Shinzo Abe, the new prime minister of Japan, has promised to end Japan’s more than two decade old recession, through some old fashioned economics which is being now referred to as Abenomics by the experts.
For the lesser mortals Abenomics is nothing but money printing. Abe plans to go in for an ‘unlimited’ money of money printing and use the newly created ‘yen’ to increase government spending on public works.
So far so good. But what’s the idea here? In the process of printing and stuffing the financial system with an unlimited amount of yen, Abe hopes to increase money supply. As an increased amount of money chases the same amount of goods and services, he hopes to create some inflation.
The target is to create an inflation of 2%. And how does that help? In December 2012, Japan had an inflation rate of -0.1%. For 2012 as a whole inflation was at 0%, which meant that prices did not rise at all. In fact for each of the years in the period 2009-2011, prices have fallen in Japan on the whole.
In a scenario where prices are flat or are falling or are expected to fall, consumers generally tend to postpone consumption(i.e. buying goods and services) in the hope that they will get a better deal in the future. This impacts businesses as their earnings either remain flat or fall. This in turn slows down economic growth.
On the flip side, if people see prices going up or expect prices to go up, they generally tend to start purchasing things. Hence, Abe’s idea is to flood yen into the financial system and in the hope create some inflation or at least get consumers to start thinking that inflation is coming and ensure that they go out and make some purchases.
In case of a scenario where prices are falling people tend to wait to buy stuff at lower prices. In case of a scenario where prices are rising or expected to rise people tend to start buying stuff because otherwise they will have to pay a higher price for it. Either ways, human beings like a good deal.
When people buy stuff businesses see an increase in incomes and profits, which in turn spurs up economic growth. So that is the theory behind Abenomics.
Now whether this economic theory translates into practice as well with prices rising and the Japanese buying and thus helping create economic growth remains to be seen.
But there is another angle to this. As explained earlier in the article, Abe’s plan is to flood the financial system with an unlimited amount of yen. As and when this starts to happen, there will be more yen in the market than before. And this will lead to a fall in the value of the yen against other currencies.
But the market does not wait for things to happen, it starts to react to things it expects to happen. Given this, the Japanese yen has been losing value against the dollar. Three months back one dollar was worth around 80 yen. Now its worth around 94 yen. What is interesting is that between January 29, 2012 and today, the exchange rate has fallen from 90 yen to a dollar to 94 yen to a dollar.
The depreciating Japanese yen makes the situation just right for the comeback of the yen carry trade. So what is the yen carry trade?
Lets go back more than twenty years to understand where it all started. In the late 1980s Japan was in the midst of both a real estate and a stock market bubble. The Bank of Japan managed to burst the stock market bubble very rapidly and the real estate bubble very slowly, by raising interest rates.
After bursting the bubble by raising interest rates the Bank of Japan started cutting interest rates and soon the rates were close to 0%. This meant that anyone looking to save money by investing in fixed income investments(i.e. bonds or bank deposits) in Japan would have made next to nothing. This led to the Japanese money looking for returns outside Japan.
Some housewife traders started staying up at night to trade in the European and the North American markets. They borrowed money in yen at very low interest rates, converted it into foreign currencies and invested in bonds and other fixed income instruments giving higher rates of returns than what was available in Japan. Over a period of time these housewives came to be known as Mrs Watanabes and at their peak accounted for around 30% of the foreign exchange market in Tokyo.
The trading strategy of Mrs Watanabes came to be known as the yen-carry trade and was soon being adopted by some of the biggest financial institutions in the world. A lot of the money that came into America during the dotcom bubble came through the yen-carry trade. It was called the carry trade because investors made the carry i.e. the difference between the returns they made on their investment (in bonds or even in stocks for that matter) and the interest they paid on their borrowings in yen.
The strategy worked as long as the yen did not rise in value against other currencies, primarily the US dollar. Let us try and understand this in some detail. In January 1995, one dollar was worth around 100 yen. At this point of time one Mrs Watanabe decided to invest one million yen in a dollar denominated asset paying a fixed interest rate of 5% per year.
She borrowed this money in yen at the rate of 1% per year. The first thing she needed to do was to convert her yen into dollars. At $1=100 yen, she got $10,000 for her million yen, assuming there were no costs of conversion.
This was invested at the rate of 5% interest. At the end of one year in January 1996, $10,000 had grown to $10,500. Mrs Watanabe decided to convert this money back into yen. At that point, one dollar was worth 106 yen. She got around 1.11 million yen ($10,500 x 106) or a return of 11%. She also needed to pay the interest of 1% on the borrowed money. Hence her overall return was 10%.
Her 5% return in dollar terms had been converted into a 10% return in yen terms because the yen had lost value against the dollar. So this was a double gain for her. The depreciating yen added to the overall return.
But let us say instead of depreciating against the dollar, as the yen actually did, it had appreciated. And let us further assume that in January 1996, one dollar was worth 95.5 yen. At this rate $10,500 that Mrs Watanabe got at the end of the year would be worth 1 million yen ($10,500 x 95.5) when converted back to yen. Hence Mrs Watanabe would end up with a loss, given that she had to pay an interest of 1% on the money she had borrowed in yen.
