Currency wars will create massive havoc in emerging markets with dollar-denominated debt. Think 1998 on steroids. The US has been in a depression for the last 6 years with almost 50 million people on food stamps (back in the Big Depression they were in food lines), about 23% unemployment if computed as it was back then, and median incomes down about 7% over the last 6 years. The rich and well-connected (government workers and other non-producers) have enjoyed a rising stock market and rising asset values in general juiced by the Federal Reserve. Meanwhile, new regulations and taxes have strangled most producers.

Now that the U.S. midterm election is over and the Senate will pass to Republican control (good luck with that given the President’s veto pen and no way to get enough votes to override a veto), it is time to think of government spending and Federal Reserve policies and what they have given us.
The US has been in a depression for the last 6 years with almost 50 million people on food stamps (back in the Big Depression they were in food lines), about 23% unemployment if computed as it was back then, and median incomes down about 7% over the last 6 years. The rich and well-connected (government workers and other non-producers) have enjoyed a rising stock market and rising asset values in general juiced by the Federal Reserve. Meanwhile, new regulations and taxes have strangled most producers.
The fix to all this according to Washington officials has been several QE programs, continued huge deficits, and huge increases in government control (regulation, the government is here to help us) of our economy. These were supposedly designed to save us (do you feel saved?), but they have actually been destroying us. We seem convinced that more debt is a solution to high debt - crazy! We also seem convinced that the fix to our economy is to have more government control of it meaning less individual freedom and more government interference in our daily lives (how is that working out for you) – again crazy! We seem to have forgotten the old adage that power corrupts and absolute power corrupts absolutely.
Financially, we are a disaster waiting to happen. Let’s look at Japan and realize that what they are experiencing is not much different than the financial crisis we seem eager to produce. This article is a bit long but oh so necessary for us to understand if we care about saving our country from another much more serious financial crisis than the last one.

The Link Among All Crises

But we have not dealt with the primary cause of nearly all financial crises throughout modern history and throughout the world: too much of the wrong kind of debt – debt which is nonproductive. Paul Krugman, the most visible spokesman for those who think it is old-fashioned and foolish to worry about the debt, recently wrote:

On the Chicken Little aspect: It’s actually awesome, in a way, to realize how long cries of looming disaster have filled our airwaves and op-ed pages. For example, I just reread an op-ed article by Alan Greenspan in The Wall Street Journal, warning that our budget deficit will lead to soaring inflation and interest rates. What about the reality of low inflation and low rates? That, he declares in the article, is “regrettable, because it is fostering a sense of complacency.”

It’s curious how readily people who normally revere the wisdom of markets declare the markets all wrong when they fail to panic the way they’re supposed to. But the really striking thing at this point is the date: Mr. Greenspan’s article was published in June 2010, almost three and a half years ago – and both inflation and interest rates remain low.

And he is right, up to a point: too much debt is not a crisis today. Too much debt is never a crisis, right up until the moment it becomes a crisis. Too much debt was not widely recognized as an issue in the US in 2006 or in Europe in 2010, but then – boom! – it became an issue. And throughout the developed world and China, today’s levels of debt, an ever-increasing amount of which is unproductive, are staggeringly high.

The currently fashionable way to deal with too much debt is to punish savers and enrich the already rich, prolonging a situation in which even more debt can be accumulated. Markets believe in the effectiveness of central bank actions precisely because they want to, not because there is any well-established basis for that belief. Yes, we have dealt with some of the problems that gave rise to the last crisis, but we have still not dealt with the underlying, fundamental problem of too much nonproductive debt. At some point, some nasty cousin of subprime debt will come along to prick our bubble. And because debt levels are now even higher than they were in 2007 and there is less scope for the Federal Reserve to intervene with interest rates, the next crisis will not be a repeat of the Great Recession but its own calamitous variant. Which will bring yet more monetary and fiscal intervention, which will produce its own unintended consequences.

And speaking of unintended consequences, let us now turn to Japan.

Japan: The World’s Largest Hedge Fund

In a (reputedly) passionately contested 5 to 4 vote, the board of governors of the Bank of Japan voted essentially to become the world’s largest hedge fund. Not only did they raise the level of quantitative easing by over 15%, to the equivalent of $720 billion a year, they are aggressively allocating and increasing portions of that money to Japanese equity markets and REITs. In a (supposedly) uncoordinated but almost simultaneous announcement, the $1 trillion+ government pension fund announced a move to sell Japanese bonds in size and increase their equity holdings in Japanese and foreign stocks by 20%, divided equally between Japanese and foreign markets. This is the equivalent of $200 billion being injected into global equity markets from one pension fund alone. We can expect that nearly every other Japanese pension fund will follow suit, meaning that potentially hundreds of billions of dollars will be thrust into global equity markets.

