Chart of the Day: JPY Forecast Model in the Money

The Model

Custom Products Research uses 5 regression models to forecast fair value for the USDJPY exchange rate. As of January 25, 2017 the fair value for USDJPY was ¥112.65, based on our main 3-Equation model (3EQ).  We had also forecast ¥114.51 based on the US-Japan 2-Yr 1 YR forward spread differential (2Y1YF) and ¥111.03 based on the inflation expectation-adjusted 2 YR US-Japan real rate spreads (IA2YS). The 5 regression models all have very high R2 with the 3 equation model at 89%, R= .944 and t-stat 121 over the last 7 years.  The inflation expectation adjusted 2 yr yield gap R2 is 90.8% over 5 years, R95% and t-stat 60.2. While the 2-Yr 1 YR forward spread has an R2 of 87% and R93% with t-stat 25.7 over last 2 years, but this falls over a longer timeframe. (for further details see January 31 report, ‘Exchange Rate Forecast…..’)

As of 1AM GMT February 24, 2017,  both  2Y1YF and 1A2YS indicated USDJPY fair value ¥112.90, which happened to be exactly the spot rate. While our 3-equation model stood at ¥111.92.

What has Changed?

Over the last month, 2-Yr yield spreads have remained unchanged at 145bps, while 2 and 3-YR inflation adjusted spreads have become more negative (-60bps to -100bps), implying a stronger Yen. Real adjusted 10-Yr rate spreads have also declined, from 0.6% to 0.09%, also implying a stronger Yen. Meanwhile inflation expectation-adjusted short-term yields have been flat. Similarly, the 2 YR 1-YR Forward rate differential has been flat at 1.9%, after having risen from 1.4% in October. 

The Outlook

We still expect the Yen to weaken towards year end, based on 4 quarter-point hikes by the Fed. (see January 1 report ‘Central Bank Policy: Fed Still Behind the Curve). Q1 GDP growth should be between 2.4-2.5%, Hourly wage growth is also 2.5% and the Bloomberg Economic Diffusion Index continues at a high level. January CPI was 2.3%, with continued upward pressure from oil and China producer pricing, supporting our ‘inflation surprise shock’ scenario. 

Unfortunately, as the BOJ is content with 1% real GDP growth and USDJPY above ¥110, no further rate cuts are expected from the BOJ (see February 17, 2017 report ‘Central Bank Policy – Why 2018 is Looking a Lot Like 2006 for the BOJ’)

For more details, or to get access to the model please Contact Us

End of 1Q FY3/17 Earnings Summary - Full-year Consensus numbers still a lot more bullish than Guidance

If we look at the 1Q Aggregate numbers, which Sectors are best and worst positioned for the rest of the year? On the positive side, names in the Information and Communication sector achieved 30% of the aggregate OP guidance. Toho (9602) achieved 39% of full-year OP and KONAMI (9766) achieved 36% of its full-year OP guidance. The Pharmaceutical Sector achieved 40% of its aggregate OP. Takeda Pharma (4502) has already achieved 113% of its full-year OP guidance and Eisai (4523) has already achieved 48% of full-year OP guidance. Transportation Equipment achieved 32% of full-year OP guidance. Honda (7267) is at the top with 45% of OP guidance achieved, followed by Toyota Motors (7203) with 38% achieved.

On the other side, only 18% of aggregate OP was achieved in the Machinery Sector. Sankyo (6417) has a negative 16% achieved and Ebara (6361) is basically at nothing achieved. Electronic Appliances companies were only able to achieve 18% of full-year OP guidance. NEC (6701) OP came in at negative 30¥bn OP so that is not a good start for them. Fujitsu (6702) is not much better losing 11¥bn at the OP level in the first quarter. Other Sectors that are not off to a good start are Construction with only 17% of full-year OP achieved, Nonferrous Metals with only 18% achieved and Oil & Coal Products with only 15% of full-year OP guidance achieved.

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State of Origin - Tokyo vs. Osaka - Osaka clearly wins....

With Australia’s State of Origin Rugby Match this evening, we thought it would be fun to compare historical price performance of Tokyo-based companies  vs. Osaka-based companies and then all the other city outside of Tokyo. Now we looked back over the last 15 years and Osaka-based companies have clearly done better. Osaka-based companies are up 84% compared to Tokyo-based companies that are only up 14% over the last 15 years. Other-based companies also did well and are up 60% since 2001.

Now our first thought was that there was a small-cap bias. However when we limit all the universes to between 100 and 400 ¥bn mkt-cap, Osaka still does better. Tokyo-based companies are down 2% over the 15 years. Osaka-based companies are up 58% and other-based companies are up 40%. We then thought that maybe the Fundamentals are better in companies outside of Tokyo. This is not the fact. We compared aggregate Sales growth for Tokyo-based companies and Osaka-based companies and there is not a significant difference. The same holds true for aggregate OP Margins.

