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How Weak Japanese Economy Contributes to a Global Stock Market Reversal

Stock-Markets / Stock Markets 2011 May 13, 2011 - 05:38 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleJack Barnes writes: In our ongoing search for possible "inflection-point" catalysts - financial stimulants that could help turn global markets upside down - the Japanese economy has to be a prime candidate.

In the last part of the 1980s, Japan was the world power - so much so that investors on the U.S. trading floors of New York each day watched the Tokyo markets with a mixture of awe and fear. An oft-cited investing aphorism of the day explained this very clearly by holding that "when Tokyo sneezes, Wall Street catches a cold."

Not long after, the Japanese miracle ended, the stock-and-real-estate markets crashed, and that Asian country fell into a funk known as the "Lost Decade" - a misnomer, since the economic malaise that's lasted virtually ever since is actually more than 20 years long.

If we fast-forward to the present day, Japan has been economically leapfrogged by both the United States and China, and is no longer the global-economy trendsetter that it once was.

But as we inventory inflection-point-catalyst candidates, we've discovered one interesting fact: In the present day, and in its present state, Japan has regained the ability to help give the rest of the world a very bad cold.

And it can do so by infecting the new heavyweight champ of Southeast Asia.

I'm talking, of course, about China.

The Japanese Economy: On a Collision Course ... With China
Of all the impacts that the March 11 earthquake, tsunami and resultant nuclear-plant disaster in Japan will end up having, the most surprising - and long-lasting - may be the way it changes that country's relationship with its next-door neighbor to the west.

It's probably the worst time possible. But the fact is that the Japan economy is on a collision course with its China counterpart. And the aftermath of that collision could contribute to the major market reversals that we've been discussing in this Money Morning series, "The Inflection Point."

The fact that Japan's government is attempting a major rebuild of the Japanese economy - at the same time that China is continuing its massive build-out program - will have both nations bidding on (read that to mean "competing" for) the same raw materials that each nation needs in order to grow whole cities from scratch.

The two nations, with a long history of invading each other, will find themselves sharing the same dirty air. The smokestacks of China will continue spewing out pollutants, which will now mix with the airborne radioactive fallout contributed by Japan.

The ways in which these unfortunate realities could sour the relationship between these two Asian heavyweights in the months to come are almost too numerous to list here. Suffice it to say that this already stressed relationship will be under an increasing amount of pressure during the rest of this year, and well into 2012.

And one place that this skirmish can be watched is in the global currency markets.

Does China Have a Yen for Japan's Currency?
The currency market has always been an arena in which each national central bank carries out the collective will of its people.

In China's case, this monetary policy has included a de facto peg to the U.S. dollar. So while the exchange rate may change incrementally between the Chinese yuan and the U.S. dollar, the changes are not significant enough to make the two currencies distinguishable from each other in the world markets.

This has meant that, while the United States has devalued the dollar, and its buying power against other fiat currencies, China has essentially also simultaneously devalued the yuan.

And that's not the end of it: This devaluation process has also meant that China's yuan has been devalued compared to its neighboring currency - the Japanese yen.

The escalation in the yen has put Japan at an export disadvantage to China. This has only been exacerbated by the end of the so-called "yen carry trade." The great unwinding, which ran through pretty much every trading "stop" in the currency markets, forced the major Western central banks to step into the markets "as one" to restore order - and calm.

These market interventions - as well as Japan having poured more than $700 billion worth of yen into the local markets in order to stabilize them since the earthquake - have temporarily capped this spike in the value of the yen. The hope is that this respite - or reprieve - will buy Japan some time so that its economy will again start to function in the aftermath of the March 11 disaster.

This puts Japan in a situation where the country must weaken the "perceived value" of the yen in the marketplace. To put this in context, Toyota Motor Corp. (NYSE: TM) the world's largest producer of cars in 2010, is now talking about pulling out of Japan if the yen continues to climb.

As a result, it is my expectation that Japan will have to continue to conduct a series of extremely large "unsterilized" currency events.

(When I talk about "unsterilized currency events," think of Zimbabwe and how it used to print currency with zero assets or debt behind it. Japan is the most indebted developed nation in the world. And with the triple-whammy of earthquake, tsunami and nuclear meltdown having acted as a right, left and uppercut combination of punches, Japan cannot now afford to pay for this in any other way. So, as traders say, it will print yen "in size." The Bank of Japan (BOJ), if it wants to break the trend of a strengthening yen in the marketplace, will have to "out-print" the United States in a fiat-currency printing war.)

But any attempt by Japan to weaken its currency could turn into a punching match with China - which isn't exactly known for allowing other nations to achieve a perceived advantage in mercantilism.

