Connecting the Dots

 | Dec 09, 2011 | 12:31 PM EST
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This is an extension of Thursday's column, "Europe's Contagion Has Already Begun." The conclusion was that European sovereign defaults could result in a Japanese insolvency. In this column I will discuss the implications a bit more deeply.

Since the collapse of Japanese stocks and the resulting deflation began in the early 1990s, the gross domestic product (GDP) of Japan has stagnated. In nominal terms, the Japanese economy has not grown in 20 years. And this metric includes Japanese government spending, which has resulted in a ratio of sovereign debt to GDP of about 200% today.

Japanese government spending was intended to stimulate private-sector investment domestically. Instead, Japanese companies have increasingly invested in operations outside of Japan while Japanese retail investors have become international speculators. I will address the financial structure of Japanese companies in another column; here we are interested in the Japanese retail investor/speculator.

Sovereign yields plunged in Japan starting around 1994, leading to big declines in loan and other interest rates. In order to gain returns, Japanese investors began borrowing at low loans rates against their personal savings (now invested in Japanese sovereign bonds) and converting these loans to other currencies, principally the U.S. dollar and German deutschmark, followed by the euro. This borrowed money was then invested in higher-yielding investment-grade bonds in these two arenas. This process is called the "yen carry trade."

It's called a "carry" because the trade is based on investors carrying a loan to make the new investments. At some point the loan they've taken against their Japanese government bonds must be repaid.

The rate differential was so high that Japanese investors were not concerned about currency fluctuations. However, the "Asian Contagion" of the late 1990s as well as the Nasdaq bubble collapse of the early 2000s highlighted currency risks. But instead of realizing the risk, exiting the trades, repatriating the funds to Japan, paying the loan off and closing the carry, the Japanese began to diversify their carry investments into other countries.

As yields have declined steadily and at an increasing rate in the U.S. and Europe, the two principal alternatives to receive the Japanese carry funds have been Australia and Brazil -- sovereign and other investment-grade bond yields there are still much higher in those countries than in the U.S. or Europe. Japanese retail investors today own more Australian bonds than they do U.S. bonds, and have almost as much invested in Brazilian debt as they do in all of Europe!

This exposure has been achieved through multiple levels of leverage. The first leverage is by way of borrowing yen at a multiple of the value of the Japanese savings. This is then multiplied again after the borrowed monies are redenominated in Australian and Brazilian currency and deployed into bonds in these countries.

As a result, Japanese investors have become the principal drivers of speculative money flows into these countries.

As mentioned in the previous column, about 25% of exports from Brazil and Australia, mostly commodities and industrial goods, go to China -- and those exports provide Brazil and Australia with the capital necessary to service the debt that has been supplied by the Japanese.

If China's purchasing of exports from these two countries decreases because China's primary export market -- the EU -- slows, yields on sovereign and corporate debt will begin to rise.

Rising yields in these countries will cause margin calls to be made against these investments, which could become catastrophic for all involved if investors can't meet the calls and must liquidate. In that case, the primary speculative money from Japan flowing into these areas will reverse as Japanese investors attempt to exit before going broke.

From here we get into a timing issue. There are two principal avenues of approach to prevent such a vicious cycle: Brazil and Australia can implement fiscal and monetary stimulus, or China can increase its purchases of debt from both areas in an attempt to preclude a Japanese rout.

The problem with the first option is that it requires preemptive stimulus policy, a violation of normal monetary and fiscal policies in both countries. The most plausible solution, then, is for the Chinese to adjust their holdings of foreign reserves by increasing purchases of Brazilian and Australian debt.

If China doesn't move swiftly as nascent signs of economic slowdown and rising yields in Brazil and Australia become evident, causing Japanese investors to exit the carry trade, the losses will be concentrated as defaults climb at the Japanese banks and investment trusts on the original and secondary leverage taken out as part of the initial carry trades.

If you're worried about the implications of this interwoven system -- and you should be -- watch the long end of sovereign yields in Brazil and Australia. They'll give you the early warning you need to protect yourself from the fallout.



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