Right now we do not have a good explanation of why on average Osaka-based companies have done better. However, if you are looking at similar companies with one in Osaka and one it Tokyo, it might be worth looking hard the Osaka one. 

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Talk of BOJ Negative Lending Rates Premature

Japan currency markets were disappointed, for some reason, last month when the BOJ failed to make any changes at their Monetary Policy meeting on April 29, causing the yen to appreciate by 5% over 4 days. Rumours had flowed during the week prior to the policy meeting, fanned partly by the Nikkei (4.19.16), that the BOJ was starting to build a consensus to follow the ECB further down it’s negative interest rate path, including negative rate lending. All of which was premature!

On March 10, 2016 the ECB had reduced its 3 key benchmark rates (deposit rate from -0.3% to -0.4%, MRO (or ‘refi’ rate) from 0.05% to 0% and marginal lending facility from 0.3% to 0.25%). The ECB also increased monthly bond purchases from €60bn to €80bn with €20bn/month non-bank euro-denominated investment grade corporate debt. (The APP (asset purchase program) will run at least until March, 2017). To further encourage lending, the ECB launched new series of 4 new TLTRO 2 (targeted long-term refinancing operations) from June 2016 (4 yr. maturity), in which banks provide collateral to the ECB in exchange for 4-yr loans. Counter-parties are eligible to borrow up to 30% of the stock of eligible loans at MRO rate, which was reduced to 0, with increasing discounts up to the deposit rate (-0.4%) for banks that exceed benchmarks, so it is expected that banks will switch from TLTRO 1 to TLTRO 2 financing (helping banks with upcoming funding needs). The first four TLTRO programs saw a 384.4bn euro take up by European banks between June, 2014 and June, 2015 contributing to the strong growth in consumer credit over the last year.

NB: ECB Credit Impulse is Consumer credit growth minus real GDP growth

The LTRO and TLTRO loans to banks have been quite successful in boosting lending, though the initial take-up in 2011-12 was largely redeposited back at the ECB and not invested in buying sovereign debt as might have been hoped. Stiff collateral requirements and 1% interest on the loans meant that most of the money was returned after 1 year when banks’ own financing situation had improved. The ECB Governing Council’s decision this time to not implement a ‘tiering system’ on rates was  highly significant in that it signaled that there is a limit as to how low rates can go.

Thus with deposit rates at -0.40% and lending rates at 0, European banks are incentivized to increase lending rather than deposit excess reserves at the ECB, while being rewarded with negative borrowing rates when exceeding ECB lending quotas.

What about Japan? It would seem that the BOJ’s tier-system on deposit rates whereby ¥220trn in bank (Basic Balance) deposits at the BOJ still enjoy 10bps interest and only ¥10-¥30trn in excess (Policy Rate Balance) deposits requiring 10bps interest paid by the banks, is only marginal at best, in encouraging banks to increase lending rather than pay a penal rate on excess deposits.  Further, as of March, the BOJ’s special loan support program, which also has stiff collateral requirements, had reached ¥24.42trn with lending rates to the banks coming down to 0 in March (with the remainder repriced every quarter over the next year).

So while the BOJ seems to be following the ECB’s line, it is clear that a corridor of 30-40bps between reserve deposit rates and BOJ lending rates is necessary for incentives to work effectively. Since banks can easily fund from their own deposits, one would expect that deposit reserve rates on a ‘majority’ of excess reserves at the BOJ would have to be -30bps before such measures as negative ‘lending support loans’ were adopted.  Further, with only one month of data since negative deposit rates came into effect February 16, it would have been premature to further reduce deposit rates without knowing their efficacy. The BOJ may also be reluctant to act before the Brexit referendum on June 23, making a move by the bank unlikely at their June 16 meeting as well. Mr. Kuroda may also be hoping to wait for his new board member from Shinsei Bank to come on board in June to avoid the narrow 5-4 margin that he enjoyed when the BOJ Adopted negative reserve deposit rates at their January meeting.

Since the BOJ’s decision to adopt negative rates, it has come under fire from the city banks, in particular, for fanning unease among depositors without a commensurate increase in lending. This blame seems premature and also possibly emanates for city banks’ frustration at the Abe’s unwillingness to give them a seat on the board in June to replace outgoing member Ishida who hails from SMBC, the first time that the city banks have not been represented on the policy board.

It would seem appropriate, however, that the BOJ examine why TIBOR rates have not come down more, whereas Yen Libor (London),  Eonia rates and US Libor are all within 7-8bps of deposit or policy rates.  Japan TIBOR rates still suggest that banks would rather pay the 10bps on excess deposits (since they receive 10bps on 10-times that amount), rather than reduce TIBOR rates into negative territory.

