Is Japan the Next Greece?

 | Feb 27, 2012 | 9:30 AM EST
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Last week, Jim O'Neill, chairman of Goldman Sachs Asset Management, speculated that the end of the Greek financial crisis would send the market searching for another victim with an extremely high debt-to-GDP ratio. Boasting a debt-to-GDP ratio of 230% (compared with Greece's 164%), Japan was O'Neill's top choice. Kyle Bass, a hedge-fund manager who made millions for his investors by betting against Greece, has been bearish on Japan for a long time, predicting that Japan would be forced to restructure its sovereign debt within one or two years. O'Neill may have gotten his timing better. Just as the Greek crisis started showing signs of resolution, the Japanese yen got hammered, dropping 6.29% in February.

Bad news about Japan is coming hard and fast. The preliminary GDP number suggests the economy contracted by 0.6% in the fourth quarter or 2.3% on annualized basis. Prices contracted by 1.6% year over year. Japan also suffered a trade deficit of $32 billion in 2011, its first since 1980, when Jimmy Carter was president. The Bank of Japan quickly swung into action, printing another 10 trillion yen ($121 billion) per year, while targeting an annual inflation rate of 1%. More yen in circulation is supposed to both boost exports and help resume inflation.

But like the market, I am skeptical.

A weakening yen might help in the short term, but Japanese companies aren't the world-beaters they once were. The Economist recently reported how in Tokyo, the Apple Store (AAPL) is packed, while the nearby Sony (SNE) showroom is "as lifeless as a mausoleum." Panasonic alone expects to lose $10 billion in 2011. In contrast, South Korean upstart Samsung made $15 billion and Apple hauled in $22 billion. To add insult to injury, Fitch recently downgraded the debts of Panasonic (PC) and Sony to one notch above junk status and placed Sharp on negative outlook.

Then there is the often-ignored elephant in the room, China, which is Japan's largest trading partner. China represented 19.7% of Japan's exports and 21.5% of its imports in 2011. Yet, in December, Japan's exports to China plunged at a year-over-year rate of 9.8%. As China's bubble bursts, expect Japan to be hit disproportionately hard.

With its first trade deficit in 32 years, 2012 could mark the year that Japan's economic competitiveness collapses. And that raises the question of whether Japan's government can still handle its more than 10 trillion yen debt load. All this negative news will weigh heavily on the currency.

Betting against the yen over the past few weeks has paid off. Just look at the performance of the ProShares UltraShort Yen New (YCS), a 2x leveraged bet against the Japanese yen vs. the U.S. dollar. Also, note that YCS now has $235 million in assets, a significant expansion over the past year or so. Many more investors are making this bet.

That said, getting the timing right on currency trades is tough. Any black swan event can send traders rushing for the relative safety of the yen. Sharp declines in currencies also tend to be followed by sharp rises. Meanwhile, Japanese companies that don't have too much Chinese exposure but are large exporters might benefit from a weaker yen. That's why I'm sticking with my bet on Japanese small-caps through the WisdomTree Japan SmallCap Fund (DFJ).


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