In the summer of 2010, a little-noted milestone took place.
China passed Japan to become the world's second-largesteconomy .
Now, Japan needs to keep an eye on the rear-view mirror. Germany
and Brazil are gaining ground and may overtake the Asian country in
coming decades as well.
Japan's steady decline -- relative to other economies --
can be attributed to a pair of factors: A rapidly-aging population
and a too-strongcurrency . These two factors are crimping demand
for goods and services at home, as well as foreign demand for
This isn't a new story. The Japanese economy has barely budged
in the past two decades after a 40-year spurt of strong growth.
Though the economic weakness has been mild, helping the country
maintain full employment, cracks have begun to emerge and the pace
of economic erosion may soon accelerate.
Problem is, this is not just worrisome for Japan, but also
its neighbors in Asia, along with the United States and key
European trade partners. That's why investors need to stay abreast
of events in Japan.
Short sellers have been surely aware of the troubles in the
Asian country. In just the two weeks ended Oct. 31, the short
interest in the
iShares MSCI JapanIndex fund (
, has doubled in size, to a whopping 19 millionshares .
Debt and trade: worrisome signs
To see why short sellers are piling on, you need only look at
Japan'sbalance sheet and itscash flow statement . On the balance
sheet, you'll find a country with a staggering amount of debt. Here
in the United States, our national debt is now more than 100%
ofgross domestic product (
) . In Italy, that figure has risen to 120% while in Greece, it's
up to 160%. Japan's debt-to-GDP: roughly 230%. Japan's government
debt is now larger than all 17 Euro member nations combined.
Even if Japan's economy doubled in size while debt stayed
constant, it would still have one of the highest relative debt
loads in the world. Trouble is, Japan's economy will not be
doubling in our lifetime. In fact, it's not clear that Japan's
economy will grow much at all in coming years: Japan's economy
generated 537 trillion yen of economic activity in 2005. That
figure in 2011: stuck at 537 trillion yen. China's economy grew
nearly 50% during that time. For further context, Japan's
inflation-adjusted economic size is the same size as it was -- back
in 1993. The fact that Japan's population is expected to shrink in
coming years will make it even harder forGDP to grow.
Indeed, it looks as if Japan's economy may actually be
shrinking, as a too-strong currency -- coupled with a trade spat
with China -- is crimping the export sector. Japan's government
just announced the economy shrank at a 3.5% annualized rate in the
third quarter (compared with the second quarter).
Simple math implies that a smaller economy means an even higher
debt-to-GDP ratio. Of course, the government has begun to think
about stimulus programs to fire up the economy, but with such high
levels of debt already in place, further borrowings run real risks:
What happens if global investors get spooked and become less
comfortable buying Japanesebonds at ultra-low rates? Simply put,
Japan's staggeringdebt load would look even worse if interest rates
(and expenses) sharply increase.
To avert catastrophe, the Japanese government has proposed a
series of tax hikes, especially in the form of salestaxes . But
those hikes would be cancelled if the economy slumps, as now
appears to be the case. As it stands, fully 40% of the proposed
2013 Japanese budget will need to be funded with debt.
Japan's greatest strength has always been its massive
export-oriented industrial sector. But that pillar of strength is
now weakening. Exports fell 10% in September from a year ago, while
machinery orders and industrial production also showed big drops in
As is the case with companies, a country can also shore up its
balance sheet (and pay down debt) by showing positive cash flows.
And surely enough, a solid base of exports has enabled Japan to
generate consistent trade surpluses that have brought cash in the
door. Moreover, Japanese culture has been that of notorious savers.
In the 1990s, many companies saved 44% of theirearnings ,
depositing the funds in low-interest accounts that gave those
companies essentially free money. In effect, a persistent trade
surplus and a high savings rate have been able to offset rising
First off, Japanese citizens are no longer big savers: They now
save just 2% of their income. And trade surpluses now look like a
thing of the past as China takes over as "the world's factory." In
the first six months of fiscal 2013 (which ends next March), Japan
generated a $40.6 billion tradedeficit and is headed for its
largest annual deficit on record. That rising deficit is not just
due to falling exports. Japan's imports are rising, especially in
the area of energy supplies as the country steps back form nuclear
To be sure, Japan's demise has been anticipated for quite some
time, but the country has managed to tread water for nearly
decades. Yet the key factors holding up the economy indeed appear
to be finally eroding, and Japan is now emerging as one of the
world's leading trouble spots.
Risks to Consider:
Upside risks are few. Japan possesses a considerable base of
assets and could start conducting fire sales to raise funds, but
that creates further long-term weakness as many of these assets
(such asreal estate ) arecash flow producers.
Action to Take -->
Short sellers are anticipating an imminent crisis for Japan. They
note that the current Japanese Prime Minister is getting a great
deal of resistance with his fiscal plans (and if history is any
guide, won't be in that position for very long anyway). If the
government enters a phase of paralysis, right at a time when vital
action is needed to boost the economy and reassure globalbond
markets, then events could spiral out of control.
In the interim, you may want tohedge your globalmarket exposure
by joining forces with the short sellers and target the iShares
MSCJ JapanETF .