Third rock from the sun: Japan, China and the land of rising tension (Part 2)

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Following the recent escalation of tension between Japan and China, FXstreet.com Analyst Gus Farrow has taken a look at the history of the conflict, the underlying causes of the recent chapter, and what implications it may hold for the FX markets.

In the second of three instalments, Farrow takes a look at the specific issues facing both Japan and China.

逆側はその逆側を持ってい The reverse side also has a reverse side – Japanese Proverb

Japan – Teaching an old dog new tricks

In Japan, the recent election of the LDP and its coalition partners ended the DPJ administration, which held the distinction of being the first non-LPD government since 1955. The election marks Prime Minister Shinzo Abe’s second term in office, with his first being between 2006-07. Interestingly his first term was characterized by a concerted and public effort to improve relations with China. However, his return has been defined by a three-pronged plan of action, namely pitting fiscal and monetary reform alongside an aggressive foreign policy.

"Abe’s sweep of the Japanese political scene has been characterised just as much by its aggression as its speed."

The Japanese economy has long suffered since the bursting of the asset price bubble in the late 80s and early 90s, leading to the ‘lost decade’ where incessant deflation lead to economists coining the phrase ‘Japanification’ to describe such troubled circumstances. This period of extended economic stagnation has been compounded by the emergence of China as a leading exporter alongside regional peers like South Korea.

Further, Yen is considered to be a safe haven currency alongside USD and is primarily driven by risk sentiment. So naturally, when the US Sub-prime crisis exploded in 2007-08, followed shortly afterwards by the start of the European Debt crisis, Yen strengthened to record levels against the Dollar and the Euro. Any economy that is predominantly geared towards exports requires a carefully managed currency. As such, the unprecedented levels of strengthening made Japanese goods increasingly less competitive. Additionally, the earthquake and Tsunami which shook Japan in 2011 not only caused severe infrastructural damage but lead to a pivot away from cost efficient nuclear energy, which in turn placed further strain on the economy.

Throughout his election campaign, Shinzo Abe’s tone has implied that enough is enough and led commentators to herald the birth of ‘Abenomics’. He has layered political blame and pressure on the Bank of Japan for their lack of aggression in preventing an excessively strong currency. He has strong armed them into adopting a 2% inflation target and wants the bank to dramatically step up its asset purchase programme. Finance Minister, and also former PM Aso recommended a target price for USD/JPY of 90, a level that after a period of rapid appreciation from the 70’s has been met. The final aspect of ‘Abenomics’, according to Marc Chandler, Global Head of Currency Research at Brown Brothers Harriman, is the stoking of nationalism and the reassertion of Japan as an international power.

"Abenomics may be a final throw of the dice by the authorities."

Abe’s sweep of the Japanese political scene has been characterised just as much by its aggression as its speed. The ‘enough is enough’ mantra of his campaign can be one explanation for his stance, but gradually analysts and observers are starting to suspect that something else may be afoot. Abe’s previous post as PM was short lived before he was somewhat abruptly forced to resign due to a combination of terrible approval ratings, embarrassing losses in the Upper House and worsening health. Markedly, the Japanese Upper House elections are scheduled for July 2013 and many feel that Abe, scarred from his previous experience, is looking to push through as much legislation, as quickly as possible. This view is supported by research by Richard Koo, Chief Economist at the Nomura Research Institute who notes that the poor proportional vote counts shows that the LDP´s policies are not as popular as one might believe and Abe is merely striking while the iron is hot.

However, there is one other factor that is simmering on the outskirts of analyst observations. That of the ‘Japanese Debt Time Bomb’, a phrase recently highlighted by Hedge Fund manager Kyle Bass on leading Financial Blog ZeroHedge. The Texas based manager highlights that Japanese debt is around 24 times central government tax revenue and that 25% of said revenue is spent on interest. Whilst pinpointing the end of a 70-year debt super cycle to the day is naïve, Bass sees it coming in the next few years. His comments hint that Abenomics may be a final throw of the dice by the authorities before the inevitable occurs. However, it should be noted that it’s said that cemeteries are full of the careers of traders who thought that Japan was on the verge of collapse over the past couple of decades.