The point is that for the yen carry trade to be profitable the yen would have to be either stagnant against the dollar or lose value. The moment it started to appreciate against the dollar, the returns in yen terms started to come down.
The yen carry trade worked in most years up since it started in the mid 1990s, to mid 2007. In June 2007, one dollar was worth 122.6 yen on an average. After this the value of the yen against the dollar started to go up, and fell to around 80 yen to a dollar. This had meant the death of the yen carry trade.
But with the yen losing value against the dollar again it makes the idea of the yen carry trade viable again. Between 2004 and 2008, stock markets across the emerging market rose as money through the yen carry trade route came in. This included India as well.
Things as they are now look ideal for the yen carry trade to start again. What helps is the fact that interest rates in Japan are very low almost close to 0%. Hence, money can be borrowed very cheaply.
As the yen carry trade picks up, investors borrow in yen, and sell those yen to buy dollars. This ensures that there is a surfeit of yen in the market leading to a further fall in its value against the dollar. This in turn makes the yen carry trade even more attractive.
Reports in the international media seem to suggest that it has already started happening. India now remains an ideal candidate for money to come through the yen carry trade route given that the Indian rupee has been gaining value against the dollar, which would make the yen carry trade even more profitable.
While the Indian economy falters, BSE Sensex, India’s premier stock market index might be getting ready for another rally. This time due to the blessings of Mrs Watanabe(s) from Japan. In fact when I had asked Professor Aswath Damodaran, how strong is the link between economic growth and stock markets, in a recent interview, he replied “It’s getting weaker and weaker every year.”
Reference: Extreme Money: Masters of Universe and the Cult of Risk by Satyajit Das
The article originally appeared on www.firstpost.com on February 6, 2013
(Vivek Kaul is a writer. He can be reached at [email protected])
If you are the kind who reads the pink papers religiously, you would have come to conclusion by now that good times are back again for the stock market investors in India, now that the finance minister has deferred the implementation of GAAR to next year. But before you open that champagne bottle and say cheers, here are some reasons why the stock market will remain flat or fall in the days to come.
Pain in Spain:
The gross domestic product (GDP) of Spain grew at the rate of 8% every year from 1999 to 2008. This primarily happened because Spain went all out and promoted the Mediterranean lifestyle. As Jonathan Carman points out in a presentation titled The Pain in Spain “Millions flocked to its sun-drenched shores, buying houses along the way. As the demand for houses increased, construction became the industry. Housing prices exploded, tripling in just over a decade.”
So far so good. The trouble was Spain ended up building way too many homes than it could sell. Even though Spain forms only 12% of the GDP of the European Union (EU) it has built nearly 30% of all the homes in the EU since 2000. As John Mauldin and Jonathan Tepper point out in Endgame – The End of the Debt Supercycle and How It Changes Everything “Spain had the mother of all housing bubbles. To put things in perspective, Spain now has as many unsold homes as the United States, even though the United States is six times bigger”.
All this building was financed through the bank lending. Loans to developers and construction companies amounted to nearly $700billion or nearly 50% of the Spain’s current GDP of nearly $1.4trillion. With homes lying unsold developers are in no position to repay. And Spain’s biggest three banks have assets worth $2.7trillion or that is double Spain’s GDP.
What makes the situation more precarious is the fact that the housing prices are still falling. Carman expects prices still need to fall by 35% from their current levels if they are to reach normal levels. This will mean more home loan defaults and more trouble for Spain. The Spanish stock market is already taking this into account and IBEX-35, the premier stock market index of the country is down a little more than 10% in the last one month. Banking stocks have fallen much more.
While countries like Greece may be in more trouble, they are not economically big enough to cause a lot of trouble worldwide. But if Spanish banks go bust, there will be a lot of trouble in the days to come. Spain has now emerged the basket case of Europe, but other countries in the European Union are not doing well either and this means trouble for China.
China’s After Party:
If things are not well in Europe, it has an impact on China because Europe is China’s biggest trading partner. The Chinese exports to Europe in March were down 3.1% in comparison to last year. Chinese exports had ranged between $475billion and $518billion in the last three quarters of 2011. In the first three months of this year the number has fallen to $430million. Falling exports are not the best news for China.
There are other things which aren’t looking good either. As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracles “In the last decade the main driver of China’s boom was a surge in the investment share of the GDP from 35% to almost 50%, a level that is unprecedented in any major nation…The investment effort focused on building the roads, bridges, and ports needed to turn China into the world’s largest exporter, doubling its global export market share to 10% in the last decade.”
This spending spree which was responsible for its fast growth is now slowing down. New road construction is down from 5000miles in 2007 to 2500 miles. Railway spending is down by 10%.
The other major factor likely to pull down growth is wage inflation i.e. salaries are rising at a very fast rate. In 2011, the average wage was rising at a rate of 15%, in a scenario where the consumer price inflation was around 5%. As Sharma points out “In fact hourly wages are now rising twice as fast productivity, or hourly output per worker, which is forcing companies to raise prices just to cover the cost of higher wages.” This has led to manufacturers moving to cheaper destinations like Bangladesh and Indonesia.
