Japan in Jeopardy

"Ingwa wa, kuruma no wa." (Cause and effect is like a wheel) - Japanese Buddhist Proverb

Japan was once the marvel of the globe.  Their efficiency and manufacturing prowess was revered and Japanese companies morphed from obscurity into global power houses.  Japanese executives were seen trolling the globe armed with fists full of Yen and the desire to snap up buildings and companies around the globe.  The Japanese stock exchange reached an all time high of 38,915 in December of 1989 and it seemed as if the Japanese were invincible.

Fast forward to today and Japan is in a world of hurt.  The current administration under Shinzo Abe is fighting deflation and slow growth with.Mr. Abe's economic stimulus plan, Abenomics consisting of three measures: monetary easing, fiscal stimulus and structural reforms.  These measures were expected to repair Japan's economy through quantitative easing strategies similar to the United States, spending to stimulate private investment and structural reforms to make the market more open to new businesses and improve labor policies to reduce the reliance on welfare and make the labor market more flexible.

After a year of actively pursuing the first two strategies the results are anything but stellar.  The effect of quantitative easing has been to devalue the Yen by more than 25%.  While this was the intended effect the results were not as expected as exports have not flourished as they have in the past.  Normally when a currency devalues it promotes exports of local products as they become cheaper on the international markets.  As Japan relies heavily on exports, devaluing the currency has been a quick fix to stimulate the economy however this time around the effect was muted by the fact that a large majority of exporters are building their products off shore.  The result is that Japan government debt has rocketed to more than 220% of GDP and this is creating a new set of problems.

At the present level (and growing) debt service payments are more than 25% of the government's annual budget and this is with interest rates at essentially zero.  Even a small rise in interest rates to say 2% would effectively make the government insolvent as the tax receipts would not cover the debt payments.  In an effort to stem this tide Japan raised its consumption tax from 5% to 8% in April.  The result of this move is that the country's economy declined at an annual rate of 7.1%.  While many believe that this trend will reverse in the current quarter there is another round of consumption tax increases expected in October 2015 so it would not surprise me to see consumption stay down for an extended period.

Another side effect of the weakening Yen has been to hike the cost of base goods like electricity.  With the loss of a large portion of the country's nuclear power and the aftermath of concern following the Tsunami and the radiation leaks Japan has come to rely more and more on natural gas powered plants.  As Japan is not a gas producer this gas is imported but with the price of natural gas tied to the USD the Yen weakness has resulted in a spike in the cost of producing electricity.  These price increases are being pushed on to the Japanese consumer who is now paying 28% more for their electricity than they were four years ago.  Between this squeeze, consumption tax increases and lackluster pay increases it is no wonder that the consumer is closing their wallets.

So the only arrow left in Abe's quiver is to change the country structurally.  The problem with structural reforms is that they do not happen overnight and Japan needs something to happen quickly as time is running out.  Amazingly through all of this the Nikkei is leaping to 6 year highs on the back of some stellar company earnings courtesy of the weak Yen but if the structural problems facing Japan are not sorted out these highs may soon be distant memories much like the high last printed 25 years ago.  While all of this seems to be unrelated to the United States consumer, one need only look at the issues that arose out of Europe's mess to see that any significant problems in the world's third largest economy would be felt around the globe.