When Beijing announced last month a change in its universally-criticized currency policy, perhaps the loudest cheer came from Japan. With prospects of a floating Chinese yuan tightening the trade gap, Japan momentarily saw light at the end of a very long tunnel. Hindered by structural deflation, Japan’s economy has lagged behind the rest of the world, missing out on the rally that allowed many markets to reclaim ground lost during the recession. An appreciating yuan could potentially allow Japan to accelerate a move out of the post-recessionary phase by providing the opportunity to compete more fairly in export markets.
Unfortunately, many analysts worry that China’s currency will remain distorted for the foreseeable future, maintaining the country’s competitive advantage. “China’s exchange-rate policy is neither complicated nor unprecedented, except for its sheer scale,” writes Paul Krugman. “It’s a classic example of a government keeping the foreign-currency value of its money artificially low by selling its own currency and buying foreign currency.”
For those investors who saw a rising yuan as the magic cure for all of Japan’s economic woes, it might be time to reevaluate the situation. Japan is crawling through the recovery, and China’s dominance of global trade is only one of the problems. Poor euro zone prospects do not create a supportive environment for Japanese exports, and the issues of a stubbornly strong yen and potential deflation aren’t disappearing any time soon.
Japan has been mired by a contractual economy caused by its shrinking population, loss of international competitiveness, and significant government debt, which is currently estimated at almost 200% of GDP. In 2009, the Internal Affairs Ministry of Japan reported 1.08 million births and 1.13 million deaths, the deepest population decline to date. This is largely due to a cultural shift; Japanese couples are having fewer children and delaying the children that they do have. The Japan Research Institute forecasts that the Japanese growth rate will decline by 0.01%, the third consecutive year of negative growth. That may sound like the subject of an anthropology course, but it has a very real impact on the country’s economy; a declining population removes one source of organic growth that has allowed the expanding nations of China and India to thrive [see India Small Cap ETF Hits Market].
Much like the United States, Japan injected cash into the economy to create jobs and offer low-interest lending to banks and businesses. In the U.S., most investors have been concerned about runaway inflation. But in Japan, inflation would be a Godsend; deflation is a more pressing issue. Japan’s National Strategy Minister, Satoshi Arai, sees eliminating price declines as a key step in stabilizing the economy. “Stamping out deflation is our top policy priority,” says Arai.
The election of new Prime Minister Naoto Kan sparked hope among some investors that Japan had finally gotten its economic act together. The Cabinet Office’s mid-year forecast called for price-adjusted growth of 2.6% for the year ending March 2011, nearly twice previous estimates. But most remain skeptical of the new government’s ability to “restore health to [the] nation’s finances,” the objective recently stated by Finance Minister Yoshihiko Noda.
Japan ETF Options
For investors looking to establish exposure–either long or short–to the Japanese markets, there is no shortage of ETF options. The Japan Equities ETFdb Category consists of eight funds, the largest of which is the iShares MSCI Japan Index Fund (EWJ). This ETF tracks the MSCI Japan Index, a benchmark that consists of several names recognized by investors around the world; Toyota, Mitsubishi, and Honda are the top three holdings. In total, EWJ has more than 300 holdings, maintaining the heaviest tilts towards the consumer goods (30%) and industrial materials (19%) sectors. EWJ charges an expense ratio of 0.52%.
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Disclosure: No positions at time of writing.