World will catch a cold if Japan gets pneumonia

The most important event in the world's financial markets so far in the new year has undoubtedly been the continuing slide in the Japanese stock market. In the past two months, the Nikkei index has dropped by about 20 per cent, and there are fears that this collapse in Japan will soon begin to undermine the strength of financial markets in the rest of the world - especially in countries such as the US and the UK, which have benefited from Japanese capital inflows in the past, and would stand to be hit quite hard if these flows were repatriated.

There is no doubt that capital outflows from Japan have been large in recent years, as indeed they have to be to offset the trade surplus which has still been running at over $60bn a year. For most of the past two years, Japanese purchases of US bonds alone have been averaging about $60bn at an annual rate, a factor which has clearly helped to hold down global bond yields and thereby boost equity prices in America and elsewhere. In addition to this, there have been sizeable purchases of sterling and other high-yielding Anglo-Saxon currencies (the dollars of the US, Canada, New Zealand and Australia have all been recipients at one time or another), essentially funded by borrowing in yen at interest rates of 0.5 per cent or less. These so-called "carry trades " have been very popular among the hedge funds and other leveraged investment entities, and there could be serious shock waves in the financial markets if they were suddenly reversed. Not only would the yen strengthen sharply, but the fuel which has been supporting bond and equity prices outside of Japan might be threatened.

Fortunately, it is difficult to envisage a sudden reversal at the present time. At root, most of these flows are driven by the existence of aggressively easy monetary policy by the Bank of Japan, and there is no reason whatsoever to believe that this is likely to change in the next few months.

Let us look at the three most important sources of capital outflow in turn. First, there are the private flows out of Japanese investment institutions into foreign bonds. These outflows have been particularly high in the second half of 1996, running at an annual rate of over $30bn by the end of the year.

There is some danger that these flows could be partially reversed if the weakness in the Japanese stock market is maintained. Certainly, in the past, there has been a correlation between the health of the domestic equity market and the outflow into foreign assets, and the weeks before the Japanese financial year end in April are typically a vulnerable period.

But the fact of the matter is that the differential between US and Japanese bond yields remains extremely high at about 4 per cent per annum, and the Japanese financial institutions still have a huge appetite for yield. It would be surprising if the attraction of this yield spread could be resisted for very long.

The second source of support for foreign markets has been the leveraged carry trades funded in yen. There are no reliable figures to show how large these trades have been, but anecdotal evidence suggests that they have been huge at times in the past 18 months.

The same anecdotal evidence indicates that these trades may not have been so large in recent months, with many hedge funds switching their funding into Swiss francs instead of yen. But anyway the remaining trades in this area seem unlikely to be seriously threatened until the market comes to expect an imminent increase in interest rates by the Bank of Japan. With the fiscal stance set to tighten by almost 2 per cent of GDP in April, this does not seem very probable.

This leaves the third main source, the official purchases of foreign assets (mainly US bonds) by the Japanese government.

These are the counterpart of the programme of foreign exchange intervention by the Bank of Japan designed to push the yen down. In recent months, with the yen having depreciated to around 115 against the dollar, official outflows have dropped sharply to an annual rate of only about $10bn.

However, if other forms of capital outflow were to dry up, leading to a renewed strengthening in the yen, there is little doubt that the Bank of Japan would enter the market again to compensate.

Hence, even if private flows were suddenly reversed, the overall capital outflow would stay high until the central bank was ready to see the yen appreciating again against foreign currencies.

And that will not happen until there is clear evidence that the recovery in the Japanese economy can be sustained in the face of the fiscal tightening that is now due.

This raises the question of why the Japanese government is imposing such a large budgetary tightening on an economy which is only just beginning to recover from its worst recession for decades, and in which the balance sheets of the main financial institutions are still very fragile. The reason became a little clearer recently with the publication of an interesting paper by Kenji Okamura of the IMF on the long-term fiscal challenge facing Japan. This makes rather dire reading, suggesting that the fiscal stance is at present totally unsustainable, with the present policy-settings likely to lead to an explosion in the public sector debt/GDP over the next several decades.

The primary source of the problem is demography, with the ratio of retired people to the working population being set to rise from 20 per cent now to about 50 per cent by 2040, an ageing problem more severe than that faced by any other developed economy. This has two unpleasant consequences. First,and most obviously, the burden of social security will rise by at least 2 per cent of GDP, even after recent pension reforms, by 2025.

Second, the shrinkage of the working population will reduce the growth of potential output in the economy from around 4 per cent in the late 1980s to only 1 per cent per annum in the second decade of the next century. This collapse in GDP growth will clearly make it much harder to control the rise in public debt in the years ahead.

Added to these long-term difficulties is the fact that the recent recession has left the Japanese government with a core structural budget deficit - ignoring the one-off special supplementary budgets of emergency spending measures - of 3 per cent of GDP which needs to be addressed as well. According to the IMF calculations, a fiscal retrenchment of 4 per cent of GDP is needed immediately to restore the public accounts to a sustainable position, on top of the 2 per cent of GDP package which is planned for fiscal 1997. If these extra measures are delayed, then the required future tightening will inexorably rise, reflecting the further build-up in debt interest which will be allowed to occur.

Faced with this bleak arithmetic, it is easy to understand why the Ministry of Finance in Tokyo is so eager to embark on fiscal tightening this year. And that in turn means that the Bank of Japan will be forced to keep the monetary pumps switched on for some time yet.


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