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Hedge Fund Monthly

Koizumi's Sinking Ship.
Brian Nicol, Finstall

May 2003

Beleaguered Japanese Prime Minister Junichiro Koizumi marked the second anniversary of his appointment on the 26th April, but there was little celebration in the labyrinths of Japanese politics. Starting off with high ambitions of breaking the mould of the old way of Japanese political wheeling and dealing, he is currently adrift with little support from the notoriously factionalised ruling LDP. The most striking example of how marginalized he has become was a recent attempt to replace the Minister for Agriculture, Forestry and Fisheries who had resigned over yet another 'scandal' involving unauthorised payments to a subordinate. Koizumi had identified several well-qualified replacements, but because he had alienated their 'faction leaders' whose endorsement the candidates needed, but did not get, much late night scurrying around and calling in of old favours resulted in the appointment of a Party veteran and former Transport Ministry official. He has consistently failed to garner the necessary support from party members to push through his reform-based strategies and has at times, proved almost confrontational in his dealings. This has led to a high degree of frustration in government, industry and investors. Nowhere is the current situation more graphically illustrated than in the near 45 percent drop in the Nikkei Index since the Koizumi administration took over. It is estimated that some 150 trillion Yen has been wiped from the stock market capitalisation of the Tokyo Stock Exchange First Section, or an amount equivalent to roughly 10 percent of the financial assets of individual Japanese. There seems to be an ever-mounting sense of crisis among the business community that at times, does not seem to be reflected by government. The opposition factions in the government seem to be almost revelling in the current predicament, perhaps as a way of telling Koizumi and his reformists that this is not what we want for Japan. Growing talk in the LDP that the mark-to-market accounting rule change should be at least delayed, smacks to some of little else than desperation, but to me it is yet another example of Japan's reluctance to adhere to a global standard.

Perhaps more due to the lack of a viable alternative, a recent Asahi poll showed that some 70 percent of the voting public want Koizumi re-elected in the upcoming September LDP leadership elections. As we get closer to the vote, I'd expect various candidates to be pushed forward by the various 'faction bosses'. He remains under constant pressure to increase spending and it may well be that some form of supplementary budget will have to be forthcoming to ensure his re-election. But it's more a question of how we go forward from there.

Japanese companies face a massive problem with pricing power which will not be rectified until old and inefficient companies are driven from the marketplace. Without a return of pricing power, there can be little hope of any headway in the fight against deflation. In an environment where wholesale prices have not risen on a month-on-month basis since May 1998, many Japanese companies have fared exceptionally well and have turned increasingly to export markets for growth. Japan's trade account numbers are impressive, but they have become increasingly dependent on a narrow band of industries. The massive problems at the banks are well documented, but they and most of the insurance sector are a lot closer to insolvency than perhaps is generally realised. It continues to surprise me that in weeks when the weaker of the large banks share prices have fallen dramatically, there is no obvious rush by depositors to remove their precious savings. Bank lending has not increased for well over 6 years on a month-on-month basis. Despite near-zero interest rates and ample funds being made available to the banks to lend, little change in lending attitudes has been apparent. Worst hit of course are Japan's medium/small businesses who employ 4 out of 5 Japanese workers and who have little alternative source of capital other than bank borrowings. It is shocking to think that the system in Japan has snuffed out a myriad of small, innovative, value added growth companies in the early stages of their development as access to additional capital has been denied. The provision of liquidity has never been a problem in Japan, but due to the tactics at the banks, the economy is simply being starved of the fresh capital it needs to be able to grow. Who have been the beneficiaries of the zero-rate policy? Well of course it is the quasi government industrial behemoths who consume capital at zero cost and ruin the pricing ability of other more efficient companies. But, they mean votes for the politicians, so there is little will to change the status quo. Following a late November last year rating cut by rating agency Fitch, they were moved to comment that "every significant reform proposal has been materially watered down by opposition from powerful vested interests."

In the West, one could have reasonably expected some sort of revolution to have occurred to arrest or at least for-shorten the slide. Japan is simply, quite different from the rest of the world. In being the largest creditor nation, it is just too wealthy with about US$500 million more coming into the country every day than going out. Now, how that wealth is used, is a different question and it would appear that successive leaders have done a better job at destroying it than some of their more despotic LDC counterparts. Japan is a country where bad business practice and mediocre management has been funded by a zero-interest rate policy where the big survive long past their sell by date and the new and innovative simply do not count. More than half of all outstanding debt is funded by the Postal Savings Bank, which is administered by the Ministry of Finance which essentially translates into votes.

Koizumi's bold new start has withered and the fight against deflation has all but ground to a halt, if it ever got started in the first place. The appointment of a new Bank of Japan governor recently may bring more of a coordinated approach to tackling the problem, but nobody is holding their breath. The Central Bank has done much to help liquidity, but is now being asked, through it's monthly rinban operations to buy approximately half of all new government debt. The banks are huge holders of Japan Government Bonds and this creates a paradox when it comes to the fight against deflation. Inflation targeting may well not be the universal panacea, but some inflationary pressure must be allowed back into the system to enable a return of pricing power. With yields in the bond market measured in terms of basis points, any pick-up in inflationary pressures would spell disaster for bonds. This would have a far more harmful effect on the teetering banking system than further falls in the equity market. I think the decision has already been made that the equity market is to be the sacrificial lamb, but it's not so much a decision, it's the Japan way, do nothing and it might go away. There is a huge lack of accountability problem in Japan, with an out-of-touch, over-aged government that has little will to form part of the global 21st Century. Can Japan avoid a financial system collapse? I think it is an awful lot closer than many would like to admit. With individual savings ratios on a disconcerting downward trend and a current account surplus increasingly financed by a lop-sided export picture, just how long can Japan survive with the highest debt to GDP ratio of any major global economy? Make no mistake, demographics and a continuation of declining savings ratios will force a change, but it is almost like these people have to hit the proverbial brick wall before change will occur. Whether it is in two months or two years, the arrival of an IMF team may not be easy to picture in Japan, but in a number of ways, like the UK in the '70s, it may be what is ultimately required.

In my opinion, one would be well advised to stay clear of Japanese equity markets except on a knowledgeable bottom-up basis. Companies are getting little in the way of guidance, help or example from an intransigent, self interest government and neither will the part-time investor.


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