Will Japan be next to feel fallout of U.S. financial crisis?

By Ambrose Evans-Pritchard
The Telegraph, London
Tuesday, September 4, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/09/04/cnjapa...

Japan's economy has slowed sharply over the summer and may now be on the brink of recession, dampening hopes that Asia will buttress world growth as America battles the sub-prime housing crisis.

In the latest grim data, Tokyo said wages had fallen for the past eight months in a row. The cumulative fall over the past year to July has been 1.9 percent, evidence of how intractable deflation can become once lodged in an economy. Business investment fell 4.9 percent, with the pace of decline gathering speed in recent months.

The seemingly endless string of weak data from Japan comes amid mounting concern in Washington that the US economy is starting to buckle, and possibly tipping into a severe slump.

Marty Feldstein, Harvard professor and former chair of White House Council of Economic Advisers, has called for an immediate 1 percent cut in the federal funds rate to 4.25 percent, advising the Federal Reserve to ignore lingering inflation as the "lesser of evils" and tackle the near paralysis of the credit markets before it is too late.

"The economy could suffer a very serious downturn. A sharp reduction in the interest rate, in addition to a vigorous lender-of-last-resort policy, would attenuate that very bad outcome," he said at the Jackson Hole, Wyoming, conclave of central bankers at the weekend.

According to Bloomberg reports, the mood at the gathering turned ever blacker as speaker after speaker warned that the economy may be on the cusp of a sudden downward dive.

Ethan Harris, chief economist at Lehman Brothers, said optimists were now few and far between. "There's a pretty strong consensus that this has got a lot more serious," he said.

While Fed chairman Ben Bernanke said the bank would "act as needed," he cautioned the market not to expect an instant bailout. "It is not the responsibility of the Federal Reserve to protect lenders and investors from the consequences of their financial decisions."

Japan is often overlooked in the global equation but it is the world's second-biggest economy by far, and top creditor with overseas assets of nearly $3,000 billion, the mirror image of US external debts. It dwarfs China as an economic power. China is displaying early warning signs of a cyclical peak, with imports turning down from April to June.

Critics say the Bank of Japan jumped the gun by ending its six-year policy of zero interest rates in July 2006, when prices were still falling. Economic growth fell to 0.1percent in the second quarter. Barclays Capital is forecasting contraction of 0.3 percent this quarter.

Charles Dumas, global strategist at Lombard Street Research, blamed the relapse on fiscal overkill by the ministry of finance, and warned that the damage could exceed the fall-out from the US sub-prime debacle.

"They are smashing the economy with a fanatical fiscal squeeze that has cut the deficit from 8 percent of GDP in 2003 to nearer 1.5 percent this year. This is a $5 trillion economy, which is not far short of a tenth of world GDP, and it is crumbling fast. We think there is going to be a recession and it will have a serious effect on global growth," he said.

The sharp rally in the yen during August will twist the deflationary knife deeper, slashing the profit margins of exporters. The "Seven Samurai" -- led by Toyota, Honda, and Toshiba -- have seen their stocks pummeled on the Tokyo bourse.

Japanese investors have taken a beating on the yen "carry trade," where they borrow in Tokyo to chase higher yields around the world. The Bank for International Settlements said in its quarterly report yesterday that the overall yen carry trade has reached $1,050 billion and the Swiss franc sister trade is $678 billion.

In the United States, large parts of the $2,200 billion US commercial paper market remain shut. Borrowers have been unable to roll over short-term notes as they fall due, forcing them to liquidate assets or cancel investment plans.

The volume of these sorts of loans has shrunk by $244 billion in the past three weeks, despite a decision by the Federal Reserve to accept them as collateral for emergency credit at the discount window. The meltdown reflects a near-total collapse of trust in counterparties suspected of covering up the true scale of their exposure to the mortgage crisis.

A dispute rages on whether this is a temporary liquidity squeeze along the lines of the 1998 crisis, which followed Russia's default, or the start of a protracted global downturn.

The Federal Reserve has abruptly changed its tune, apparently stunned by the rush for safety two weeks ago when yields on three-month US Treasury notes plunged at the fastest rate ever recorded, eclipsing both 9/11 and the October 1987 crash.

Fed governor Frederic Mishkin hinted at a pre-emptive move to stave off a possible recession, saying it would be wise for policymakers to "react immediately to a house price decline when they see it," rather than wait for the economic damage to become evident.

US car sales fell to the lowest level in nine years in July as tightening credit conditions cut off funds to marginal buyers. The Case-Shiller home price index showed a 3.2 percent fall across the country in the past year, with drops of 11 percent in Detroit, 7.7 percent in Tampa, and 7 percent in Washington, D.C.

Yale professor Robert Shiller said prices could fall by half in some regions. The property bust has cut home equity withdrawals from $800 billion a year to nearer $250 billion, knocking away a key prop of the spending boom. Households are having to retrench as it becomes harder to roll over credit card debt.

Axel Weber, president of Germany's Bundesbank, described the current panic as an old-fashioned bank-run that would fizzle out as investors returned to their senses. "There is no underlying problem in terms of insolvency. It's one of liquidity," he said. "What we are seeing now is that what was held off the balance sheet is rolling back on to the balance sheets of banks, and the issue is simply one of leverage. The market for asset-backed securities has not collapsed. The underlying assets are impaired, but delinquency rates are on the order of magnitude of 8 percent to 10 percent. I think what we're seeing at the moment is a total over-reaction in the market. Basically the underlying, intrinsic value of these things is maybe 80 percent" of face value, said Weber.

Germany's IKB bank and SachsenLB have between them required E25.4 billion in credit guarantees put together by Berlin to cover sub-prime exposure built up through Irish funds, known as conduits. It is effectively a German state bailout. IKB said yesterday its losses are likely to reach E700 billion.

Stephen Jen, economist at Morgan Stanley, said the Federal Reserve's swift move to cut the discount rate by a half point to 5.75 percent on August 17 would most likely prove to be "the beginning of the end of the financial crisis," but said there was a risk of sliding into a 1991-style recession triggered by weak consumption.

Mr Jen said it was bizarre that equities were rebounding while parts of the debt were still frozen, with LIBOR fixing rates still at abnormally high levels.

The "dichotomy" will have to break sooner or later. Morgan Stanley is betting on recovery.

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