Figure 1: Tibor vs JPY LIBOR

Figure 2: ECB Deposit Rate vs EONIA

Figure 3: USD Libor vs Federal Funds Effective Rate

La liberté , L'égalité , Les droits (entitlement)

France; Labour Management Negotiations. They even wanted the shirt on his back

I go to France a couple of times a year and was lucky enough to spend several weeks there over the past month. Last December, I had intended to go to Lyon, a 3 hour train ride from Paris, for the ‘La Fête des Lumières’,  but the festival was unfortunately cancelled due to the Paris Terrorist attacks.

To get myself in the mood, I usually bring along a book and this time chose Thomas Piketty’s ‘Capital in the Twenty-First Century’, a book which I had put down shortly after it came out in 2014, when I got bogged down in the detail and minutia after the first couple of hundred pages. 

After my first week in Paris, I completed ‘Capital’ and was somewhat shocked by the conclusions. The major theme of the book is that the return on capital r has historically been significantly greater than global growth, so a return of say 5% (assuming limited interest, dividend and capital gains taxes) and only 1-1.5% growth, implies that asset-owning classes find it easy to only consume 20-25% of their income while accumulating the rest. 

Of course private capital, has seen periods of protracted contraction, particularly around WWII, with weak markets,  asset destruction and high taxation. But what alarmed Piketty, is that over the last 30 years,  strong returns and lower marginal income and capital gains taxes, have resulted in private capital rising to almost 700% of national income in the US, with Japan a surprising second at 600% (and 450% among developed countries). He forecasts this to rise a further 50% by 2090. Private assets have consistently grown faster than national wealth, such that wealth gradually became more and more concentrated, peaking between 70- 80% of wealth for the top 10% globally around 1910. Though wealth destruction in Europe during the WWII and a 25% one-time tax in France shortly after the war, saw private wealth as a multiple of national income there and elsewhere decline until 1970, it is once again approaching the extreme of the early 20th century when income and inheritance tax was virtually non-existent.

Mr. Piketty also addresses inheritance as one of the villains in proliferating this inequality. Though he does not include Japan in his inheritance data, while it is impossible to provide meaningful data for the U.S., given the treatment of ‘gifts’. I, however, took Japan inheritance data and was surprised to find what 25  years of value-destruction can do (If the gov’t data is to be believed)[1]

In terms of income, Japan’s top 1% received a little less than 10% of total income, putting Japan at or slightly below Germany, which at 10% was average among the advanced country sample. While the US remains significantly above everyone at 24%.

Mr. Piketty’s solution for this inequality is quite simple,  raise the marginal tax rate to 80% on income above $1mn and introduce a wealth tax of 1% between $1mn and $5mn,  2% or more for $5mn and 5%+ for $100mn or more. His data shows that two-thirds of European wealth is actually inherited wealth and though he has nothing against wealth, per se, he is only willing to accept it if it contributes to the greater ‘utility’ and overall growth.  His assertion is that the recent trend for the mass accumulation of wealth has done nothing to enhance the overall ‘utility’ for society nor promote growth. Furthermore, he sees government debt as simply benefiting the wealthy class, and as such, it should be reduced by hefty one-time taxes on private assets.

The natural extension of his thesis is that a healthy democracy requires equality, which includes economic well-being and that globalization only helps the higher echelons of wealth while hurting those at the bottom.  On this point, I sympathize with his argument, because a society where the poorest paid cannot afford to properly feed their families or offer education opportunities to their children, will eventually stagnate and lead to a proliferation of walled communities.  It only makes things worse, when 26% youth unemployment, as in France, leaves people with little hope. Where I disagree is the attitude towards ‘entitlement’, that seeks to protect those already fortunate to have a job, even if it prevents new job opportunities for those on the margin.

Mr Piketty also proposes a progressive wealth tax or one-time tax to cut national debt, the servicing of which he claims unfairly penalizes the poorer classes. His utopian proposal is further stretched when he proposes a pooling of national debts to support poorer nations . He also proposes an international wealth data base to fully comprehend who has wealth and where.

Mr. Piketty’s suggestions are not just pie in the sky. It is suggested that his proposals were the basis for President Holland’s 75% marginal tax. Though the 75% marginal tax rate was later ruled unconstitutional by France’s Constitutional Council, a 0.5-2% wealth tax on assets above 1.3mn euro that was introduced when he came to power in 2012 remains. Mr. Holland’s socialists also raised the capital gains tax on real estate from 25% to 29% for the French and up to 70% on residents of non-cooperative states (read tax havens). Although the book was very thorough, I was disappointed that more examples from Japan, Australia or Canada were not included, where taxes may be more progressive and the phenomenon of ‘old money’ less pervasive.

