S&P downgrades Japan: a cautionary tale?

the S&P downgrade

Last week Standard & Poors downgraded the sovereign debt of Japan, reducing its rating on the Tokyo government’s bonds by one notch, to AA- from AA.  In doing so, S&P cited:

–high government debt ratios

–persistent deflation

–an aging population and shrinking workforce

–social security expenses at almost a third of the government budget, and rising

–the lack of a coherent plan to address the growing debt problem, and

–the global recession, which has worsened the situation.

With the possible exception of the last point, none of this is exactly news.  S&P could have cited all the other factors five years–or even ten years–ago.

What’s going on?

Two things, in my opinion:

1.  The Liberal Democratic Party, the dominant force in Japanese politics for the past fifty years, was tossed out of office in a landslide victory for the opposition Democratic Party of Japan in August 2009.  This happened once before, in the late 1980s, when the Socialist Party, from which the DPJ springs, did the same thing.  On both occasions, the transfer of power was followed by heavy-duty partisan infighting within the winning party, stunning ministerial ineptitude and legislative paralysis.  The past eighteen months have demonstrated that chances of another charismatic leader like Prime Minister Koizumi of the LDP emerging from the current fray are pretty remote.

2.  There’s a business cycle pattern to changes in the credit agencies’ ratings.  While the globe is expanding, the agencies’ ratings lag the economic reality.  They end up being too bullish for way too long.  In contrast, after having been castigated by the regulatory authorities and the markets for this behavior, the agencies become excessively cautious.  They downgrade aggressively and actively search for high-profile instances to do so, in order to tout their new-found conservatism.  Once the economic cycle turns up, of course, the rating agencies have tended to quickly forget this prudence and resume their former generosity to client bond issues.

no market reaction, but lots of expert commentary

Since the ratings downgrade contains no new insights into Japan’s malaise, the reaction from financial markets has been ho-hum.  But pundits have seized on this chance to air their views.  Internal commentators have been beating the drum again for economic reform.  External ones have reiterated their stance that Japan today is a look into the future for the US if we don’t mend our ways.

my thoughts, too

Since everyone else is doing it, I thought I’d also give my views about Japan (yet again), based on my twenty-five years of experience in the Japanese equity market.  Here goes:

1.  Reform just isn’t going to happen.  For decades, Japan has followed a policy of preserving the status quo, even at the cost of no economic growth.  The result has been that creative destruction, where a new generation of firms rises from the ashes of the old, isn’t allowed to happen.  Weak and inefficient entrants in an industry aren’t compelled either to change their ways or fail.  They receive explicit and implicit social protection instead.  So they drag down the strong.

2.  Perversely, the economic stagnation and mild deflation that result from this policy help perpetuate the system.  Lack of economic growth keeps interest rates low. Domestic investors have few viable investment alternatives, so they continue to put their savings into government bonds.    Therefore, Tokyo can fund continuing deficits easily and at low cost.  In a funny sense, the worst thing that could happen to Japan over the next several years would be for the economy to spontaneously (it would take a miracle, though) begin to grow.  Alternatives to government bonds would arise for investors.  And interest rates would likely go up, raising Tokyo’s financing costs.  Voilà, government debt crisis.

3.  There is a point of similarity, I think, between the Japanese situation and the American that is something to worry about.

It’s not in the industrial base, which is much more dynamic and much less hide-bound in the US than in Japan.

It’s not in the politics, either, though both the Capitol and Nagatacho are to my mind similarly dysfunctional.  But the Japanese electorate has put up with legislative failure for over twenty years.  I think, however, as Americans work out that Washington is not meeting its needs, change will come swiftly and dramatically.  We’ve already seen some of this twice within a little more than two years.

One of the most striking aspects of Japan to me as an investor is the strongly held belief in that country of its cultural and economic superiority over everyone else.  The fact of this belief isn’t so surprising.  Every major power seems to think more or less the same thing about itself.  Certainly, the US does, too. But in Japan, sort of like in France, its intensity stands out.  Neither seems to me to have a sense of perspective/humor about itself. (I’ve been told, for example, by a Japanese CEO in a face-to-face interview that he didn’t want foreigners like me holding stock in his company.  Why?  …we’re subhuman, that’s why.  Actually, he told my translator, who skipped over that part–both unaware that a “subhuman” might actually understand a little Japanese.)

If you think it’s a priori impossible for a foreigner to have anything to teach you, you can be blind to the objective situation–meaning that a sense of national pride that’s out of control will act as a barrier to beneficial change.

Although the US may have prominent individuals who believe as intensely as the Japanese/French that anything domestic is superior to anything foreign, I think most of us have a little more common sense.  Again, however, only time will tell.

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