Bank of Japan Governor Kuroda said that the move was necessary to achieve their inflation target of 2%. Core Japanese inflation fell to 1.2% last month (after adjusting for the sales tax increase) and has been falling for the last six months. He has a target of 5% nominal GDP growth, by which we assume he means 2% inflation and 3% real GDP growth. The fact that nominal growth has been almost literally zero for the last 20+ years doesn’t seem to impact his optimistic target.

In his comments after the announcement, Kuroda-san said, “[However,] it is important for the BOJ to strongly commit to achieving its price target to get its price target firmly embedded in people's mindset.... [Thus] we have pledged to do whatever it takes to achieve our 2 percent inflation target at the earliest date possible.... It won't do much good in trying to shake off the public's deflation mindset if you just say inflation will reach 2 percent someday.”

I guess using the phrase whatever it takes is working so well in Europe that Kuroda decided to try it out in Japan. At least the currency market believes him: the yen is getting thrashed as I write this.

Local analysts give him almost no chance of approaching 2% inflation in the first part of next year. Household spending fell another 5.6% in September, and another round of consumption tax increases is due to kick in next year. The consumption tax was raised from 5% to 8% last April, which resulted in a 7% contraction of the economy in the second quarter. The tax will rise another 2% (to a total of 10%, or double the original amount) next October.  Seriously, if you are in the middle of a recession, the general prescription is to cut taxes, not double the national sales tax over a period of a year and a half. Taking away 5% of Japanese consumption is not going to be good for GDP or the inflation rate, especially when so much of your aging nation is living off fixed incomes that essentially pay them no interest.

Real wages have been falling for well over a year and are now down 3% year-over-year. I’ve written extensively on the deflationary impact of Japanese demographics. All of this data, taken together, is not the stuff of which inflationary fears are made.

And thus Kuroda’s ostensible reason for increasing the money supply: we need more inflation, and economic theory says quantitative easing is the way to get it. The argument from the Bank of Japan is that it is simply applying the same strategy that the United States, Great Britain, and Europe have used to such stunning effect.


Japanese debt-to-GDP is approaching 250%. This year the government deficit is 7.6% – or the US equivalent of a deficit of about $1.3 trillion. (The actual US deficit in 2014 was $463 billion.) And Japanese government budgetary requests amount to a spending increase of about 6% for 2015 … although Prime Minister Abe assures us that Japan will be close to a primary balance by 2020. Rots o’ ruck on that one, Abe.

Ten-year Japanese bonds are now yielding 0.45%, and five-year JGBs yield a minuscule 0.11%. The Bank of Japan has essentially become the Japanese bond market. The balance sheet of the Bank of Japan will rise about 1.4% of GDP each month for the foreseeable future. That is easily more than twice the amount of debt the government of Japan will issue. That means they will have to go into the market and buy already-issued bonds. Thus, the government pension fund announces that they will serendipitously sell their bonds (at a profit, of course) to the Bank of Japan and purchase equities. Such fortuitous timing for the Bank of Japan.

Marcel Thieliant of Capital Economics notes that the BoJ already owns a quarter of all Japanese state bonds and a third of short-term notes (The Telegraph).

The actual Japanese strategy, over time, is to move the bulk of government debt off the books of banks, insurance companies, and pension funds, so that when, in some distant future, the Bank of Japan allows interest rates to rise, it will not devastate the balance sheets of Japan’s most important institutions.

Head ’Em Up and Move ’Em Out

And this is where the move by the Japanese pension funds is so important. At the end of the day, the pension funds are moving out of JGBs and into equity and especially foreign equity precisely because they have lost faith in their ability to meet their obligations in an environment of continual and rising QE. The pension funds have forced the Bank of Japan to boost its QE support in order to absorb the amount of JGBs that will be put back on the market.

This is precisely what I predicted in both Endgame and Code Red and in this letter over the past four years. Investors, and that includes pension funds and insurance companies, have no choice but to diversify outside of Japanese bonds. Not to do so would be a dereliction of duty, but their shift forces the BoJ to increase its quantitative easing perhaps faster than it would like to.

This dynamic has the potential to spiral out of control. The more the yen falls, the more apparent it becomes that Japanese individuals and institutions are fleeing the Japanese bond market, and the greater will be the move to sell bonds. Unless the Bank of Japan can absorb all those bonds, interest rates will have nowhere to go but up, which would be devastating to the government of Japan.

