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Is Japan's Recovery Sustainable?   (November 3, 2005)


I received a query from an experienced financial analyst in Tokyo, Taro Akasaka, who writes a very well-informed blog on real estate issues and news in Japan.

Mr. Akasaka was kind enough to ask my opinion of a key economic question:

"One of my concerns these days, as a financial analyst in Tokyo, is how the coming US economic slowdown might affect the Japanese economy. Will it be the undoing of Japan's recovery, or will we shake off America's doldrums and continue our spell of growth?"

In other words, is Japan's recovery sustainable, even if America slides into recession?

The question cannot be answered, in my opinion, without considering these macro-economic issues:
  • global capital flows into Japan
  • capital flows out of Japan into China
  • the direction of interest rates in Japan
  • the demise of excess global liquidity
  • the dependence of Japan's economy on exports to China and the U.S.

    In general, I am not an optimist on the global economy 2006-2012. Therefore I am very skeptical of analysts who foresee a healthy Japanese economy while the rest of the world is in a global depression. The Japanese economy remains dependent on exports for growth, and if the market nations, especially the U.S. and China, fall into a deep, prolonged recession, then how can Japan prosper? The same can be said of the E.U., which is also entirely dependent on exports for its growth.

    From this perspective, every economy in the world is seeking to follow the Japanese model of high growth through exports. Unfortunately, that leaves only one consumer nation, the U.S., which will soon collapse under the imbalances of its trade deficits, governmental deficits and real estate bubble. Once the U.S. crumbles, the dollar will also decline precipitously, causing the other global currencies to rise. Once the U.S. economy and dollar fall, then China will quickly follow, as it is very dependent on exports to the U.S. and to other countries which also depend on the U.S. market. Furthermore, there are huge imbalances in China's economy which I have discussed in other articles. When the U.S. stops being able to borrow money in order to buy $1.6 trillion annually of other nations' goods, then only nations which do not depend on exports can prosper. Are there any such nations?

    In other words, it seems to me that the world economy is like a line of dominos. Once the U.S. topples, it will inevitably knock down all the other nations which trade with it and lend it money. The other major economies--Japan, the EU. and China, all depend on exports for growth. Their domestic demand has been too weak to drive growth for over a decade. People in these regions save enormous amounts of money which they are afraid to spend. Why? Do they feel hopeful and optimistic about the future? If so, why do they save rather than spend? This is true in both Europe and in Asia. Do these nations invest in their own assets and productivity? Somewhat, but then why are they lending 80% of their savings to the U.S. via purchases of U.S. Treasuries and corporate bonds? This is not a vote of confidence in their own economies, and not healthy for the U.S. either, where this huge capital inflow has created a housing bubble which will destroy wealth just like the real estate bubble did in Japan.

    The other factor which is not being appreciated is the enormous creation of liquidity by the world's central banks. Huge sums of money have been created by the Federal Reserve, and to keep their own currency suppressed against the dollar, other central banks have lowered interest rates and created excess liquidity in their own economies. The world is truly afloat on borrowed money. Once liquidity dries up, and interest rates continue rising in the U.S., then there won't be so much money to invest in real estate--in Japan or the U.S. I am sure you know that commercial real estate in the U.S. is also in a big bubble. Buildings which once rented for $50 per square foot in 2000 are being sold for more money than during the Dot-Com Boom, but they only rent for $31/square foot now. Where is the positive cash flow? How can rents go up when millions of new square footage are being built? The oversupply of commercial and residential real estate in the U.S. will be truly huge by next year.

    In my view, the rise of real estate values in Japan is entirely the result of large capital inflows from the U.S. With too much money laying around in the U.S. (as a result of excess liquidity and trillions in low-interest money borrowed from foreigners via Treasuries and corporate bonds), firms are looking to invest in bargains, and so large amounts of capital are flowing into Japan. At the same time, Japanese investment money is flowing out to build factories in China and the rest of Asia. The Japanese multinationals realise they must invest in low-cost plants outside Japan while maintaining the high-value manufacturing in Japan. While this will enable them to prosper globally, it doesn't necessarily make real estate in Japan a high-return investment.

    According to the Wall Street Journal of November 2, 2005, Japanese capital is flowing into the U.S.:
    During the first eight months of this year, Japanese investors poured a net 14.5 trillion yen, or $126 billion, into foreign stocks and bonds, up 19% from the same period the previous year. If the current pace continues, such investments for 2005 will be the highest since 1989, when the government started compiling the current data, surpassing last year's $174 billion. To buy dollar-based assets, investors first have to sell their yen to buy the U.S. currency, which makes the yen weaker against the dollar.
    You might have noticed my entry on the Kondratieff Cycle, which suggests a global depression will gather steam 2006-2012. All the pieces are in place for just such a depression: unsustainable imbalances in trade, in liquidity, in real estate valuations, in government debt, in private debt and in currency valuations.

    In my opinion, Japan is blessed with a leader of political genius. Koizumi has enabled Japan to improve its macro situation greatly. But even with these improvements, I don't believe it is possible for the generation behind the Baby Boom to generate growth in Japan from domestic consumption alone. Demographically, there just aren't enough people to spark domestic growth. As everyone knows, Japan's population will soon start declining, and a huge number of people will begin retiring, putting a major financial strain on the government and on their private pensions and savings--and on their children. Furthermore, if interest rates ever rise in Japan in response to improved conditions, then the government will have to pay much higher interest rates on its vast amount of public debt. While that will help the bondholders, it will cause a fiscal crisis for the central government, which already spends huge sums paying interest on the public debt. The same crisis will also strike the U.S. government as it must pay higher interest on $8 trillion.

    I would like to believe that Japan will avoid the effects of a collapse in U.S. real estate, the dollar and trade, but I don't see how any major nation can avoid the negative effects of such a decline.

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    copyright © 2005 Charles Hugh Smith. All rights reserved in all media.

    I would be honored if you linked this wEssay to your site, or printed a copy for your own use.

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