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Japan's gain could be your loss
After 15 years, Japan's economy is growing again, which means the Bank of Japan won't be flooding global markets with free money. Say hello to higher interest rates.
By Jim Jubak
It's officially over. After 15 years -- yes, 15 years -- of no growth, Japan's economy is poised to grow by as much as 5% in 2006. After eight years of slowly but steadily falling prices, Japan can now smell a welcome whiff of inflation. And after years and years of 0% short-term interest rates, the Bank of Japan is widely expected to finish the year raising those same rates to 0.5%.
So take a moment to cheer for the end of what has been called the lost decade in Japan. Then, buckle your seat belts.
Because what's good for the Japanese investor and the Japanese CEO and the Japanese consumer isn't at all good for international financial markets. The recovery in Japan is likely to usher in hard times in financial markets and economies around the globe. And no economy is at greater risk of taking a body blow from a Japanese economic recovery than that of the United States.
The problem is that during Japan's lost decade, the world has gotten hooked on ridiculously cheap Japanese cash sloshing around the financial markets.
The downward spiral
The Bank of Japan pursued two strategies as it fought to bring the country out of the deflationary slump that gripped the nation after its stock market started collapsing in the 1990s.- The bank cut short-term interest rates to 0%. This move received the most attention around the world. The problem that the Bank of Japan ran into is one that keeps central bankers around the world up late at night worrying: Once deflation has really taken hold of an economy, cutting interest rates won't help. With prices falling steadily and consumers convinced that they'll keep falling, there's no incentive to borrow today to buy today; prices will be lower tomorrow. With consumer demand slumping, businesses have no incentive to borrow, even if the money is effectively free, since they are looking at falling, and not growing, customer demand in the future. The lack of consumer and business spending increases the level of worry about the future. That, in turn, encourages consumers and businesses to hold onto their cash rather than spend it.
- Faced with these deflationary expectations and having exhausted the conventional remedy of lower interest rates, the Bank of Japan launched Japan onto uncharted financial seas. If cutting interest rates to 0% didn't jump-start Japan's economy, maybe flooding the economy with money would work. At the worst, it would at least prevent the collapse of banks and industrial companies struggling under the burden of loans made during the height of Japan's great real-estate bubble, which had since turned sour.
Opening the floodgates
This effort took many forms. In September 2002, for example, with the Nikkei 225 ($N225) stock index at 9,000 -- down more than 75% from its high of nearly 38,916 at the end of 1989 -- the Bank of Japan started to buy shares in troubled companies to keep the Japanese stock market from sliding even further. To keep the market for Japanese Treasury bonds functioning smoothly, the bank also bought government bonds. And in an effort to flood the financial markets with free money in the hope that somebody would borrow it if it was just cheap and plentiful enough, the Bank of Japan bought billions in short-term debt.
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Calculations by The Financial Times put the extra cash at something like six times beyond what the bank needed to put into the Japanese financial markets to get interest rates to fall to 0%. The bank's target for liquidity soared from something like $50 billion when this policy began some five years ago to something like $250 billion to $300 billion by the time the bank decided last week to end its policy of flooding the markets with cash.
Until this year, pretty much nothing happened. Japanese consumers and businesses that weren't interested in borrowing $1 of free money were just as uninterested in borrowing $2 in free money, it turned out. It took a quite probably unrelated boom in exports to China and the U.S. to get the Japanese economy rolling again starting last year.
So, if no one in Japan wanted to borrow all that free money the Bank of Japan was pumping into the economy, what happened to it?
It went overseas -- looking for higher returns.
Some was invested by Japanese savers, banks and investment companies. A favorite investment was the relatively high-yielding debt issued by the U.S. Treasury. Japanese holdings of U.S. Treasury debt climbed 115% from "just" $318 billion in December 2001 to $685 billion in December 2005. China has shown faster growth in recent years -- to $257 billion in 2005 from $79 billion in 2001. That's 225% in four years. Still, Japan remains far and away the biggest holder of U.S. Treasurys.
Some of the cash was borrowed in Japan by overseas investors who used the free money to buy U.S. Treasurys, gold and mortgage-backed securities, among other assets. This carry-trade, as it's called, is extremely profitable because access to free money means that investors can leverage their own cash with borrowed money to the tune of 5 or 10 or 20 to one.
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