Will the current level of JGB absorption, which is about 4% of total government debt per year over and above newly issued debt, be enough one year or two years from now? If it isn’t, I fully expect another announcement increasing QE to an even more stratospheric level. Japan is still behaving in a gentlemanly fashion, to be sure. The pension funds will give the Bank of Japan a heads-up as to their plans, and it is likely there will be some give and take, but the direction is certain. This is not something that can happen overnight, as moving hundreds of billions of dollars into equity markets without radically roiling the markets is not possible. But this cattle drive is getting rolling – “head ’em up and move ’em out.”

The debt-to-GDP ratio of Japan will rise another 25% in the next few years, but the amount of that debt on the balance sheet of the BoJ will increase by over 50% in just the next three years. By comparison, that would be the equivalent of the Federal Reserve’s purchasing $8 trillion worth of government bonds and equities. That amount of money beggars the imagination … but it will still leave the Japanese government owing just a shade under 200% of GDP.

Since the government of Japan simply cannot survive in an environment of significantly rising interest rates without serious intervention by the Bank of Japan, QED, the BoJ is going to go on quantitatively easing well into the next decade. They will literally need to monetize 200% of GDP (or more!) while the government of Japan somehow manages to get into an actual surplus, so that the BoJ can withdraw from the markets and allow interest rates to rise to market levels. And if that debt-to-GDP ratio is pulled down to a more normal 40 to 50% (70%? – pick your favorite level for “reasonable”) and they have a balanced budget, then interest rates will actually remain reasonable from the perspective of the government.

But if the Bank of Japan withdraws anytime soon from the bond market, there will be no Japanese bond market for the foreseeable future. Interest rates will rise with the same market force brought to bear by Jay Gould’s corner on the gold market. I know I’ve been beating this drum for a number of years, but you can see this coming. Japan’s past reckless spending leaves them with no other choice than to monetize their debt and destroy their currency.

The Bank of Japan is now the Japanese bond market. There is no one else. Japanese pension funds and investors are fleeing the Japanese bond market and putting money into “hard” assets like the local stock market or real estate if they want to keep the money in Japan, or they are moving it into investments denominated in other currencies.

The chart below shows the fall of the Japanese yen against the dollar in the last two years. Note that the dollar has risen some 40% against the yen. Since its recent high, the yen has dropped a similar amount against the euro and the Korean won. It is even 50% lower against the Chinese renminbi. That is a breathtaking move for a currency in so short a time.

The yen is now almost 114 to the dollar as I write early Monday morning, continuing its drop of last Friday. Expect to read about pushback from many countries over the next few weeks. They will become even more vocal when the yen crosses 120. And then 130 and at every point until the yen is at 200 to the dollar. The only question in my mind is, will the Bank of Japan monetize enough Japanese debt so that it can withdraw its quantitative easing before the yen reaches 200? I actually have real money in 10-year yen put options that says they can’t. But then again, that assumes that a response by the Federal Reserve for QE4 doesn’t develop. Please note that I’m not saying that the yen will go straight to 120, much less 200, from here. It will probably do so in an uneven and volatile manner similar to what we’ve seen in the past few years. But it is my belief that the overall direction is for an ever-depreciating currency.

If the yen depreciates only 10% a year, that exerts an inflationary force of less than 0.5% a year. Given the market dynamics already at work in Japan and given the stated goal of 2% inflation, that is nowhere near enough. There will come a time in the not-too-distant future when inflation again starts to recede uncomfortably below 1%, and the only way Governor Kuroda will be able to maintain his credibility will be to double down on even more aggressive QE. Whatever it takes, indeed!

These are not simple men at the helm of the BoJ. They fully will understand that they are eroding the value of their currency – and that, in fact, is part of their intention. In his comments after the meeting, Gov. Kuroda came right out and said, “Overall, a week yen is positive for Japan’s economy.” He hopes that by weakening it he will put some competitive zing back into Japan’s exporting industries. By targeting equities, Japanese leaders hope to alleviate much of the pain to investors and their pension funds by fomenting a rising market. And Japanese corporate profits are up significantly – far more than those of their European and US counterparts – over the last two years as the yen has fallen.

I am sure the “unintended” consequences of Japanese actions are discussed at the monthly meeting of central bankers at the Bank of International Settlements in Basel. Perhaps they are even discussed aggressively. But at the end of the day, all Kuroda-san can do is shrug his shoulders and tell the other members he has no choice.

And he doesn’t. If he does not continue in his present course, he will face a deflationary depression of the first-order, and that would have an even greater negative impact on the world than what he is attempting to do now.

But it is remarkably naïve for the market to believe in the illusion that the central bankers of the world have it all under control, that they have this all thought out, that they have modeled it perfectly, and that these new Japanese actions are simply part of the plan.