 

China – The importance of managing expectations

Meanwhile in China, despite a decade of unbelievable growth and development, the leadership transition in November came about at a time of relative economic instability, where the main question being asked is if China will have either a hard or soft landing from the dizzy heights of its recent achievements.

The Chinese economy has seen consistent out performance on its annual targets over the past ten years, averaging close to 11% growth despite the 2008-09 financial crisis. However, more recent growth targets have fallen as low as 7.5% last March. To offer some perspective as to the difficulties facing the Communist Party leadership, former President Hu once famously remarked to former US President Bush that his greatest concern was how to create 25 million jobs a year, just to sustain growth.

"The past decade has seen such unbelievable progress that expectations have grown, and the high-water mark is proving more difficult to consistently match."

Despite GDP growth rates that stuttering European economies could only dream of, the reality on the ground in Beijing is far from the black and white understanding that many westerners subscribe to. A social contract exists between the Communist Party and the Chinese people that translates in layman’s terms as, “let us rule, and we will make your lives better”. The past decade has seen such unbelievable progress that expectations have grown, and the high-water mark is proving more difficult to consistently match.

Further, the relationship between the Communist Party and the people is not as simple as many would believe. For every charge that China suppresses human rights, there is an opposing call claiming that the Government is too soft and needs to be more aggressive both domestically and internationally. Nationalism is an especially powerful force in China and the explosion of anti Japanese protests across the country last year will have served as a stark reminder to the Politburo what they may expect if they fail to manage expectations. China´s future looks bright, but the flags waved by passionate citizens will not necessarily be red.

The rise of China has seen a number of border disputes and concerns raised by its neighbours. However, perhaps an alternative view could be that after a long period of colonisation and rebuilding, the Chinese dragon has awoken and is stretching its wings. Rather than viewing the Communist Party as having an inherently aggressive foreign policy in the stereotypical Soviet mould, we may be best served considering that the party may be doing the bare minimum to meet demand and placate domestic fervour without sparking major international incidents. After all, this is the same Communist Party that realised that China was falling behind the rest of Asia and pro-actively instigated economic reforms. A look to North Korea offers a sober reminder of what a dogmatic embrace of communism results in.

A number of analysts believe that the days are numbered for the Communist Party. However, expectations of a collapse are far from imminent, but with the rate of reform and development being demanded, the process may be more of a natural development rather than a sudden event. In this sense, talk of a ´hard or soft´ landing may not be as suitable for Chinese economics as it is for Chinese politics. Perhaps the most appropriate question is whether the Communist Party can make the smooth transition to becoming more open and democratic, or will it collapse and lead to the chaos seen following the fall of the Soviet Union.

"...talk of a ´hard or soft´ landing may not be as suitable for Chinese economics as it is for Chinese politics."

However, when looking at the nationalist drum beat sounding from Beijing, a further element to consider may be the question of official corruption in China. While there may have been a certain level of tolerance of Communist Party behaviour in the past, the dawn of the internet and social media specifically in recent years has forced an unwelcome air of transparency upon the ruling elite.  The internet is heavily censored domestically, but with increasing numbers of students studying and working abroad, ‘Chinese walls’ are being torn down. Further, a generation of increasingly innovative developers are able to stay one step ahead of state censors in a perpetual game of cat and mouse.

While frustrations are often felt at the corruption of the lower level local officials, claims in publications such as the New York Times and the Economist, that former Premier Wen Jiabao’s family have amassed billions of dollars in recent years was met with stern, but not complete censorship. Further, in 2012 Bo Xilai, son of one of the Eight Elders of the Chinese Communist Party and once hotly tipped to become President, became embroiled in a scandal involving the murder of a British businessman and a host of questionable financial arrangements. With both the past and future of the Politburo leadership showing questionable ethical characteristics, it is understandable that questions, no matter how censored, start to circulate. Against such a backdrop, the distraction of nationalistic rabble rousing could be quite appealing.

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