I didn’t expect to be writing this article so soon. The idea first came up after the Bank of Japan unexpectedly eased monetary policy on October 31st The BOJ increased its bond buying program from 70 to 80 trillion and tripled its ETF purchases from 1 to 3 trillion yen. The surprise move lead to a 292 pips rally in the USD/JPY and on October 31st the currency closed off the week at 112.32. In the next month the Yen continued to be sold aggressively and last Thursday the Dollar/Yen spiked at a high of 118.97. But let’s start from the beginning.

The Rise of Abenomics

The latest round of easing is a continuation of a BOJ policy started back in 2012. After coming to power in December of 2012, the current prime minister of Japan, Shinzo Abe, started to implement a set of policies termed ‘’Abenomics’’. The aggressive policy changes involve radical quantitative easing, increase of public investment and structural reforms. Abe appointed Haruhiko Kuroda as head of the Bank of Japan with a mandate to generate 2 percent inflation. The inflation goal lead to the bank embarking on a massive buying spree during which the BOJ balance sheet almost doubled.

What’s Behind the Japanese Obsession with Inflation?

To find out why the Japanese authorities are so obsessed with inflation, we have to take a look at some history. The country’s asset bubble collapse in the late 80s coupled with a round of BOJ tightening led to a rush for cash, bringing the USD/JPY exchange rate from 254.11 (yes that’s 254, no typo) in January of 1985 to 127.44 in January of 1987. The increased purchasing power of money led to falling prices across the board. The Consumer Price Index fell from 2.5 percent in 1985 to – 1% in 1987.

However, a significant part of the fall in the CPI can be attributed to the 1986 oil price crash. Japan has very little natural resources and imports almost all the oil needed.

The Myth of Japanese Deflation is Born

The chart of the Japanese CPI from 1985 to 1990 fits almost perfectly with the Crude Oil price chart during the same period (see below). Of course there is a small lag period of couple of months as the lower oil prices filter through the economy. The 1986 oil crash lead to a brief deflation period in 1987 but prices rose few years later as oil rebounded during the lead up to the first Gulf War.

As the excesses of the asset bubble corrected, GDP fell. This would retroactively be blamed on the ‘’deflation’’ boogieman. But despite the claims that falling prices caused the ‘’Lost Decade’’, the data shows something else. There was no deflation in Japan during the first few years after the bubble burst. In fact, apart from the brief dip to -1% in 1987 due to oil prices, CPI actually grew during this time period. The chart below shows the lack of correlation between the CPI and GDP from 1985 to 1990.

What Caused the ‘’Lost Decade’’?

If falling prices didn’t cause Japan’s ‘’Lost Decade’’ then what did? Now we come to the second piece of the puzzle, government intervention. The asset crash in the late 80s sparked insolvency at financial institutions, which were bailed out by the government and the central bank. This led to the postponement of losses. The bailed out banks continued to lend money to money losing enterprises, prolonging the stagnation. In response to the crisis, the government started an economic stimulus project.

Japan’s Debt to GDP ratio, a measure commonly used by investors to assess a country’s ability to make future payments on its debt, spiked from 60 percent in 1990 to over 130% in 2000 and then exploded in the following decade, eventually reaching a high of 227.20% in 2013. This is the highest Debt to GDP ratio in the world. Even the more conservative measure ‘’Net Debt to GDP’’ brings us to a whopping 134 percent, just shy of Greece’s 155%.

In an economics paper by American economists Carmen Reinhart and Kenneth Rogoff, the authors looked at the effect of high debt on growth and concluded that when gross external debt reaches 60 percent of GDP, a country's annual growth declined by 2%. For levels of external debt in excess of 90 percent of GDP growth was roughly cut in half. Now let’s take a look at Japan’s GDP from 1990 to 2014.

As can be seen from the chart above, growth remained anaemic despite an explosion in government debt. The European Debt Crisis confirmed the conclusions made by the Reinhart and Rogoff paper.

Only One Arrow Remains

Looking at the history is important because it lets us know that we’ve been here before. The three arrows of Abenomics are: radical quantitative easing, increase of public investment and structural reforms. As I demonstrated above, increased government spending didn’t translate to GDP gains and may have acted as a drag on growth instead. Structural reforms have been non-existent so far, although a recent article by the Prime Minister in the Wall Street Journal says that this will change soon. I wouldn’t hold my breath and the reason why is what happened on November 18th.

Abe Calls Snap Elections, Delays Tax Hike

After the disastrous GDP data showed that Japan slipped back into recession the Prime Minister called for snap elections. Abe also delayed the planned sales tax increased from 8% to 10%.

With Abe shooting blanks and unwilling to make tough choices, it’s hard seeing him push through the needed structural (especially labor) reforms. Instead, what’s more likely is that the Bank of Japan will be left to carry the entire burden of Abenomics. This is despite BOJ officials repeatedly ‘’encouraging’’ the Prime Minister to go ahead with the hike. Not only did the Bank lobby for the tax hike, officials warned that a delay could lead to a loss of investor confidence in government debt.

Bank of Japan Left to Shoulder the Burden

Of the three arrows of Abenomics, only one remains: Quantitative Easing. The BOJ has been left to shoulder the whole burden of so called ‘’reforms’’. Let’s take a look at what happened to the Yen since the Bank announced its aggressive QE policy in December of 2012. The chart below shows the USD/JPY during the past two years. The currency pair traded at 82.37 at the start of December. We are currently quoted at 117.85, an increase of a massive 42 percent. The Yen suffered similar losses against all major currencies.

The 150.00 mark is now only 28 percent away and if history repeats itself, we could easily see this level in the next few years. But 150 is not only my target. Albert Edwards of Societe Generale, ranked No. 1 for global strategy in surveys by Thomson Reuters every year since 2007, just set a target for the pair at 145 versus the US Dollar and 170 versus the Euro. The BOJ move on October 31st also led to several forecasters increasing their USD/JPY targets and this was before the sales tax delay by Abe.

There Will be No Japanese Bailout

The lack of political will to implement structural reforms and put Japan’s financial house in order will continue to weigh on the Yen. The ineffectiveness of the public works projects will lead to more sluggish growth and the BOJ will be forced to pick up the slack. But perhaps more importantly, there doesn’t seem to be anyone in Japan who is willing to make a sacrifice. The voters naturally don’t want higher taxes, the Prime Minister is scared of the voters and BOJ officials want to keep their cushy jobs and can only offer ‘’encouragements’’ to Abe. Furthermore, the situation is not new, the country has been dealing with this quagmire for the past few decades.

It doesn’t seem like anyone is willing to change course until the massive debt load leads to spiking interest rates and by then it will likely be too late, as we’ve seen during the European Debt Crisis. But unlike Greece, Japan doesn’t have a Germany to lend money from. The massive size of the debt is now over 10 Trillion dollars. This makes any type of international bailout impossible. When (not if) interest rates start to go up, Japan will have to fend for itself.
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