Japan's Deep Seated Problems Are Finally Surfacing

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.

 

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...

 

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:

 

... and, if you’re Japan, your monetary base goes vertical:

 

That’s three very similar charts, but the next one looks nothing like the preceding ones:

 

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.

 

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 to...wait for it... 1%.

It gets worse.

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?

Fiscal Cliff Averted, China Good News, Even From North Korea ... Rally Baby!!!

Shares everywhere is set to start the year on a positive note after a tentative deal to avert the "fiscal cliff" in the US and encouraging economic news from China.

Dow Jones futures were 250 points higher - about 2 per cent - after the deal was agreed in a late-night meetings in Congress, setting the scene for a good start to the trading year. The Dow Jones Industrial Average had closed 166.03 points higher at 13,104.14 on Monday after signs of a possible deal.

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The ''fiscal cliff'', which was set to kick in on January 1, would have led to $US600 billion of tax increases and spending cuts. It's important to remember that there's some tightening of fiscal policy, which is good news - that's what the US economy needs given its budget position - but it's not so severe as to cause a hard landing. The elimination of a 2 percent payroll tax cut, coupled with higher income taxes on the wealthy, will help reduce growth in the first quarter to 1 percent, from 3.1 percent in 2012’s third quarter, the latest data available. The expected slowdown is a lot better than no deal at all. What markets hate most is UNCERTAINTY.

The first half slowdown will mean that the U.S. will make limited progress in reducing unemployment in 2013 - which if you remember will mean continued liquidity by Federal Reserve for a prolonged period as it will take sometime to whittle down the unemployment rate.

There were also encouraging signs from China as data showed its manufacturing activity expanding last month for the third straight month. The purchasing managers' index (PMI) remained steady at 50.6 in December, although it was slightly lower than HSBC bank's PMI survey of 51.5 - a 19-month high. The lift in manufacturing appeared to have been reflected in rising commodity prices over the past few weeks, adding to suggestions the worst could be over for the global economy.

In another boost for financial markets, China's President, Hu Jintao, said in a New Year's Eve address that the country would work towards fostering global economic growth. The country would "step up efforts to promote strong, sustainable and balanced growth in the world economy", said Mr Hu, who is set to step down as president in March.

News that the North Korean leader, Kim Jong-un, had called for a "radical turnabout" in his country's economy and offered an olive branch to South Korea would also lift the market. In a rare new year's address broadcast on state television, Mr Kim said 2013 would be a year of "great creations and changes in which a radical turnabout will be effected" and that ''the building of an economic giant is the most important task'' facing North Korea.

"An important issue in putting an end to the division of the country and achieving its reunification is to remove confrontation between the North and the South," he added.

Very Interesting Economic Research - The Trilemma!

The title of the post seemed so unlikely. How can economic research be categorised as interesting? The working paper is entitled: SURFING THE WAVES OF GLOBALIZATION: ASIA AND FINANCIAL GLOBALIZATION IN THE CONTEXT OF THE TRILEMMA by Joshua Aizenman, Menzie D. Chinn and Hiro Ito. The hypothesis states that a country may simultaneously choose any two, but not all, of the following three goals: monetary independence, exchange rate stability, and financial integration.



This concept, if valid, is supposed to constrain policy makers by forcing them to choose only two out of the three policy choices. Given that Asian emerging market economies have collectively outperformed other developing economies in terms of output growth stability, it is possible that their international macro-policy management, determined within the constraint of the trilemma, has contributed to preparing these economies for higher output vulnerability possiblyexacerbated by recent globalization.

If the Asian economies do show robust and sustainable recovery while the advanced economies do not, that would have two implications. First, robust recovery is evidence for the Asian economies “decoupling” from the advanced economies. Second, it suggests that the Asian economies, most of which are quite open to international trade in goods and financial assets, are better prepared to cope with economic crises in a highly globalized environment.

History has shown that different international financial systems have attempted to achieve combinations of two out of the three policy goals, such as the Gold Standard system-guaranteeing capital mobility and exchange rate stability and the Bretton Woods system providing monetary autonomy and exchange rate stability. The fact that economies have altered the combinations as a reaction to crises or major economic events may be taken to imply that each of the three policy options is a mixed bag of both merits and demerits for managing
macroeconomic conditions.



