Is Japan Starting to Suffer a Subprime-Induced Credit Crunch?

Today’s Telegraph has a good piece, “Japan is the next sub-prime flashpoint,” by Ambrose Evans-Pritchard. And before I get to the piece, I want to say a few things about the author.

A number of readers detest Evans-Pritchard, and I am at a loss to understand why. He wears his biggest fault on his sleeve, namely an overwrought writing style. I don’t find that offensive because he always has factual backup from high quality sources for whatever has him whipped up. And frankly, I like the contrast with the American bland style that gives every point of view an airing, no matter what lightweights or even wingnuts they have to go to to give the contrary point of view. He is less extreme than Greg Palast, who has done first rate work on US voter fraud that just about never sees the light of day here (he’s an American working for the BBC) and it’s easy to discredit him because he too has an overly sharp, accusatory style. But he too delivers the goods.

I much prefer a writer who is up front with his viewpoint than one who pretends to be objective but slants his analysis and reporting in ways that only someone who knows the terrain can detect. I’m reading a book now that sets my teeth on edge (Tim Harford’s The Logic of Life) that does precisely that, and I guarantee that it will be well reviewed despite the fact that it is intellectually dishonest.

Now to the substance. Evans-Pritchard says a great deal of subprime debt has gone unaccounted for, and one place it is likely to be housed is Japan. The reason it hasn’t come to light so far is the fiscal year for corporations starts April 1, so the financial statements for FY 2007 won’t be released till late spring.

There are a couple of minor things I quibble with. One is that Evans-Pritchard attributes the deterioration of the Nikkei to credit tightening when the rise of the yen is another big culprit. The yen was 124 as of June last year; it’s been trading between 105 and 110 this year. Investors run from the carry trade when risk perceptions rise, plus the yen even now is undervalued. The country runs chronic, massive trade surpluses, yet they keep buying foreign assets to keep the yen down. The level of the yen has a very large impact on competitiveness, and the Nikkei always falls when the yen goes up. There is a fair question as to how the causality runs: the US/European credit crisis led to a flight from risk that appears to be the proximate cause of the initial rise of the yen; the credit tightening may explain why it is staying where it is (and in my view, destined for 100 before too long).

However, the fall since the beginning of the year in the Nikkei is out of proportion to the continued movement of the yen, which confirms the debt thesis.

Second is that Evans-Pritchard neglects to explain that Japan effectively has a dual economy: a sluggish/depressed domestic economy and an (at least till recently) booming export sector. Commentators on Japan tend to focus on the former and completely miss the latter.

From the Telegraph:

Just as battered investors had begun to glimpse signs of recovery in America, the next shoe has dropped with an almighty thud in Japan. Echoes are rumbling across the Far East.

The Tokyo bourse has crumbled, suffering the worst start to the year since the Second World War. The Nikkei index is down 17 per cent since Christmas, and the shares of Japanese banks are leading the slide. Mizuho Financial, Mitsubishi UFJ and Sumitomo Mitsui have all been punished as hard or even harder than those US banks at the epicentre of the sub-prime debacle.

The nagging fear is that Japan’s lenders – the conduit for the world’s greatest stash of savings – have taken on a far bigger chunk of mortgage securities, collateralised loans obligations and other exotica from America’s structured credit boom than they have yet revealed.

Americans and Europeans have so far confessed to $130bn of the estimated $400bn to $500bn of wealth that has vanished into the sub-prime hole. Somebody, somewhere, must be sitting on a vast nexus of undisclosed losses. We may find out soon enough whether the hold-outs are in Japan. The banks have to come clean under the country’s strict new audit codes by the end of the tax year in March.

“We think this is where the next big problem is going to pop up,” said Hans Redeker, currency chief at BNP Paribas.

“We know from Bank of Japan’s lending survey that the banks are already tightening hard, so something is brewing. Right now, we are in the lull before the second storm in global markets, and Asia is going to be the source of the nasty surprises,” he said.