I remember when I was looking at real-estate in France, asking the realtor if  they thought the seller was flexible on price, to which they often replied, that the seller was from  old money (meaning that they didn’t particularly need the money so they weren’t very inclined to negotiate). There also seems to be more a cultural trend towards property ownership in the anglo world where countries like France or Germany have home ownership rates which can be as low as 33% in Paris and 44% in Munich.  In Canada home ownership is about 70% in English Canada and 65% in Quebec. In Iceland, where I was born, home ownership has been as high as 85%, labour participation over 80,% and not coincidentally there has always been a general sense of social equality.  Obviously, home ownership is a huge factor if one is to feel that they are benefiting from growth.

I am a big believer in the ‘laffer curve’ which states that as tax rates go above a certain level, incentives to work diminish, such that total tax income starts to decline. Some economists have put this level at between 52-55%. Although Mr. Piketty and others have put this a between 72%-80%, claiming that the marginal utility of after tax income above $400,000 for the 1%  is so low that it does not rise to that of the median income earner until marginal tax rates exceed 70%. (Peter  Diamond and Emmanuel Saez, The Case for a Progressive Tax: From Basic Research to Policy Recommendations, May 2012). However, as the NY Times recently noted, there are several US states where the top 1% account for between 30-40% of income tax, and as such, respective tax departments often keep running projections of expected tax from top earners, where a few people moving to other states can mean a difference of hundreds of  millions of dollars in tax receipts.

The importance of growth as referred to by Mr. Piketty and world leaders cannot be understated. Growth feeds mobility! When asked, “do we live in a society that promotes equality”, we should not refer to equality of results but ‘equal opportunity’.  However, such opportunity dries up as growth stagnates.

Many studies have shown that the top 1% indeed has a higher savings rate than the median income earners. This can be seen as either a hindrance or support for growth; savings implies reduced consumption though savings is necessity for investment.

One potential pitfall to Mr. Piketty’s argument is that, as all investor today are painfully aware, ROA has declined significantly in recent years as lower discount rates lifted asset prices, making it difficult to get a decent return (unless prepared to increase ones leverage). How many one-percenters would be willing to lend to Germany for 10 years at 0.2% or 0.6% to France. Surely, long term growth prospects are better than this! Unfortunately declining ROA is likely part of a trend as it seems to be affected by demographics.[2]

As for government debt; in the end, when central banks face the back end of their trade and are forced to sell debt at higher rates, it will no doubt be the wealthier class that will have to absorb these losses. Similarly, as social spending climbs, whether for health or pensions, I suspect we will see a much greater focus on ‘needs based’ disbursements.

Back to my trip. After the first week in Paris, I was ready to get out into the country and spent time in Nantes and Dijon in the Loire region. One of the reasons to get out of Paris was to escape several scheduled protests by students and unions against the  ‘loi de travail’,  Mr. Hollande’s last attempt to salvage legitimacy by introducing more flexible labour laws. Unfortunately, these protests have caused huge traffic jams around Paris and the cancellations of many trains. Nonetheless, Hollande’s Socialists have continued trying to increase work hours and make it easier for employers to rationalize their work force through the ‘loi de travail’ employment laws, which were designed to make it easier to reduce staff with lower payouts, give greater working hour flexibility and reduce overtime rates. All of which continues to be vehemently opposed by a vocal minority, whose past successes against the Hollande government have only emboldened them.

This reminds me a famous strike at General Motors in 1984. At the time, both the American and Canadian branches of the UAW union were negotiating with GM. Though the US side had at least 100,000 unemployed members, Canadian factories were near full operation thanks to a Canadian dollar that had depreciated 35% over the previous years (similar to now). As a result of this, the Canadian UAW insisted on hourly wage hikes whereas the US side avoided a strike by compromising on wages to get more members back to work.

The bottom line is that the Canadian union won an increase, holding US production hostage,  at the expense of a schism with the UAW. Though CAW wages are now 30-35% higher than those at US plants (including legacy pension benefits), CAW auto-related membership fell about 35% between 1985 and 1995, and auto-related employment in Canada has declined about 35% to 120,000 since 2000. Between 1998 and 2008, unionized jobs in Canada decreased at twice the rate of non-union ones’[3]  The most belligerent CAW union plant in St. Therese Quebec was eventually closed after producing 4 million cars. The unions have done well at maintaining legacy contracts while new employees come in at completely different pay scales.  So any victory on wages and working conditions seems pyrrhic at best.  One would think that there is a lesson here for France which finds itself competing against Spain or newer members of the EU.

