Sunday, February 7, 2010

Is there a future for Japan?

Dear Andreas, Do you see Japan ever coming out of its crisis?

Japan is certainly one of the saddest stories in recent economic history: From its buoyant catching-up in the 1960s and 1970s, through its stock and housing market bubble induced roaring in the 1980s, and into its long stagnation in the 1990s and 2000s. Despite not having been severely affected by the last financial frenzy, as its banks were
still licking their wounds from their quasibankruptcy in the 1990s, Japan has been one of the hardest hit economies in the global downturn following the financial crisis. Industrial production had dropped by almost 40% at the low point of the recession on the back of crumbling international trade. Since then, the economy has bounced
back somewhat, following the global recovery. However, Japan, famous for its decade of deflationary stagnation, is now facing its worst deflation ever.

Hence, there is currently quite a normal doom-and-gloom sentiment about Japan: that it might never see solid growth and normal price increases again. In fact, one needs
to stress two factors, which, in our view, are sometimes forgotten when one looks at
Japan. First and foremost, the low absolute GDP growth rate, that we are likely to see
over the next decade, does not necessarily mean that the average Japanese will, in fact,
see low or even declining income, given that the population is shrinking. This is a positive

However, it is exactly this demographic challenge that could pose the most formidable
threat to Japan on the price front. The government debt-to-GDP ratio is likely to
surpass 200% in the coming years. Concurrently, the aging of Japan‘s population is
accelerating. Older people usually tend to sell their assets in order to provide for their
retirement. This in turn is a large challenge for the Japanese government bond market,
as new supply of bonds will likely be met by a shrinking demand. The days of low Japanese
interest rates could quite soon be over. Obviously interest rates tending higher in
a deflationary environment would be unbearable for the already stressed Japanese
real economy. It could ultimately force the

Bank of Japan to act as a buyer of last resort, which will have to monetize the government
debt at an accelerated pace. What seems currently – given the ongoing deflation – very
unlikely, i.e., a very high inflation rate, could therefore become the new Japanese environment.
This in turn could seriously weaken the Japanese yen in the long run In conclusion, wherever one looks,
 the Japanese economic fundamentals do not inspire confidence. There might always be
some short-term investment opportunities in Japan. However, unless one believes in a
major, yet-to-happen technological breakthrough from which the country could profit,
it is currently not our favorite long-run market.

[ubs capital markets]

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