With sky-high public debt, near-zero interest rates, and an economy that is reportedly a basket case after two decades of stagnation, Japan's currency should be falling through the floor. Instead, the yen’s strength is a challenge to those who seem to believe Japan is sliding into oblivion.
The downgrading of Japanese government debt by a US ratings agency in late January was the cue for another round of doomsday predictions.
On Jan. 27, Standard & Poor’s (S&P) cut its rating on Japanese sovereign debt one notch, to AA-minus, three levels off the top ranking and on a par with that of fiscally troubled Spain. It argued that the ruling Democratic Party of Japan "lacks a coherent strategy" to address the country's financial woes.
Leaving aside the issue of credibility of the rating agencies, all of which were classifying sub-prime junk bonds as high-grade investments right up to the credit crisis, there is no denying the dire state of Japan’s public finances.
It’s often written that the country has the highest national debt as a percentage of GDP – at around 200 percent – in the OECD or in the industrialized world. In fact, only Zimbabwe’s is higher. The US by comparison, at around 60 percent, is only a touch above the global average.
Still, while the Japanese government issued more new debt than it collected in tax revenue in the last fiscal year, the economy has not collapsed, and the yen has actually strengthened. Investors are largely unconcerned because the debt is virtually all domestically held, and the yields demanded are very low. Japan is also sitting on some very large reserves of assets, unemployment is falling, and profitability is increasing at its major corporations as they benefit from the global recovery and fast-growing Asia.
'Weakness does not explain strength'
And yet the advice on how to fix the economy keeps coming from around the globe, along with claims that Japan is teetering on the edge of the abyss.
“My favorite question for people who hold those views is: ‘If Japan is so weak, why is the yen so strong?’ It’s somewhat of a head-breaking question for those who prefer the view that Japan is weak,” says Scott Callon, chairman of Ichigo Group Holdings, an asset management company with around $5 billion in funds invested exclusively in Japanese companies and real estate. “They typically want to explain yen strength in terms of weakness – the yen is so strong because the Bank of Japan is so weak, or because the political system is fragmented. But this doesn’t make sense... Weakness does not explain strength.”
“When you buy the yen, by definition you sell another currency, the dollar or the euro or the Australian dollar, etc., against it,” continues Mr. Callon, pointing out the huge size of the global foreign exchange trade. “And that incredibly active and liquid market, representing the collective wisdom of millions of market participants globally, has taken a very strong view on the Japanese currency and the inherent strengths of this country and its economy.”
One of those strengths is the huge piles of cash and bonds that the country built up over decades of blistering growth and giant trade surpluses: more than $1 trillion in foreign exchange reserves (mostly US Treasury bonds), $1.4 trillion (about the size of Russia’s economy) in the Government Pension Investment Fund reserves, and $1.5 trillion (about the size of Canada’s economy) in household savings.
In order to fund its spending, the state has essentially borrowed against these funds, and from companies and financial institutions that buy government bonds. Martin Schulz, senior economist at the Fujitsu Research Institute in Tokyo, describes this as a form of “deferred taxation” that will eventually have to be paid back by the Japanese people.
Japan's big strength
The biggest strength of the economy, however, and the source of this accumulated wealth, remain the nation’s companies. Having survived the global slowdown, they recently recorded their fifth straight quarter of collective profit rises. Wages also grew in 2010 – albeit for the first time in four years - unemployment had dipped back below 4.9 percent by the end of the year, while overall corporate earnings are projected to grow 31.5 percent in the fiscal year to March.
Unlike the government, a large portion of Japan’s big corporations are debt-free, and not a few of them have large war-chests with which they intend to take advantage of the current strength of the yen by acquiring overseas assets. Canon, for example, recently earmarked a trillion yen ($12.25 billion) for overseas takeovers over the next few years.
Canon is also just one Japanese company posting record sales to fast-growing Asia, with many firms now making more money there than in their domestic market.
Under the radar
It’s not only Japan’s famous global brands that are flourishing, but numerous others that are largely under the radar. A case in point is Murata, a maker of specialist components that go inside smartphones. Although few know its name, it commands a 50 percent share of the global market of some of these parts, and recently announced profits that were up 270 percent in the nine months to December. In addition to the likes of Nintendo and Nissan, it’s these companies that enable Japan to run a huge trade and current account surplus, even with the yen at around 80 to the dollar.
This is not to ignore Japan’s serious structural issues, including its shrinking population, which is its “single biggest problem,” according to Takashi Shiono, economist at Credit Suisse in Tokyo. Much of Western Europe, along with South Korea, is facing a similar situation; while the legacy of the one-child policy will soon begin to make China’s demographics even more skewed.
Despite the shrinking population and accompanying deflation, Japan has managed to nudge productivity and growth upward. To kick-start the domestic market, though, unprofitable "zombie companies" would have to be allowed to fail, suggests Mr. Shiono, something that would cause unemployment and break the “social consensus.”
For all its problems, Japan’s profitability, high employment, and competitiveness should still make it the envy of much of the West, not an object of scorn or pity. As Ichigo’s Mr. Callon puts it, “Pound for pound, is Japan is punching well above its weight.”