The Japanese are attempting to export the one Japanese product the world does not want: their deflation. It is not clear how the central banks of the world will react to the yen at 130, let alone 140 or 150. With proper fiscal, regulatory, and tax reform, the United States can cope with a rising dollar. I’ve been writing for a long time that the dollar is going to become stronger than any of us can possibly imagine. And not just against the yen. But monetary policy alone is not enough to deal with the challenges that a strong dollar presents.

I am not sanguine about Europe, where QE is still streng verboten. Neither is it clear what the proper course for China should be. Allowing the renminbi to strengthen along with the dollar would create deflationary impulses in China and weaken their own export competitiveness. But to allow their currency to fall would threaten the dollar relationship of their internal debt financing. Properly understood, Chinese government debt may be approaching 200% of GDP (when total government obligations are taken into account). That is a staggering sum for an emerging, growing economy, even one with China’s dollar reserves. My guess is they’re going to need every penny of those reserves. The good news, I suppose, is that they have them.

To think that the Japanese are not busy triggering a major currency war is to favor hope over political reality. It is true naïveté. Politicians are going to want to be seen doing something about currency fluctuations that hurt their local businesses. This will put pressure on their central banks and prompt urgent calls for protection. The bad news is that we’re sliding into this currency crisis at a time when debt is at nosebleed levels and still rising, when Europe seems ineluctably headed for another phase of its crisis (and another recession), and China is struggling to balance a most unbalanced economy.

In the same way that we connected farmers and bankers in every corner of the United States back in the 1870s, we have now connected businesses at every level in every corner of the world. To think that we can somehow manage our Brave New World economy with any greater success than President Grant and his Treasury Secretary achieved is to rely on a huge dollop of hope, and hope is not an economic management strategy.

How do we recognize where and when the serious problems will develop? We’ll close with a slightly edited version (from Endgame) of Michael Pettis’s timeless list of “five things that matter”:

1. Debt levels matter. The best way to measure them is as total debt to

GDP or external debt to exports. As a general rule, the more debt you have, the more difficulty you are going to have servicing it. Coupons matter, too. Low rates are much more serviceable than high rates.

2. The structure of the balance sheet matters, and this may be much more important than the actual level of debt. Not all debt is equal. An investor has to distinguish between inverted debt and hedged debt. With inverted debt, the value of liabilities is positively correlated with the value of assets, so that the debt burden and servicing costs decline in good times and rise in bad times. With hedged debt, they are negatively correlated.

Foreign currency and short-term borrowings are examples of inverted debt. This makes the good times better and the bad times worse. Long-term fixed-rate local-currency borrowing is an example of hedged debt. During an inflation or currency crisis, the cost of servicing the debt actually declines in real terms, providing the borrower with some automatic relief, and this relief increases the worse conditions become. Highly inverted debt structures are very dangerous because they reinforce negative shocks and can cause events to spiral out of control, but unfortunately they are very popular because in good times, when debt levels typically rise, they magnify positive shocks.

3. The economy’s underlying volatility matters. Less volatile economies are less subject to violent fluctuations, especially if the performance of the economy is correlated with financing ability. This is especially a problem for countries whose economies are highly dependent on commodities. Typically, commodity prices go down in bad times, making it that much harder to export profitably.

4. The structure of the investor base matters. Contagion is caused not so much by fear, as most people assume, but by large amounts of highly leveraged positions, which force investors into various forms of delta hedging, that is, buy when prices rise, and sell when they drop.

5. The composition of the investor base also matters. A sovereign default is always a political decision, and it is easier to default if the creditors have little domestic political power or influence. Unless foreign investors have old-fashioned gunboats or a monopoly of new financing, for example, it is generally safer to default on foreigners than on locals. It is also easier to default on households via financial repression than it is to default on wealthy and powerful locals.

As you can see, the structure and ownership are almost more important than absolute debt levels themselves. This has very important implications, which we will go into as we go country by country around the world.

The insight that it is better to borrow in local currency versus foreign currency is critical. The United States and the United Kingdom, for example, are able to borrow exclusively in their own currency. This acts as an important shock absorber in bad times. It also creates an incentive to use devaluation and inflation as a means of financial repression. Devaluation hurts foreign bondholders, and inflation eases payments in your own currency in the short run.

Currency wars will create massive havoc in emerging markets with dollar-denominated debt. Think 1998 on steroids.

Markets are creatures of emotion and leverage. If either one turns negative in a world where deflationary pressures are building, then the only inflation we have seen – asset price inflation – will be threatened. Even with Godzilla-sized Japanese QE.

Print this post

Do you like this post?

Add your reaction to this article