When I was in Nantes, about 200 police in riot gear, suddenly locked the doors to the train station as we waited for the TGV. It turns out that there were 4,000-5,000 students marching towards the station and they had actually blocked some trains in other cities by sitting on the tracks. Hearing a few warning shots and seeing the tear gas cannisters was a bit unnerving and I started to appreciate how much the student unions and labour unions were working hand in hand to protect their vested interests. I came across more peaceful protests in Dijon the following week.

Though I believe that minimum wages need to be raised to promote hiring more regular workers, which would in turn encourage employers to invest more in training their labour force; I can’t help but feel that these students are undermining themselves where employers are even reluctant to give them training apprenticeships because the labour/social costs seem excessive or they are afraid that once hired, new employees will be impossible to rationalize if necessary in the future. 

The minimum wage in Paris is already around 10.50 euro (Y1295 compared to Y907 in Tokyo). And it is said that obligatory social costs nearly doubles the true costs for employers. France, unfortunately seems to have only created about 350,000 new jobs with stagnant wages since the GFC, whereas Germany has created 1mn and UK close to 2mn. Labour participation rates are also much higher in the UK and Germany than in France. This is why it is highly unlikely that the Socialists will make it past the first round in the Presidential election next year and that is why the Socialists will likely pass a sharply watered down version of their reforms in the end.

One potential hope for the Socialists is former Socialist economic minister Emmanuel Macron, an investment banker in another life, who having supported a longer work week, is seen a quite progressive. However, I am cautious given that Mr. Macron was the person who engineered the French government’s increased share ownership in Renault (partly to protect jobs and partly because Renault has received more dividends in the last year from Nissan than it has paid out itself). The same law also doubled long-term (ie. Over 2 years) shareholders' voting rights. Mr. Ghosn, who was called to the Élysée Palace in 2012 to explain himself when Renault decided to build the new Clio in Turkey,   established a truce with the Socialist government earlier this year when he unsuccessfully tried to role back the increased French government’s interest in Renault,  that was far from satisfactory for either Nissan employees or shareholders. 

I decided to take a look at how French companies with government ownership have  performed since the adoption of the Florange Law in April 2014, which in addition to doubling long-term shareholders voting rights also made it more difficult to rationalize or sell under-performing business units. The answer is 29% underperformance. Now we see why neither Mr. Ghosn nor myself is comfortable when all shareholders interests are not necessarily aligned.

Government ownership in crucial industries is not entirely bad. It certainly makes more sense for partial government ownership in a utility that has a 30 year investment horizon for nuclear plants and needs debt guarantees, than it would for private equity (ie. TXU) . However, it’s pretty clear that government investors and private investors rarely share common interests. I learnt this several years ago when talking to a consultant for Petro China who claimed that some of his advice against non-commercial investment had been ignored in favour of securing strategic energy supplies. 

It was thus disappointing to see the CFO of 85% government- owned French utility EDF resign in March,  over government insistence that the $27bn EDF-funded  Hinkley Point nuclear plant in the UK was going ahead as planned. The plant currently makes no commercial sense, requiring a 35-yr wholesale supply contract with the UK that is 3x the current price given recent energy price declines. Corporate governance also took a hit in April when the CEO of Air France stepped down after very public rebuffs against attempts for reorganization in 2014, . The airline had been trying to shift traffic to its subsidiary Transavia and Hop to compete with low price rivals Ryanair and Easy Jet. With much lower load factors than its sibling KLM, 13% higher costs per ASK and 35% lower revenue per employee than British Airways, Air France needs further rationalization despite recording its first profit in 7 years last year (thanks to lower fuel prices). However, pictures of HR managers scrambling over fences  to escape attacking union members last October triggered ugly memories of previous strikes at Moulinex and Michelin, revealing a difficult mood for concessions.

Though only representing 8% of the workforce, France’s unions remain unfettered in their determination to protect what they see as their inherent rights. Unfortunately, I fear that this view of  ‘entitlement’ will simply serve to proliferate the growing chasm between the British, German and French post-GFC recoveries.

Despite all this, I still enjoy my biannual treks to France, particularly as I spend more time enjoying the culinary and cultural richness of the remote regions. I also feel a need to show support to the French by visiting while tourism is depressed after the horrible terror attacks. However, my preparation now includes consulting, a web site that gives the latest on planned strikes around France. I hope to bring along some lighter reading for my September trip.

[1] The effective inheritance tax in Japan was 13.2% with 4.3% of  estates paying taxes, despite raising  the marginal tax rate to 55% last year (the highest in the world).

[2] For example, the working age population of Japan peaked in 1992 at 62.7%, at 63.6% in the US in 2000, at 53.2% in Europe in 2008 and will peak at 58% in China in the next year. All suggesting that the natural rate of interest  and expected ROA has declined over the last 25 years.

