The Hindu Business Line : Japan: First in, first out?

There has been many a false dawn in the Japanese policy domain over the last decade. However, the right men and the right policy co-ordination do seem to be in place for one final opportunity to solve the problem on government terms. Otherwise, crises will resolve themselves with unforeseen but often unpleasant consequences, says V. Anantha-Nageswaran.

THE long-awaited break in the relentless decline in US stocks came yesterday. US stocks rallied almost from the beginning of the day and maintained their uptrend. On technical considerations, such a rally was overdue. The question is whether it will be sustained even over the short-term — a week or two. We remain ambivalent.

The direction of the market in the coming weeks and months would be dictated by

(a) the strength of the earnings reports (or, the depth of their warnings) for Q3 and guidance for Q4 from major companies with leadership for their various sectors, and

(b) the economic data flow on consumer spending and employment and household income strength.

Longer term, risks are tilted to the downside because of the impending war on Iraq and valuations being high based on optimistic expectations for earnings next year. The price-earnings ratio on Standard and Poor's (based on historical earnings) has come off the lofty perch that it was occupying but it is hardly in the cellar for us to scream `value' at the top of our voices (see chart). Please note that the current level is well above the 30-year historical average of 17.3 and the lows reached during the extended decline of 1974-82 of around 7.1 in 1980, based on this quarterly chart.

Long-term concerns on stocks: War and valuation

Currently, assumptions by consensus on the trajectory of the likely war on Iraq, its impact on oil prices and the consequent economic growth in the US in 2H03 are all skewed quite considerably to the benign-to-beneficial side. In this regard, Nicholas Kristof' piece in The New York Times on Thursday on the psychological profile of Mr Saddam Hussein is very important and insightful.

It paints a disturbing picture of the man, his thinking and his goals. So, if the US somehow presses ahead with the war, his reactions are unlikely to follow the rulebook and one is not sure the US would be fully in control of it and be able to ward it off. Also, Gerard Baker's column in Financial Times on Thursday points out that the US would try hard to prevent inspectors going into Iraq. If they do, it weakens their case for war considerably. Short of an incredible bargain that the US strikes with Mr Saddam Hussein himself, war appears inevitable.

Thus, a combination of fierce determination to wage war and an enemy who harbours grand ambitions to be a man of history and destiny, is hardly a recipe for optimism for the rest of the world. Yet, that is precisely what Wall Street has embraced for next year.

Yield spreads widened, despite Wall Street rally

It is equally important to record here that the yield on high-grade and high-yield bonds ignored the rally in stocks and moved higher as did their spread over treasury yields. Nor has the dollar risen significantly against global currencies on the basis of the strength in equities. The table has to be read from right to left. For example, the current spread on high-yielding bonds with BB credit rating with a maturity of about five years over the 5-year US Treasury note is around 586 basis points, compared to only 336 basis points about six months ago.

Nonetheless, we keep our eyes open for a sustainable rally in equities in the fourth quarter of this year (based on past seasonal patterns) in the US while recognising that long-term hurdles remain for stocks to break out of their three year decline.

To reiterate, the hurdles are: Optimism for 2003, optimism for the quick and victorious resolution of a likely war on Iraq and high valuation relative to history.

Pieces falling into place in Japan

However, all eyes are on Japan. The Nikkei 225 stock index slumped to an intra-day low of around 8200 on Thursday and Friday's close at above 8500 appears too healthy and robust in comparison.

The Bank of Japan (BoJ) concluded its two-day meeting today with no change in interest rates. It joined thus the European Central Bank and the Bank of England, which met yesterday, and left their respective policy interest rates unchanged at 3.25 per cent and 4.0 per cent respectively.

The only difference is that the rate in Japan is already at 0.0 per cent. Short of unconventional policy measures, the BoJ had no room to lower rates.

That is what the BoJ did some weeks ago when it offered to purchase equities directly from Japanese banks. Today, it flushed out the details of such a scheme. The link below takes the interested reader to the details: www.boj.or.jp/en/seisaku/02/ sei0209b_f.htm

BoJ spells out plans for banking system

The BoJ had offered to hold the securities it purchases (up to a maximum of around $16 billion or yen 2 trillion), up to 2017. It will start purchases as soon as necessary approvals are obtained from the government and continue up to September 2003 or until September 2004, if the target of yen 2 trillion is not reached by September 2003.

In addition to framing these guidelines, the BoJ also made a detailed statement on the disposal of non-performing loans (NPL) in the Japanese banking system.

Very briefly, NPL are those on which the lender had ceased to receive interest payments and where the repayment of the principal amount outstanding is also in doubt.

To most of us, the details would be arcane and of less interest. However, they do suggest that slowly but steadily some jigsaw pieces in Japan are falling into place.

The BoJ policy outline suggests a proper estimation of the extent of NPL, adequate provisioning for such newly estimated NPL and possible public injection of funds into those banks that are deemed to have won the confidence of the market with "respect to the transparency of its financial condition and management strategy". The document also suggests that the government should aid corporate restructuring after the disposal of NPL based on appropriate evaluation.

The policy outline appears pragmatic. It invokes the right degree of market discipline and does not shy away from suggesting, what I believe, an inevitable substantial role for the visible hand of the government in the short-term, given the mammoth nature of the task of disposing off NPL that have accumulated over the decade.

Weaker yen is par for the course

The reaction of the exchange rate is quite insightful for us. Subsequent to the publication of the deliberations of the BoJ and the policy outline for the disposal of NPL, the yen managed to weaken above the 124 level.

We have argued in recent days that a weaker yen is an inevitable component of any comprehensive policy measure to resolve the issue of NPL and to revive the Japanese economy. We have also wagered that the US government would assume a stance of benign neglect or benign indifference to yen weakness if it is seen as a component of a comprehensive policy package that is credible and is serious.

As Japan stands on the threshold of such a change, it is entirely consistent that the yen weakens, in our view.

There has been many a false dawn in the Japanese policy domain over the last decade. However, this time, it does seem that the right men and the right policy co-ordination are in place for one final opportunity to solve the problem on the government terms. Otherwise, crises will resolve themselves with unforeseen but often unpleasant consequences.

We are quite encouraged by these developments and thus willing to contemplate the possibility of rising exposure to Japanese equities. However, we are not in a rush and would wait to see more specific steps and announcements from the government in the weeks ahead.

Indeed, a Japan that has come to grips with its problems could reduce the risk-premium for the region, over time and provide a genuine diversification opportunity for international investors, away from the US.

Rest of Asia should rejoice, not resent

If the yen weakness accompanies policy developments as outlined above, it would not only be inevitable for Asian currencies to weaken — to preserve their export competitiveness amidst weak global economic demand — but also churlish of Asian governments to protest it. We are firmly of the view that a combination of a weaker yen and a Japanese economy that has stopped shrinking is better than a combination of a strong yen and a shrinking economy, for the rest of Asia, including China.

What a pity then, that, at the end of such rosy contemplation, we are reminded of the risks of a looming war with its own unpredictable consequences, as the US Congress authorises the use of force against Iraq by its President.

(The author is the Regional Head of Investment Consulting in Credit Suisse, Asia-Pacific. He writes here in his personal capacity. Please address feedback to nageswar@singnet.com.sg)

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