Ailing Japan Cozies Up to China

02/08/2010 9:18 am EST

Focus: GLOBAL

Carlton Delfeld

Editor, The La Jolla Letter and Pacific Gains

The new Japanese government's diplomatic opening to China springs from economic desperation, writes Carlton Delfeld in Around the World with ChartwellETF.com.

Japan’s sovereign credit rating outlook was [recently] cut to "negative" by Standard & Poor’s over the bleak prospects for reducing the country’s swelling debt load.

"The outlook change reflects our view that the Japanese government’s diminishing economic policy flexibility may lead to a downgrade unless measures can be taken to stem fiscal and deflationary pressures," the agency said in a statement.

Japan is really in a fiscal box, and it is hard to see a way out unless it takes steps to invigorate stronger economic growth. Unfortunately, it shows no political will to do so.

Japan’s tax revenue for this year is expected to total about half of the government’s expenditures, forcing a new round of debt issuance totaling nearly $500 billion. That would bring Japan’s public debt to about $9.4 trillion, or 180% of gross domestic product, by March 2011. While debt at such levels would be by far the highest in the industrialized world, 90% of its sovereign debt is currently held by domestic investors. For the US, about 55% of our public debt is owned by foreign institutions.

The only bright spot is that Japan’s exports were up last month 12% year over year. Exports continued to be driven by the growth of Japan’s neighbors in Asia. Exports to China rose by 43% and exports to Asia overall were up by 31%. In a sign of just how dependent Japan is on emerging market growth, however, exports to the US fell 7.1% even compared with a low figure in December 2008.

But all this just affirms Japan’s overdependence on exports to fuel even modest growth. And Japan also is overly dependent on foreign investors to boost its stock market. It is estimated that about 40% of the broad TOPIX index is held by foreign investors. In addition, any meaningful rally is always led by foreign buyers bargain hunting or just hoping for a turnaround.

In short, the Japanese consumer is still frugal, spending down their savings, cynical about the country’s politics, pessimistic about the future, and seemingly content to dwell in the shadows of Japan’s past glory and real untapped potential of the country. Japan has lost its swagger.

Another issue that concerns me is that Japan under its new leadership is seemingly backing away from its traditional strong alliance with America. Martin Sackler of the New York Times notes that secretary general of Japan’s governing Democratic Party, Ichiro Ozawa, in particular is leading the charge to act on the belief that Japan’s economic future is increasingly tied to China, which has already surpassed the United States as its largest trading partner.

"This has been a golden opportunity for China," said Kunihiko Miyake, a former high-ranking Japanese diplomat who was stationed in Beijing. "The Chinese are showing a friendlier face than Washington to counterbalance US influence, if not separate Japan from the US"

In the four months since Mr. Hatoyama took office, there has been an unusual flurry of visits back and forth by top-ranking Chinese and Japanese officials, including one last month to Tokyo by China’s heir apparent, Vice President Xi Jinping. In an unusual manner, Mr. Hatoyama even went so far as to arrange a meeting between Mr. Xi and Emperor Akihito at the Imperial Palace in Tokyo on short notice, breaking protocol that such audiences be arranged more than a month in advance.

In my view, this shift in tone and action is a huge diplomatic blunder and based on wishful and naive thinking about both economics and security.

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