Given these reasons it is highly unlikely that China will continue to grow at the rates that it has been. Since 1998, China’s economic growth has averaged around 10% and it has never fallen below 8%. As Sharma points out “China’s looming shadow is about to retreat to realistic dimensions.” Sharma expects Chinese growth to slowdown by 3-4% percentage points in comparison to its current growth rate over the next decade.
A Chinese slowdown will mean disaster for nations which have been thriving by exporting commodities to China. In 1998, when China was a $1trillion economy, to grow by 10% meant it had to expand its economy by $100billion. This could have been done by consuming 10% of the world’s industrial commodities, raw materials like oil, steel and copper. In 2011, China is a $6trillion economy. If this economy needs to grow by 10% or $600billion, more than 30% of the world’s commodity production would be needed. With growth slowing down, China’s commodity requirements will come down as well. As Sharma puts it “It’s my conviction that China – commodity connection will fall apart soon”.
China’s stock markets remain largely closed to international investors. But the Hang Seng index listed in Hong Kong has a lot of Chinese companies. This index has gone up 0.9% over the last one month.
The Kangaroo Won’t Jump:
In fact the Aussies are already feeling the heat with a slowdown in Chinese exports. Australian exports to China in 2011 stood at A$72billion (Australian dollar), up 24% from 2010, or around 26% of total exports. An ever expanding China bought coal, iron ore and natural gas from Australia, driving up Aussie exports. But exports for the month of February fell to A$24.4 billion, the lowest in an year. Coal exports were down by 21% to A$3.4billion. The S&P ASX/200 one of the premier stock market indices in Australia, has been flat for the last one month.
Brazil – God’s Own Country:
The rise of China has led to huge demand for Brazilian commodities. As Gary Dorsch an investment newsletter writer points out in a recent column “Brazil has been enjoying an economic boom based on soaring prices for its natural resources including crude oil, agricultural products, such as soybeans, corn, and cattle, and metals such as iron ore and bauxite-aluminum.”
The rise of Brazil was captured very well by Glenn Stevens, governor of the Reserve Bank of Australia. Stevens pointed out that in 2006, money received from shipload of iron ore could buy 2,200 flat screen TVs. In 2011, the same shipload could buy 22,000 flat screen TVs.
Since the start of the financial crisis a lot of money printed by Western governments to revive their economies has flowed into Brazil. This has driven up the value of the real, the currency of Brazil, and made Brazil one of the most expensive countries in the world. As Sharma points out “Restaurants in Sao Paulo are more expensive than those in Paris. Hotel rooms cost more in Rio than French Riviera”.
An expensive currency has meant that imports rising faster than exports. This situation is expected to get worse as China’s slowdown and the demand for Brazilian commodities falls. In fact the impact is already being felt. As Dorsch points out “Brazil’s economy stalled out in the past two quarters, showing near zero growth in Q’3 of 2011 and Q’4 of 2012. Factory output in February was -3.9% lower than a year ago.” The premier stock market index Bovespa is down 4.5% over the last one month.
On a totally different note the most popular television serial in Brazil is a soap opera called “A Passage to India” shot in Agra and Jodhpur and which has Brazilian actors playing Indian roles and as Sharma puts it, they could “pass easily for North Indians”.
India- Done and Dusted:
The economic problems of India deserve a separate article. But let me list a few. In the year 2007-2008 (i.e. between April 1, 2007 and March 31,2008) the fiscal deficit of the government of India stood at Rs 1,26,912 crore. Fiscal deficit is the difference between what the government earns and what it spends. For the year 2011-2012 (i.e. between April 1, 2011 and March 31, 2012) the fiscal deficit is expected to be Rs 5,21,980 crore.
Hence the fiscal deficit has increased by a whopping 312% between 2007 and 2012. During the same period the income earned by the government has gone up by only 36% to Rs 7,96,740 crore. The targeted fiscal deficit for 2012-2013 is Rs 5,13,590 crore. This is likely to go up given the fact that the rupee is depreciating against the dollar and thus our oil bill is likely to go up, pushing up our fiscal deficit. This would mean that higher interest rates will continue to prevail.
The stock market obviously realizes this and hence has fallen by 1.8% over the last one month, yesterday’s brief rally notwithstanding.
Over the last few years stock prices all across the world have moved in a synchronized fashion because the international investors like to move in a herd. Whenever there has been trouble in the United States or Europe it has led to emerging markets all across the world falling. Now we are in a situation where the emerging markets themselves are in a lot of trouble. So it is a no brainer to say there will be no rally in the stock market in the near future. Unless of course a certain Mr Ben Bernanke decides to open up the money tap again and go in for Quantitative Easing Round Three or to put it in simple English, print some more dollars. If that happens, then investors can get ready to have some fun.
(This article was originally published on May 8, 2012 at http://www.firstpost.com/economy/the-pain-in-spain-will-get-us-too-so-forget-market-rallies-302278.html. Vivek Kaul is a writer and can be reached at [email protected])