After suffering eight consecutive losing sessions for the first time in two years, knocking more than 5% off the Nikkei prior to Friday’s 1% bounce, it’s clear the Tokyo equity market is loath to buy into the economic “revival” happy-talk offered by a played-out government and a pliable media. Monday’s second quarter GDP report, which is expected to register positively for the second consecutive quarter, likely will be widely hailed as further evidence that Japan’s economy is back on track. But with equities stuck in ranges seen in the second quarter of 1999, and the Nikkei down nearly 18% from the 20,000 plateau it finally reached last February, it could be that this year’s second quarter will end up marking the economy’s cyclical high point. More recent data (the second quarter, after all, ended in June) hardly suggests Japan is in the early stages of sustainable expansion. Household spending fell 2.6% year-on-year in July, industrial production declined 0.7% from the previous month, and indications are that by mid-year capital spending was already tailing off rapidly from its relatively stepped-up pace (3.3% y-o-y growth) earlier in the year.  

The extent to which Japan’s so-called “growth” has been attributable to wasteful construction projects financed by massive government borrowing was underscored again overnight with confirmation of Moody’s second downgrade of Japanese government debt.  At the end of the current fiscal year next March, Japan’s will have a  national debt of more than $6 trillion at current exchange rates, equal to 130% of GDP.  A quarter of that total has been run up since 1992 in repeated, failed programs of Keynesian fiscal “stimulus” operating on the false notion that the very act of government borrowing promotes prosperity. In fact, as long as the Japanese bureaucratic elite rules out a supply-side, incentive-oriented approach that would generate increased revenues through marginal tax-rate cuts, the burgeoning debt implies a huge increase in future tax burdens, which itself is a factor blocking sustainable expansion from taking root. 

The combination of Japan’s yawning debt burden and deflationary monetary policy presents significant ongoing risks to Japan’s fragile financial system. Faced with few other profitable opportunities for fresh lending as their commercial loan portfolios deteriorate, Japan’s banks have been aggressive buyers of government issues. In the past 18 months, Japanese banks have more than doubled their holdings of JGBs, which continue to post deflation-based yields of less than 2%. Assuming, though, that at some point the monetary authorities find a way to overcome their long-running string of deflationary policy errors, JGB yields will rise to a level approaching a global norm of at least 4%, which would entail a commensurate loss for the banking system’s asset base.  It’s also possible, though, that awareness of these systemic risks has been among the factors biasing the Bank of Japan to maintain its deflationary policy stance.