Japan’s Deep Seated Problems Are Finally Surfacing

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Great write up from Maudlin’s site:

In case you are not familiar with the GPIF in Japan, it is the largest pool of government-controlled investment capital on the planet — outstripping even the infamous Arab sovereign wealth funds. The GPIF controls ¥128.6 trillion, or $ 1.25 trillion.

The GPIF holds almost 70% of its assets in bonds — and the vast majority of them are of the local variety. The reason for this is because the GPIF is (and has always been) run by bureaucrats from the Ministry of Health, Labour & Welfare, as opposed to, say, investment professionals.

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Source: GPIF


How did that allocation to domestic bonds do last year? Well, as it turns out, not so great:

Q1 2013
Q2 2013
Q3 2013
Q4 2013
Total 2013
Domestic Bonds
-1.48
1.18
0.18
-0.14
Domestic Stocks
9.70
6.07
9.19
27.05
Int’l Bonds
4.01
1.64
8.16
14.34
Int’l Stocks
6.14
7.13
16.23
32.17
Source: GPIF

Fortunately, over the last twelve years the GPIF has managed to meet its targets — by growing at an annualized rate of 1.54%. In any other professional investing mantra, it is a pathetic figure.
Thankfully for the GPIF, despite their largest allocation throwing off negative returns, the BoJ’s actions in weakening the yen boosted the Nikkei, and the central-bank-inspired strength in equities and bonds elsewhere in the world helped GPIF’s performance to pass the smell test for 2013.

(Japan Times): The national average annual income of a local government employee was ¥7 million in 2006, compared to the ¥4.35 million national average for all company employees and the ¥6.16 million averaged by workers at large companies. Their generosity to even their lowest-level employees may explain why so many local governments are effectively insolvent: Drivers for the Kobe municipal bus system are paid an average of almost ¥9 million (taxi drivers, by comparison, earn about ¥3.9 million).

School crossing guards in Tokyo’s Nerima Ward earned ¥8 million in 2006. (Such generosity to comparatively low-skilled workers may explain why in the summer of 2007 it was discovered that almost 1,000 Osaka city government employees had lied about having college, i.e., they had, but did not put it on their resumes because it might have disqualified them from such jobs!) 

Furthermore, unlike private sector companies, public employees get their bonuses whether the economy is good or bad or, in the case of the Social Insurance Agency, even after they lose the pension records of 50 million people (2008 year-end bonuses for most public employees were about the same as 2007, global economic crisis notwithstanding).


In addition to their generous salary and bonuses, public servants get a wealth of extra allowances and benefits. Mothers working for the government can take up to three years’ maternity leave (compared to up to one year in the private sector, if you are lucky). Some government workers may also get bonuses when their children reach the age of majority, extra pay for staying single or not getting promoted, or “travel” allowances just for going across town. Perhaps the most shocking example Wakabayashi offers is the extra pay given to the workers at Hello Work (Japan’s unemployment agency) to compensate them for the stress of dealing with the unemployed.

Back in November 2013, a seven-member panel led by a Tokyo University professor Takatoshi Ito and convened by PM Shinzo Abe published its final recommendations for the future of the GPIF, and those findings set the behemoth on a course into far more turbulent waters:

(Pensions & Investments): The panel’s Nov. 20 final report said the GPIF’s 60% allocation to ultra-low-yielding Japanese government bonds — defensible in the deflationary environment of the past decade — should not be maintained in the inflationary one Mr. Abe has promised as a centerpiece of his quest to revive Japan’s economy.

The seven-member panel urged the GPIF and other big public funds in Japan to diversify into real estate investment trusts, real estate, infrastructure, venture capital, private equity and commodities, while shifting more assets to active strategies from passive and adopting a more dynamic approach to asset allocation.
Governance of those public funds, with combined assets of roughly $ 2 trillion, should be strengthened by making them more independent of the ministries that oversee them.

The recommendations make sense, but the challenges of revamping investments at a fund controlling such a large chunk of Japanese retirement savings will be considerable. To put the size of the GPIF into perspective, should the decision be made to allocate a mere 5% of its assets to a particular asset class, that would require the deployment of $ 60 billion.

The redeployment of those holdings of JGBs is likely to cause future problems, but that didn’t concern one of the GPIF panel members, Masaaki Kanno, an economist at JP Morgan in Tokyo, who, after the findings were published, made a couple of predictions:
(P&I): In a Nov. 20 research note, Mr. Kanno predicted the GPIF would be permitted enough flexibility to allow allocations to yen bonds to drop to 50% by the summer of 2014.
The Bank of Japan’s recent policy initiative to flood the market with liquidity, meanwhile, could set the stage for a seamless transfer of that huge amount of Japanese government bonds, Mr. Kanno said.