[3] Statscan

'Japan Premium' Continues for TIBOR vs. LIBOR

The expression ‘Japan Premium’ gained popularity following the failure of Hyogo Bank in 1995 and collapse of Yamaichi Securities in 1997.  In 1997, the TIBOR (Tokyo Interbank Rate) overseen by the Japan Bankers’ Association (JBA) the rate at which Japanese banks (mainly city banks) lend to one another, rose to 30-35 bps higher than LIBOR (London Interbank Offered Rate) which is set by the British Bankers’ Association. Since about ¥100trn of Y433trn in bank lending (with more derivative transactions tied to LIBOR/TIBOR) is priced off of Tibor, one has to ask why the ‘premium’ still exists where the financial position of Japan’s banks is no longer an issue. This discrepancy also undermines the efficacy of the BOJ’s new negative interest rate policy.

A 2002 study suggested that the premium was due to declining long-term JGB yields, a flatter yield curve and weaker bank share prices, which all served to raise the risk premium. [1] Some regulators blame the discrepancy on the pedantic nuance, where  London bankers are being asked ‘what they think they have to pay’ as opposed to ‘what they think the prevailing rate is’ in Tokyo. However, some have alleged that TIBOR rate setting involves some collusion.[2]

This premium is all the more surprising given the publicity received from the Yen Libor fixing probe which saw heavy fines for Deutche Bank, UBS and Barclays (among others) for allegations of price fixing between 2005-2009.

One of the main objectives of increasing the ‘excess reserves’ in the BOJ’s ‘current account reserves’ is to ensure that banks follow the central bank’s policy rate. In the case of Japan or the ECB, the rate on  excess deposits becomes a floor for interbank overnight lending where the central bank tries to keep interbank lending close to the lower bound to have an effective interest rate policy. Japan’s excess reserves (the reserves in excess of mandatory reserves and special lending commitments) has averaged ¥178trn over the last 3 months, well above the ¥30trn, or so, we calculate as necessary to maintain bank discipline within the lower bound of -10bps. Still the fact that TIBOR is 18bps above the floor is surprising as I had expected the gap to come down to 10bps, for a TIBOR of close to zero. For reference, Euribor  rates are currently hovering at -18bps compared to the ECB deposit rate of -30bps. While Eonia overnight bank rates have been hovering around -25bps, only 5bps above the ECB deposit facility of -0.30%.

Meanwhile the premium for interbank rates over the 3 mo. Interest swap swap has expanded as banks factor in further cuts to deposit rate in the future.


[1] Vicentiu Covrig, Buen Sin Low, Michael Melvin, A Yen is Not a Yen: TIBOR/LIBOR and the Determinants of the Japan Premium

[2] FT March 19, 2014, FT February 16, 2013

Abe’s Growth Promises and Defying the Law of Demographity

As an undergrad in Economics, I was introduced to Gary Becker’s ‘Rotten Kid Theorem’ which argued that a benevolent figurehead could transfer utility to his children because they recognized that it was in everyone’s interest to maximize total welfare, even if one happened to be a ‘rotten kid’. Because of the expectation of future wealth transfers, family members adjusted their expectations in certain periods so that they could maximize their utility over time.

I was fascinated how one could apply this analysis to the theory of employment in Japan in contrast to the West. Employee loyalty to their firms was enhanced by promising a degree of long-term employment, in exchange firms could afford to invest in their employees, rotate them between divisions to get a better understanding of how the entire firm worked, and when they approached their mid-late thirties, both firm and employee would theoretically start to see a higher payoff.

 In contrast, Western firms which often focused on developing experts, with limited reciprocal obligations between firm and employee, were forced to deal with their ‘rotten kids’ (sic employees) by offering them instant gratification with high wages and bonuses lest they move on to the next highest bidder. The drawback being, that Western firms would be afraid to invest too much in their employees (lest they move on to their competitors) limiting the overall potential utility curves or ‘pareto optimality’ that the collective firm could achieve.

Being the early ‘80’s, business literature was obsessed with analyzing the Japan miracle, with books such as ‘Kaisha, The Enigma of Japanese Power, and Japan as #1’ must reads. Japan’s growth translated into per capita income growth that was driven by growth in high value auto and electronics and the real estate bubble.

By 1990 Japan had one of the world’s highest per capita GDP along with the US and Sweden as manufacturing reached 25% of GDP. Today manufacturing has fallen to 18.2%, which doesn’t seem so bad when one thinks that the US is only 12% manufacturing. But, unlike the US, it has been unable to develop a financial services, IT and software sector that can export on a global scale. Worse however, Japan’s per capita income has now fallen below many of its OECD counterparts.

…….though it doesn’t look as bad in purchasing power parity (PPP) terms because deflation has generally supported real purchasing power (below).


