Japan's Red Inc

National Review, March 10, 1997 by John Dizard

Something nasty is happening to Japan's financial system. In the short run -- and contrary to what I used to think -- it could cause a flight to U.S. bonds, which would be bullish. But in the long run, it just might mean a U.S. bond market crash, higher interest rates here, and even the end of the line for the great Bush/Clinton boom.

It was just a half a dozen lines long, but the wire service report that crossed bond traders' desks on February 3 had the effect of putting the speculators at the market's edge on the equivalent of a war alert.

Ordinarily, the monthly statement from the Bank of Japan disclosing its foreign exchange reserves is pretty dull. The number invariably marches up, as the Bank buys more dollars or other currencies flooding into the country from the sale of all those cars, Nintendo games, watches, and stereos. The dollars then go into the Bank's Treasury bond accounts, mostly with the Federal Reserve, where they pile up in the single biggest support for the U.S. government's borrowing program.

But now, for the first time in three years, the BOJ reserves declined. The traders quickly did their arithmetic and realized the Bank had spent money supporting the weakening yen. Which meant that the biggest owner of U.S. Treasury bonds had turned into a seller.

American hedge-fund managers, the ones who are betting a lot of their own money along with their investors', have spent some time, and, who knows, maybe some money developing their own sources within the Japanese Ministry of Finance. They have to. As the American public has deserted the bond market in search of what it believes are guaranteed double digit returns in stocks, speculators and foreign central banks have become the lenders of new money to the Federal Government, and, by extension, all of us.

The speculators want to be a friend of the trend. And the trend, they believe, is likely to be set in Tokyo.

Here's the problem: the Japanese banking system is insolvent. There may be, indeed is likely to be, a major bank failure after the end of the Japanese fiscal year on March 31. The most likely candidate to take a fall is the Nippon Credit Bank. Does this mean the Japanese will buy U.S. bonds or sell U.S. bonds? Does it mean the yen will drop further with the financial crisis, or does it mean that it will rise as foreign assets are repatriated? What is the Bank of Japan's rescue plan? Or, rather, is there a plan?

"It's on this question that all of 1997 turns," says Ray Dalio. Dalio runs Bridgewater Associates, a $5.5 billion hedge fund dedicated to the global fixed-income and currency markets.

There are two sides to the debate. The bond bears, of which I have been one, believe that the BOJ may be forced to liquidate part of its U.S. bond holdings to provide dollars for the Japanese banks or to keep the U.S. currency from rising to unacceptable levels. The bond bulls think that both the BOJ and the Japanese private institutions will have to buy more U.S. paper, which will supply the fuel for a rally in the T-bond market.

I've been converted -- at least for much of this year.

The Bank of Japan is faced with an economy that is still in dire need of stimulation. The Japanese government has created a huge fiscal deficit attempting to offset the contraction in the private economy with public works projects and spending schemes. Now that the elections for Japan's parliament are past, it's going into reverse, increasing consumption-based taxes and reducing the pork projects.

So Japanese fiscal policy has become more contractionary. Theoretically, monetary policy could be stimulative. But the overregulated, in fact, rigged Japanese markets are in what the Keynesians used to call a liquidity trap. Only in this case (sorry, liberals) the liquidity trap is caused by government-orchestrated planning, not eliminated by its application.

The Bank of Japan can't cut rates any further -- short-term interest rates in Japan are one-tenth what they are in the U.S. Even at that low level, the commercial banks can't find enough good private borrowers to lend to. Private borrowers are just too gloomy. This process can get to the point where prices can be falling while interest rates are still positive, which is a deflationary depression. That is no fun, as you learned from all of those black-and-white newsreels about breadlines, farm foreclosures, etc.

The most effective tool the Bank of Japan has left is devaluation of the yen, which has the effect of importing some inflation, and providing enough monetary stimulation to keep the economy steady while the private sector gets back on its feet. Exporters such as the auto companies or electronics exporters get to cut their prices or increase their profits.

This is where the unstable Japanese financial structure comes in. The private financial institutions have their own reasons to want to buy foreign securities, especially the U.S. Treasury bond. Basically, they have been borrowing from the Bank of Japan at one half of one per cent, then buying U.S. Treasury bonds, and maybe leveraging it 10 to 1 -- make that 20 to 1.