The China Bubble

The press is starting to warm up to our view that the Chinese situation resembles Japan in the 1980s. 

I'm not going to call it a bubble because the growth positioning of India is enviable, but the prices of property in Mumbai, Gurgaon and other parts of the country relative to income are astounding, humbling and shocking to me.

China rushes towards a Japan-style bubble

By Peter Tasker

Emerging markets, it seems, have had a good crisis. In contrast to the debt-ridden G7 economies, they have quickly resumed their growth trajectory. No surprise, then, that US emerging market mutual funds are experiencing record inflows. The stellar performance of the Brics markets - Brazil, Russia, Indian and China - is due to continue into the distant future.
Such is the narrative now forming among investors. To anyone who has lived through the rise and fall of the Japanese bubble economy, it should set off alarm bells.

Remember that it was in the years following the 1987 "Black Monday" crash that Japanese assets went from being expensive to absurdly overvalued and the Nikkei's dizzy rise to 39,000 forced the bears to throw in the towel.

Then, as now, the logic seemed unassailable. While the western world was stuck in the post-crash doldrums, the Japanese economy had got back on track with apparent ease. Japanese corporations were using their high market capitalisations to finance acquisitions of foreign trophy assets. Japanese banks boasted the world's strongest credit ratings.
But what you saw was decidedly not what you got. The crisis, far from leaving Japan unscathed, exacerbated its structural problems and laid the groundwork for a far greater disaster. And it was the weak western economies, not Japan, that produced healthy investment returns over the next decade.

In reality, 1980s Japan was never going to be terminally damaged by weakness in export markets. Its current account surplus and strong fiscal position provided the macro policy leeway to make any slowdown strictly temporary. The Bank of Japan duly put the pedal to the metal and the recently deregulated banks went on a patriotic lending spree. High-end consumption boomed but the real action was in the asset markets and capital investment, which soared as a proportion of gross domestic product.

Sound familiar? It should, because the same dynamic is evident today in China and some other emerging economies.

At the 2008 peak, the price-to-book ratio of the Shanghai stock exchange was over seven times, well above the five times achieved by Japanese stocks in 1989. After the turbulence of the past 18 months, the ratio has fallen to 3.3 times, still the world's second highest after India, and residential real estate trades at multiples of income that make the US housing boom look tame.

Why would China's rulers embark on a such a disastrous course? Because the alternative - unleashing deflationary forces stored up over years of mercantilist policies - would be too painful to contemplate. That was the choice made by Japanese policymakers, who had 100 years' experience of managing a quasi-capitalist economy.

While we can call these bubbles, based on anecdotal evidence emerging markets investors are convinced that they have survived and are immune to what ails the first world.  Time will tell, but a nagging feeling tells me I've seen this story before.

Japanese Demand for U.S. Debt Is Bound to Weaken Dramatically

By way of the always dramatic and usually accurate Ambrose Evans comes this piece that ties in with my view that markets are not recognizing the severity of the Japanese situation and how this will impact future purchases of U.S. Treasury securities.

It is Japan we should be worrying about, not America

Japan is drifting helplessly towards a dramatic fiscal crisis. For 20 years the world's second-largest economy has been able to borrow cheaply from a captive bond market, feeding its addiction to Keynesian deficit spending – and allowing it to push public debt beyond the point of no return. 

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). 

Implications: The Japanese carry trade is likely to continue losing favor, leading to a strengthening impact on the Yen and weakness for the Dollar.

Secondly, the rapidly deteriorating situation makes it increasingly a fait accompli that the Japanese will not be able to continue their Treasury purchases at a time the U.S. desperately needs their support in the wake of the Fed's completion of their $330 billion purchase program.

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".

The IMF expects Japan's gross public debt to reach 218pc of gross domestic product (GDP) this year, 227pc next year, and 246pc by 2014. This has been manageable so far only because Japanese savers have been willing – or coerced – into lending for almost nothing. The yield on 10-year government bonds has been around 1.30pc this year, though they jumped to 1.42pc last week. 

"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.
The pillars of the government debt market are crumbling. If Japan's bond rates rise to global levels of 3pc to 4pc, interest costs will shatter state finances. 

Japan is descending into a debt situation where it is only a matter of when not if.

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." 


"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." 

And some particularly ominous conclusions that portend where we think U.S. strategy is headed:

It wasted its immense fiscal firepower, scattering money for 20 years on half-baked spending projects to keep the economy afloat. QE was too little, too late, and this is the lesson for the West. We must cut borrowing drastically over the next decade, and offset this with ultra-easy monetary policy. Does Downing Street understand this? Does the White House? Does the European Central Bank? Clearly not.

 

Why Japan Is In Worse Shape Than the U.S.

Another on target analysis and the reason why it makes sense for all investors to protect themselves from an inflationary spiral in the U.S.  Secondly, many investors are looking to diversify out of dollars, are Yen really that better a choice?  What about the pound or the euro? lots of issues there as well. 

Japan appears vulnerable, because it is even more indebted and its poor demographics are a decade ahead of ours. Japan may already be past the point of no return. When a country cannot reduce its ratio of debt to GDP over any time horizon, it means it can only refinance, but can never repay its debts. Japan has about 190% debt-to-GDP financed at an average cost of less than 2%. Even with the benefit of cheap financing the Japanese deficit is expected to be 10% of GDP this year. At some point, as American homeowners with teaser interest rates have learned, when the market refuses to refinance at cheap rates, problems quickly emerge. Imagine the fiscal impact of the market resetting Japanese borrowing costs to 5%.

Over the last few years, Japanese savers have been willing to finance their government deficit. However, with Japan’s population aging, it’s likely that the domestic savers will  begin using those savings to fund their retirements. The newly elected DPJ party that favors domestic consumption might speed up this development. Should the market re-price Japanese credit risk, it is hard to see how Japan could avoid a government default or hyperinflationary currency death spiral.

For years, the discussion has been that our deficit spending will pass the costs onto “our grandchildren.” I believe that this is no longer the case and that the consequences will be seen during the lifetime of the leaders who have pursued short-term popularity over our solvency. The recent economic crisis and our response has brought forward the eventual reconciliation into a window that is near enough that it makes sense for investors to buy some insurance to protect themselves from a possible systemic event. To slightly modify Alexis de
Tocqueville: Events can move from the impossible to the inevitable without ever stopping at
the probable. As investors, we can’t change the course of events, but we can attempt to protect
capital in the face of foreseeable risks.