                                                                                                                                                                                   Source: OECD, Custom Products


                                                                                                                                                                                 Source: Bloomberg, Economist, Custom Products

At least if you have to live off a diet of Big Macs and fries, you are still relatively better off in Japan. Japan's relative purchasing power is actually much more compelling where typical Asian cuisine is considered.

Japan, however, is no longer dominant in many technologies that it pioneered, such as LCD, solar, lithium ion batteries, memory, smart phones and high speed trains; much of which  have largely passed on to Asia.  

Though there are, no doubt, many burgeoning technologies waiting for the light of day, venture capital in Japan is still nascent with $1bn invested last year compared to $50bn in the US. Sure, one could say that this would provide infinite opportunities for overseas venture capital investing in Japan, but the reality is that these firms are far more interested in duplicating successful global models in Japan rather than trying to adapt Japan’s Galapagos technology worldwide.

The days have passed when most department stores had their elevator girls and train stations had their confetti bag laiden ticket clippers waiting at the exits. But Japan, if anything, is moving further towards a service Economy.  Unfortunately, the labour productivity gains over the last 20yrs have come almost exclusively from the manufacturing sector, with retail, transport, restaurants, hotels and business services falling well below their global peers for productivity.[1] At least the service is still great!

Significant revisions to the labour personnel dispatch laws in ’95 and ’99 made it much easier to employ irregular and subcontract workers, and hence began a dumbing-down of the workforce since less time was spent on education and training in general (putting Japanese workers in more direct competition with their Asian neighbors).­  Average monthly wages (including overtime, bonus and social welfare deductions) have generally been flat over the last 5 years, though increased 0.3% in 2015 due to overtime and bonuses, but management is reticent to add to fixed costs with wage increases as it would rather maintain flexibility through higher bonuses. Legally mandated social welfare costs, mainly paid by employers, have risen at a compound rate of 1.39% pa over the last 20 years while nominal wages have only increased 0.27% pa, such that social welfare costs have risen from 10.4% to 14.8% of wages during this time (Keidanren December 2015).   

Ministry of  Health, Labour and Welfare




Ministry of  Health, Labour and Welfare

In many ways, Japan has fallen prey to the Asian deflation which has forced it to compete with its Asian neighbor in the technologies that it once dominated. No longer are companies, like SONY, able to command a premium for products such as they enjoyed with the Trinitron TV in the seventies. It is now largely a question of price as the gaps in quality have gradually disappeared. So we now buy LED or OLED screens rather than looking for a particular brand TV. When was the last time you heard the salesman say ‘it’s made at Kamiyama (previously Sharp’s showcase factory and sign of quality)?

In the late 90s, both Japan and Korea were trying to penetrate the Chinese market, Korean manufacturers made a conscious effort to go for share by reducing prices for their key high growth products. Japanese manufacturers, on the other hand, thought they could command a premium for their products. As demand fell behind, Japanese manufacturers started lowering prices in an effort to gain market share. This brought the once proud showcase factories in Kamiyama, for sharp, and Yokkaiichi for Toshiba into direct competition with their Korean, Taiwanese, and Chinese rivals. Japan tried to compete by using relaxed labour laws for contracts employees which served to suppress wages. In the end, many of these lines were transferred elsewhere in Asia.

Source:Trading economics


Japan has seen a sharp downturn in terms of trade (output prices divided by input costs)  since 2000, hurting wages and profitability.

Japan has also seen its white goods industry slowly losing its advantage to LG, Haier, Daewoo , and TCL or Seiki in the case of LCD TVs. Sanyo has been absorbed into Haier, and Sharp may soon go to Foxcon.

In 2000, the UN calculated that Japan would have to accept 381,000 immigrants annually if Japan was to maintain her peak 2005 population of 127.5mn. The same study forecast that Japan would need to accept 608,000 immigrants annually to keep its peak working population.

10 years ago, the Japanese labour dispatch company Fullcast made a presentation to a Diet committee claiming that Japan needed 5 million foreign workers, including 500,000 in health and elderly home workers,   if she was to grow over the next 10 years. Several years later, the first group of 50 Indonesians who had managed to pass the rigorous Japanese nurse helper’ exam came, but it seems that it was never more than a trickle.

For more than 20 years, the warnings of the shrinking of Japan’s population have gone unheeded and have rather been met with a tacit acquiescence, an eery resignation to ones fate, as if nothing could be done to stem the problem.  Only now the government is starting to pay lip service to this crisis by trying to promote increased labour participation and childcare services with its ‘ichioku sokatsuyaku shakai’ plan (‘100 million actively participating society in 50 years’).