Thus, if China continues to act according to form, it will need to step into the currency markets and buy up most, or even nearly all, of the yen that Japan will be printing. This would be an attempt to strengthen the yen, blunting any currency advantage that the Japanese economy might have achieved. I don't believe that even China can soak up the level of currency printing that Japan needs to happen.

In the current environment, however, this won't be a slam-dunk play for China: In the aftermath of the disaster, in its hour of need, the world's major central banks have been rallying around Japan and taking steps to weaken the yen.

This is the first time since the historic 1985 Plaza Accord, or the 1987 Louvre Accord, that the major central banks have united in the global currency markets in order to weaken a specific country's currency.

That these major nations are working in concert again speaks volumes about the perceived gravity of this current situation involving the Japanese economy. The interventions of March 2011 by the central banks are not yet fully understood by the market. I believe, in hindsight, they will be a major chapter in the banking structure of tomorrow.

A Look Ahead
If we cast our eyes forward - in an attempt to see what may still develop - we can see that Japan faces some major potential issues involving China and some of its other neighbors.

For instance, Japan has always had an energy shortfall, but with the loss of a key nuclear plant, and growing anti-nuclear sentiment, that shortfall is worse than ever. Here at Money Morning, we've discussed some of the potential solutions to Japan's energy shortfall - including projected increases in liquefied natural gas (LNG) imports - but have done so acknowledging that they're only "partial" solutions.

Some of the potential points of friction include:

•Energy Scuffles: Japan needs to boost energy importation by a large amount in the aftermath of the March 11 catastrophe. It needs to boost LNG imports and construct cross-country natural-gas-powered plants to replace its lost nuclear-power capacity. But the Eastern China Sea natural-gas field - of which both claim a piece - remains a point of serious contention.
•The "Rare-Earth Wars:" Rare-earth metals are central elements of many technologies, meaning that advanced economies such as Japan and the United States have a great need for these raw materials. But China now controls as much as 97% of global-rare-earths production - and is restricting exports. In its current weakened state, Japan needs these more than ever, meaning this will certainly exacerbate the friction the two nations are already experiencing.
•A Knee-Buckling Debt Load: Critics rant about America's government debt burden, but Japan - at 225% -- has the highest level of public debt as a percentage of gross domestic product (GDP) of any major economy in the world. This could limit Japan's maneuverability as it tries to rebuild, and any kind of a credit scare could have ripple effects throughout Asia.
•The Aftermath of the Powerplant Disaster: Japan's nuclear accident will be a costly one - on many levels. First and foremost, the contamination will last for years - and won't be limited to Japan proper. The air and waters of the region have been contaminated, and the damage won't really be known for years. As already stated, it will force Japan to seek alternatives, which will raise prices in a way that can't help but prove costly to China. And the accident has opened the door to virulent protests over - and heightened worldwide scrutiny of - nuclear energy, an energy source that China absolutely must rely upon.

Japan's economy has been hurt much more than most realize by the earthquake, tsunami and all that came after. Now, as a nation, Japan will be looking for something to rally around. The Japanese people are known for their stoic nature. They are also known for being unwavering when they decide to take a course of action. How they respond to the pressures that are mounting on the Japanese economy will be interesting to watch.

Equally interesting will be the effects that Japan's tragedy, and its aftermath, have on China, a key to global growth. If the ripple effects of Japan's problems cause China to stumble, then the Japanese economy could end up being a true inflection-point catalyst.

[Action to Take: The coming gross-domestic-product (GDP) crunch that is hitting Japan is not yet factored into the markets. That country's electricity shortfall will become increasingly noticeable in the coming months.

The Tokyo Electric Power Co., the operator of the ruined nuclear powerplant, is in dire straits. This means that the Japanese government will have to shoulder the immense long-term costs of the Fukushima radiation crisis. Japan is going to start printing yen, as the traders say, "in size." Going forward, you want to track the CurrencyShares Japanese Yen Trust (NYSE: FXY).

When the yen starts to drop in value, we want to be ready to ride its decay. As the U.S. dollar increases in value, Japan will be trying to devalue the yen to parity with U.S. cents, if possible.

Watch for a parity trade to break out in terms of the Japanese yen for the Chinese yuan. You may ask why we are talking about U.S. dollars when this is a Japan-versus-China trade. The reason is that China is still maintaining a de facto peg to the U.S. dollar, loosening it incrementally over time.

This means that, from a correlation-trade point of view, yuan are dollars when talking about trading partners. A change in yen-versus-yuan will include U.S. dollars as a synthetic marker.]

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