Eventually, Japanese government bonds should drop to between 30% and 40% of the GPIF’s portfolio — higher than the 20% to 30% range typical of leading public pension funds abroad to account for Japan’s rapidly aging demographic profile, Mr. Kanno said. Meanwhile, another ¥30 trillion ($ 300 billion), or a quarter of the fund’s assets, should eventually shift into “risk assets,” according to the J.P. Morgan report.

The BoJ certainly does have a policy initiative to “flood the market with liquidity,” but that policy initiative is the continuation and expansion of a policy that has been in operation for 20+ years — namely, the purchasing of the government’s own debt with freshly printed yen.
In 2001 the Japanese termed it ryōteki kin’yū kanwa, but today everybody knows it as quantitative easing.

In a paper which analyzed Japan’s initial experimentation with QE, published in February 2001, Hiroshi Fujiki, Kunio Okina, and Shigenori Shiratsuka (all three senior BoJ economists) suggested that once a zero interest rate had been reached, if the situation still appeared dire, MacGyvering an alternate solution might not be the greatest idea in the world:
(Monetary Policy under Zero Interest Rate: Viewpoints of Central Bank Economists): [F]urther monetary easing beyond the zero interest rate policy, most typified by the outright purchase of long-term government bonds, should be viewed as a bet which we would only be forced to explore in the event the Japanese economy stands on the brink of serious deflation. Considering the uncertainty and risks surrounding these unconventional measures, it is quite inappropriate to introduce them merely on an experimental basis. Of course, this does not mean that further monetary easing may not be warranted in any circumstances, nor that other easing measures not covered in this paper are infeasible…

2329.png 
With regard to monetary policy in Japan, there seems to be some oversimplified idea that the adoption of inflation targeting would be a panacea for current economic difficulties. This should remind central bankers, who must make policy decisions on a real-time basis amid drastic structural transformation, of the unfruitful traditional “rule versus discretion” debate in terms of monetary policy implementation.

Perhaps Abe and Kuroda prefer watching reruns of Friends to perusing BoJ policy recommendations?

The subsequent expansion of the BoJ’s QE policy can be seen clearly in the chart on the previous page. It highlights beautifully the problem with heading down the treacherous QE trail: ever-increasing amounts of money must be printed to keep the wheels turning.

Once you start, to stop is not a decision that is made by you, but rather it eventually gets made for you. In the meantime, your balance sheet just swells and swells. The BoJ’s has increased almost five-fold since 1997 and is up 80% since the beginning of 2012:

2343.png 
and, if you’re Japan, your monetary base goes vertical:
2358.png 
That’s three very similar charts, but the next one looks nothing like the preceding ones:
2373.png 
Japan’s population is actually declining — fast. And under the crush of that breaking statistical wave, everything gets harder for Japan.
Japan’s population “pyramid” looks more like a top-heavy baking dish. There are already more over-65s than under-24s; but it is estimated that by 2060 Japan’s population will have fallen from 128 million to 87 million, and roughly half of those remaining will be over 65.

2387.png 
The ONLY answer for Japan is immigration — lots of it — but that, I am afraid, is a total non-starter for the insular Japanese. The depopulation problem already loomed on the horizon like a distant oil tanker in 1989 when I lived in Tokyo. What has changed since then is that the tanker has now docked.
In 2003, it was estimated by the UN that Japan would need 17 million new immigrants by 2050 to avert a collapse of the very pension system we’re examining this week. Those immigrants would amount to 18% of the population in a country where immigrants currently amount towait for it… 1%.

It gets worse.
2414.png
Of that 1%, most are second- or third-generation Koreans and Chinese, descendants of people brought to Japan from former colonies.
As of October 1, 2013, there were all of 1.59 million foreigners in Japan, and that is after net immigration ROSE for the first time in 5 years, with 37,000 new immigrants taking a bit of the sting out of the 253,000 decrease in Japanese citizens in 2013.

So… Japan’s fate is set. In coming years the ageing population will be drawing down its pension funds at an ever-increasing pace, even as the largest pension fund in the world is being forced by the government into allocating more of those funds to riskier assets in order to try to stimulate growth in the moribund economy.
Meanwhile, the Bank of Japan is embarking on an experiment in monetary prestidigitation the likes of which has never before been seen; and in order for it to be successful they will need the GPIF to not only not SELL JGBs but to BUY MORE of them.

In addition, Shinzo Abe is promising the Japanese (and every holder of JGBs, which are yielding a paltry handful of basis points) that he will generate 2% inflation, thus rendering their JGB holdings completely useless.
The whole thing is madness — madness built on the promise of the delivery of a dream.

Already the BoJ is buying up to 85% of some JGB issuances, and an estimated 91% of Japanese bonds are held domestically. What do you think happens when the GPIF turns from buyer to seller?

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