Greater monetary independence could allow policy makers to stabilize the economy through monetary policy without being subject to other economies’ macroeconomic management, thus potentially leading to stable and sustainable economic growth. However, in a world with price and wage rigidities, policy makers could also manipulate output movement (at least in the short-run), thus leading to increasing output and inflation volatility. Furthermore, monetary authorities could also abuse their autonomy to monetize fiscal debt, and therefore end up destabilizing the economy through high and volatile inflation.

Exchange rate stability could bring out price stability by providing an anchor, and lower risk premium by mitigating uncertainty, thereby fostering investment and international trade. Also, at the time of an economic crisis, maintaining a pegged exchange rate could increase the credibility of policy makers and thereby contribute to stabilizing output movement. However, greater levels of exchange rate stability could also rid policy makers of a policy choice of using exchange rate as a tool to absorb external shocks. Prasad (2008) argues that exchange rate rigidities would prevent policy makers from implementing appropriate policies consistent with macroeconomic reality, implying that they would be prone to cause asset boom and bust by overheating the economy. Hence, the rigidity caused by exchange rate stability could not only enhance output volatility, but also cause misallocation of resources and unbalanced, unsustainable growth.



Financial liberalization is perhaps the most contentious and hotly debated policy among the three policy choices of the trilemma. On one hand more open financial markets could lead to economic growth by paving the way for more efficient resource allocation, mitigating information asymmetry, enhancing and/or supplementing domestic savings, and helping transfer of technological or managerial know-how (i.e., growth in total factor productivity).

Also, economies with greater access to international capital markets should be better able to stabilize themselves through risk sharing and portfolio diversification. On the other hand, it is also true that financial liberalization has often been blamed for economic instability, especially over the last two decades, including the current crisis. Based on this view, financial openness could expose economies to volatile cross-border capital flows resulting in sudden stops or reversal of capital flows, thereby making economies vulnerable to boom-bust cycles.

Thus, theory tells us that each one of the three trilemma policy choices can be a double-edged sword, which should explain the wide and mixed variety of empirical findings on each of the three policy choices.

Furthermore, to make the matter more complicated, while there are three ways of pairing two out of the three policies , the effect of each policy choice can differ depending on what the other policy choice it is paired with. Hence, it maybe worthwhile to empirically analyze the three types of policy combinations in a comprehensive and systematic manner.developing economies may have been trying to cling to moderate levels of both monetary independence and financial openness while maintaining higher levels of exchange rate stability. In other words, they have been leaning against the trilemma over a period that interestingly coincides with the time when some of these economies began accumulating sizable international reserves (IR), potentially to buffer the trade-off arising from the trilemma.

None of these observations is applicable to non-emerging developing market economies. For this group of economies, exchange rate stability has been the most aggressively pursued policy throughout the period. In contrast to the experience of the emerging market economies, financial liberalization has not been proceeding rapidly for the non-emerging market developing economies.The additional dimension is the role of IR holding. Since the Asian crisis of 1997-98, developing economies, especially those in East Asia and the Middle East, have been rapidly increasing the amount of IR holding.

China, the world’s largest holder of international reserves, currently holds about $2 trillion of reserves, accounting for 30% of the world’s total. As of the end of 2008, the top 10 IR holders are all developing economies, with the sole exception of Japan. The nine developing economies, including China, Republic of Korea (Korea), Russian Federation, and Taiwan, hold about 50% of world IR. Against this backdrop, it has been argued that one of the main reasons for the rapid IR accumulation is economies’ desire to stabilize exchange rate movement.

According to one perspective, economies accumulate massive IR to achieve a target combination of exchange rate stability, monetary policy autonomy, and financial openness only a handful of economies have achieved combinations of ERS (exchange rate stability) and IR that significantly reduce output volatility. Such economies include Botswana, China, Hong Kong, Malaysia, Jordan, and Singapore. However, the fact that three Asian economies are among the economies with large IR holding and great ERS may explain why Asian economies are often perceived to be currency manipulators although they are more of exceptions than the rule.if policy makers put greater weight on real exchange rate stability, it is better to pursue more exchange rate stability and greater financial openness (which implies lower levels of monetary independence), which could have a volatility-enhancing impact on investment and output, though the answer depends on the level of IR holding.

Due to that we have not seen the deluge of hot money frolicking in these markets over the past 10 years, the greater good or the lesser evil. One interesting outlier is China; its level of monetary independence is so high that it contributes positively to higher investment volatility despite having a combination of very high IR and ERS. Despite the high volatility-increasing impact of the trilemma configuration on investment, the volatility-reducing effect on the real exchange rate seems to be outweighing the former and contributing to lower output volatility although relatively it is not such an open economy.