The iTraxx Japan index measuring default risk of 50 Japanese companies saw its biggest one-day jump ever on Thursday to 77.5. Rightly or wrongly, it is flashing a serious distress signal.

What we know is that Japan’s economy – still the second biggest in the world by far – has fallen over a cliff since October. It remains joined to America’s hip after all. The decoupling theory has failed its first test.

Japan’s machine orders dropped 2.8 per cent in November and a further 3.2 per cent in December. January housing starts fell to the lowest in 40 years, down 18 per cent on the year. Tokyo property was off 22 per cent. Can this still be blamed purely on a change in building rules?

“Recession is a clear and present danger in Japan,” said Tetsufumi Yamakawa, chief Japan economist for Goldman Sachs. “The leading indicators are deteriorating very sharply. Inventory is piling up at a rapid pace. There are clear signs of deceleration in exports of steel and semi-conductors to China,” he said.

Yes, China. It turns out that the intra-Asia trade that was supposed to immunise the region against a slump is a disguised supply-chain ending up in the US market. American shoppers still make 30 per cent of global demand, just as it did a decade ago. Nothing has really changed.

“We think the Bank of Japan may have to start easing by the middle of the year,” said Yamakawa.

There is not much monetary ammo left. Interest rates are 0.5 per cent. So it’s back to zero, and helicopters of central bank cash (“quantitative easing”), those peculiar hallmarks of Japan’s past battle with deflation. The brief attempt to “normalise” Japan Inc has already failed.

We tend to forget that Japan remains the world’s top creditor nation by far, the shy master of fate. The country’s net foreign assets of $3,000bn roughly match the net debts of the US.

The yen “carry trade” – borrowing cheap in Tokyo to chase yields from New Zealand, to Brazil, Iceland, and above all Britain – has juiced the global asset boom this decade by $1,000bn. It is perhaps the biggest liquidity pump of them all, yet it stopped pumping in August. Indeed, it is sucking the money back out again. The yen is soaring.

Where have the Japanese recycled the quarter trillion dollars they earn each year from their surplus? Official data shows that their holdings in US Treasury bonds have not risen.

The Swiss offer us a clue, says Redeker. They are Europe’s Japanese, champion savers looking for returns abroad. They devoured US sub-prime debt on a much bigger scale per capita than the Americans. Hence the $24bn in write-downs by UBS.

So far, Japan’s biggest three banks have admitted to just $4.7bn in total losses between them. The figure is rising. Mitsubishi, the biggest, has just raised its tally to 12 times the sum admitted in November. This looks like a replay of the early 1990s when fear of losing face delayed the awful news.

Hong Liang, Beijing economist for Goldman Sachs, is not much more hopeful about China’s prospects this year. “The combination of a US slowdown and monetary tightening in China is never welcome, but the accumulated problems have to be resolved this year,” she said.

Inflation at 6.9 per cent is getting out of hand. The root cause of overheating is the weak yuan. The central bank has piled up $1,500bn of foreign reserves trying to stop it rising. The longer this goes on, the more inflationary it becomes. So Beijing has begun to step up the pace of revaluation, letting the yuan rise at an annual rate of 20 per cent in January. There will be casualties. Large chunks of China’s manufacturing export industry have wafer-thin margins. A rising yuan tips them into the red.

China’s mercantilist drive for export share is a double-edged strategy. The trade surplus has risen at $80bn a year, increasing tenfold since 2002 while the economy has merely doubled. The result is that China is as dependent on the US economy as Mexico.

So the storm spreads East. Haruhiko Kuroda, head of the Asian Development Bank, warned that the region would catch a cold after all as the US sniffles and sneezes. “Asian economies are not totally immune. A significant slowdown in the US economy will most certainly affect the region’s growth,” he said.

The global watchdogs are scrambling to rewrite the script. The World Bank has cut its China growth forecast from 10.8 per cent to 9.6 per cent in 2008. Private banks are slashing deeper.

Once the striptease starts on the onset of a global downturn, it usually has a long way to run.