dollar-based manufacturers
like China and Hong Kong. But I think the biggest problem is confidence... as in the Asian crisis.
The combination of both the Japanese and the U.S. economy in trouble at the same time really increases the sense of doom and gloom that can drive stock prices well below the normal valuations -- and that could mean a heck of a bear market in the U.S. where valuations remain way above long-term averages. Can we say
6000...! Unlikely, but it is the combination of factors, as in the
Long Term Capital
blowup, that creates crashes.
Japan is also a great lesson in the devastating impact of deflation -- something central banks need to learn to fear as much as inflation. But that's another story.
TSC: What do you think about the rest of Asia?
We see the Pacific ex-Japan region as having a stronger reform and restructuring effort than Japan, and greater growth prospects. And the valuations overall are still lower. I've tended to say this could be a great year for
the Pacific ex-Japan. Japan's fate hinges on things we can't control, even corporate Japan can't control. It's hinging more on the central bank, the LDP and whether there's an inflection point where people start to decide it is as bad as it could get.
When I was recently quoted in
The Wall Street Journal
as saying I wanted the Nikkei to go to 10,000, what I meant was I want a sense of crisis. Japan needs a sense of crisis. Asia, ex-Japan, was shaken up incredibly by the Asian crisis. Japan ignored it, by and large.
TSC: Back in 1999, investors in Japan had a great year, and not too long ago there was talk of a recovery. Why didn't that pan out?
Earlier, we were having what looked like a true recovery in the Japanese economy. Last year there was restructuring going on, on an individual company basis, and the financial system was being restructured fairly dramatically. But you still have the last, ugly bank debt to deal with. That's turning out to be far more difficult than the government had hoped. And obviously they had hoped that much of the challenge facing the financial system would be grown out of by a robust economy.
I think a lot of Japan's problem today is one of confidence. There's still tremendous wealth in Japan. But all the government's efforts to prime the economy have been met with tremendous skepticism, and domestically, people are uncertain where the future lay, and internationally, people would see one positive and one negative message and remain confused. There's just been a deterioration of any confidence that the LDP can lead the country forward, and somewhat that has to change, whether it's by radical change within the LDP or by
the party's removal.
TSC: When you talk about consumer confidence, are you referring to deflation and the idea that consumers aren't spending any money, and that's causing prices in Japan to keep falling?
People need to spend money, but when you're uncertain about your job and the future, you tend to save. But that's brutal for the domestic economy. In Japan, property prices are down 65% since their peak in 1991. If you told people in the U.S. that 10 years from now, your house would be worth less than half what it's worth today, and the Dow would be at 1200, how much spending would they do?
TSC: So the Dow would have to fall to 1200 from its current level to equal the fall of the Nikkei from its peak?
The Nikkei is now back to its 1985 level. And in 1985, the Dow was at between 1200 and 1300.