Our Largest Asian Trading Partners Are in Trouble: China and Japan

On Friday, we learned that the US economy added just 88,000 jobs in March against expectations of a 200,000 gain. Previous months’ jobs numbers were upwardly revised, tempering some concerns, but taken at face value it was not a good number.

Are you really surprised, dear reader? The US economy is not in recovery mode. It’s sick, very sick. It responds to heavy doses of monetary and fiscal stimulus but then relapses, needing ever larger injections to maintain some semblance of health.

But we don’t intend to pick on the US today. It’s sick, but it’s not terminal yet. Japan on the other hand…

Following new Bank of Japan (BoJ) Governor Kuroda’s first foray into monetary insanity, with his intention to increase Japan’s monetary base by $1.4 trillion by the end of 2014, it’s very difficult to see how Japan isn’t in the terminally ill ward. Or, at the very least, under the supervision of Nurse Ratchet, awaiting a lobotomy.

What does it actually mean though, to ‘increase the monetary base’? Well, a nations’ monetary base consists of physical currency (usually a very small percentage in the modern age of electronic banking) and bank reserves. ‘Bank Reserves’ are the portion of depositor funds that are not lent out to clients. It is a regulatory requirement that banks keep some funds in ‘reserve’ to meet withdrawal requests. These reserves are usually held by the nations’ central bank.

The planned increase in Japan’s monetary base will mostly come from an increase in bank reserves. The BoJ will achieve this by buying Japanese Government Bonds (JGBs) and to a lesser extent equity and real estate exchange traded funds.

It works like this: they buy the JGBs from a bank or a pension fund (via a bank), and the bonds then sit on the asset side of the BoJ’s balance sheet. To pay for the purchase, the BoJ creates ‘money’, which shows up on the liability side of their balance sheet in the form of bank reserves.

This is just a technical way of saying that the BoJ is expanding its balance sheet. Balance sheet expansion and an increase in the monetary base is basically the same thing. By increasing the ‘base’, the BoJ hopes to increase all the other forms of credit money that sit on top of this base.

Doubling the base in less than two years is a crazy gambit. If it ‘works’ it will smash the yen and, in time, pop the asset bubble that is the Japanese bond market. Remember, when bonds yields decline, the price of a bond increases. Japanese bond prices have been increasing for…we don’t know how long. A long, long time. So long that not many Japanese investors think they could ever fall.

Following Kuroda’s announcement last week, the yield on 10-year JGBs spiked down to 0.30%. In other words, the bond price spiked to all-times highs. Then prices tanked as yields plunged back to 0.60% on the same day. Welcome to the future in the volatile JGB market.

But the point to think about is this…what will be the effect of the bursting of a huge bond market bubble? Japan’s total debt outstanding is around US$10.5 trillion. Over 60% of it is held by Japanese banks (around 40%) and Japanese pension funds (around 20%). If Kuroda succeeds in generating inflation of 2%, bond prices will fall, potentially wiping trillions off the market price of the outstanding bonds. These losses will hit bank and pension fund equity, and destroy a large swathe of middle class savings.

The BoJ, in their lobotomised insanity, will try to prevent this by buying up every bond that hits the market. They may even reach their monetary base target ahead of time. Which means the only way to release the short term pressure building due to this extraordinary situation is via the currency, the yen. It will take the full brunt of this unprecedented Japanese experiment.

In time, the JGB market will topple too. Japan’s vaunted savers are growing older and will need to consume more and save less. They won’t be able to keep on financing the government’s deficits, which means the BoJ will eventually directly finance government spending. When this happens, there is really no hope left for a country. There is only currency collapse and a huge fall in living standards for the people.

What all this means for Australia and Australian investors we haven’t yet worked out. It’s something we’ll take an in-depth look at in tomorrow’s edition of Scoops Lane, a subscriber only weekly email.

But as Australia’s second largest trading partner, it’s worth looking into. Because when a currency collapses, the country in question cuts back on its purchases of foreign goods.

On the topic of trading partners, it’s all been happening over in China recently, with political and business delegations descending on the Middle Kingdom for the annual Boao Forum. This is an important get together for Australia, given China now takes in around one-third of our exports; our largest customer by far.

But for all China’s importance and ‘insatiable’ appetite for our raw materials, something is not quite right. The chart below shows Australia’s two largest miners, BHP and Rio, against the performance of the ASX200 over the past 12 months.

BHP and RIO — Where’s the China Boom?



While both companies have underperformed the index, they did play catch-up in late 2012 and early 2013 as investors bet on a Chinese economic rebound. But since mid-February the miners have retreated again as the reality of China’s difficult economic future gains broader acceptance.

With China suffering credit-boom induced growing pains, and Japan about to experience a currency crisis, Australia is in an interesting position. ‘Interesting’ being a euphemism for dangerously exposed to a sharp fall in trade while our borrowing requirements are becoming increasingly onerous.

More on trade and its importance to a country like Australia tomorrow.

Greg Canavan
for Markets and Money

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


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