Last year, Mr. Abe introduced the second act to his ‘Three Arrows Plan’ with the slogan ‘Y600trn GDP and 100mn active population’ as the pillar of his growth plan.  At current trends, Japan’s population which peaked at 128mn in 2008 will fall to 86.7mn by 2060. The new plan focuses on 3 key areas for its success: holding the line on population decline to 100mn by 2065 by lifting the birthrate from 1.4 to 1.8 per 100, increasing the labour participation rate of the 9.5mn unemployed and underemployed and lifting wages, particularly for irregular workers. The math is simple enough, 3% annual wage increases (1% real) gets you to ¥600bn in 5 years. But the plan falls short on details.


IMF Working Papers 2012[2]


Japan’s birthrate would be higher if childcare was better, allowing for a higher labour participation rate (above). Household income for low wage earners also doesn’t really support a second child (below), while female workers who try to supplement the household income are further disadvantaged.


 Source:IMF Working Papers 2012


Ministry of  Health, Labour and Welfare

Unfortunately, I am pessimistic that any significant real income growth is likely over the next decade. Japan has been undergoing de-industrialization over the last 25 years as manufacturing has fallen from 25% of GDP in 1990 to 18.2% last year. Manufacturing jobs enjoy about 15% higher incomes than those in the service sector (Min of Health, Labour & Welfare). Demographics hurt too, because the average Japanese is now 47yrs old, which coincides with peak productivity. Labour participation rates have fallen from 62% to 59.5% since 2000 but part-time participation has doubled from 14.5% to 30.5% since 1995. Labour productivity is still down sharply from peak in March 2007 (101.4 vs 119.1, Japan Productivity Center).

Few of the 1980's revisionists could have envisioned Japan’s current predicament; low wages and low growth. And many new graduates who would have subscribed to the 'rotten kid theorem' as new recruits in the 80's under lifetime employment, may have had second thoughts. Japan faces the prospect of becoming another Italy, which might not be too bad, depending on your perspective.


[1] EU KLEMS data

[2] IMF Working Papers 2012, Who Can Boost Female Labour Force participation, Yuko Kinoshita, Fang Guo



As a longtime follower of Softbank, I’ve always enjoyed what new challenges and dreams Masayoshi Son would lay out. And though I appreciate guidance, I was a bit taken back by his 300 year plan in 2010. Despite some earlier stumbles with Ziff-Davis and Kingston Technologies, Softbank finally succeeded with the listing of Yahoo Japan in 1996. When Softbank bought Japan Telecom in 2004, many didn’t know what to believe, thinking that it was quite a departure from their core strengths. One of their competitors lamented, “We don’t know how to respond, [They] are used to fighting guerilla wars and we don’t know how to fight a guerilla war”.

Several years later, I ran into one of the former executives at Japan Telecom who oozed with admiration saying, “What they did with Japan Telecom was nothing short of miraculous”. Given this record of success and increasing forecasts for the value of Alibaba, from $25bn in 2009 to $300bn shortly after the 2014 listing, one can appreciate why Mr. Son enjoyed a certain ‘confidence’. Then Softbank purchased Sprint in the summer of 2013, just after Sprint had bought Nextel with the massive bandwidth that it owned. I must say though, that I was perplexed and it wasn’t until the following year when Softbank made a bid for T-Mobile when it all made sense. It would have been the perfect strategy, had not the misguided US federal antitrust officials nixed the deal, questioning the anti-competitive aspects of the deal. Such convoluted logic, that two weak players and two dominant players, make for a more competitive playing field; would probably have Joan Robinson, with her ‘monopolistic competition theory’, rolling in her grave.

 In late 2014, Softbank was raising money to pad down its war chest and some brokers called me, asking whether I was interested. I remembered how Softbank had had to offer the syndicate of 15 or more banks its cash flow from the 2004 Japan Telecom purchase as collateral and over 4% interest to close the ¥1.7trn loan. So when the broker said that the subordinated 7-yr bonds paid only 2.5%, I decided to pass. In the last year, Softbank’s interest bearing debt has reached ¥11.6trn and net debt ¥8.3trn (including ¥3.1trn in bonds). Markets have increasingly priced Softbank against its core assets (Ch1). As the share price of its assets have fallen, fears that Softbank  getting out of its US quagmire would take more than [a] Sprint, have weighed heavily on the shares. The price of insuring Softbank’s debt has also risen to 383bps, but surprisingly, the recent bonds have held up much better than the equity. (Ch2) Like the former JT executive, however, my admiration for Mr. Son’s chuzpah is unshaken.

Chart 1: Softbank and its Holdings

The yellow line represents the combined market capitalisation of Softbank's holdings in Alibaba, Sprint, Yahoo Japan and Gung Ho

Chart 2: Softbank Shareprice, Volatility, CDS and Bond Prices

Note: Chart shows Softbank's share price (inverted) against stock volatility and CDS. Softbank's 53/8 bond traded at 98.741 as of 2/10/16 while Softbank 21/2 traded at 100.446