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  • Writer's pictureEdward Ballsdon

Modern Finance in 1 Chart

Updated: Apr 22

Returns of the Nikkei in Yen, USD and Gold


There is a lot of debate about Japan's Ministry of Finance (MinFin) potentially intervening in FX markets to prop up the Yen, given that it has weakened by 17.5% versus the USD since Jan23 and by almost 50% since 2021.

The problem is that Japan is in a debt trap, with the Bank of Japan (BoJ) owning ~ 50% of outstanding Japanese government debt (JGBs). The government is still running a large deficit (greater than 5%/GDP) and the BoJ has confirmed that it will continue to buy JGBs by simply expanding its balance sheet - this is Quantitative Easing (QE).

Indeed, whilst other Central Banks around the world, from the RBA in Australia to the FED in the US, have been reducing their government bond holdings (Quantitative Tightening), the BoJ has been the only Central Bank to continue QE, in large part due to the country being in a debt trap.

Simply put, the more the BoJ expands its balance sheet and increases the amount of its currency in circulation, the more the Japanese currency will be debased.

One of the issues facing the BoJ and MinFin is that the Yen depreciation has caused imported goods to increase in price. But due to the way that inflation is calculated, if the currency no longer depreciates, there will be significantly disinflationary pressures in the next 12 months. This disinflationary pressures will be even stronger should the currency appreciate from current levels.

The disinflationary impact can be seen by the light brown line in the chart below, which assumes that $Yen remains at 152. The red line shows how the disinflationary force will be greater should the Yen appreciate by 10% over the next 6 months.

So why doesn't the BoJ just stop expanding its balance sheet? Indeed the BoJ did not undertake balance sheet expansion from when the Real Estate and Nikkei stock market burst in 1990 until 2011, when it commenced its QE program. The problem was that in that period "Debt Deflation" took hold in the private sector - real estate and equity prices continuously declined in value (but the Yen maintained its value vs foreign currencies).

As can be seen from the chart above, the start of the BoJ's balance sheet expansion coincided with the start of the rise of Japanese Real Estate prices and the Nikkei stock market index. But crucially it also was the high in the value of the Yen, which has only depreciated ever since.

Clearly the MinFin and BoJ have been able to "monetise debt" without causing a major financial crisis as a) the government's debt is denominated in Yen, b) it is 80% owned by domestics and c) because Japan runs a current account surplus (so it is not dependant on foreigner's to fund the debt).

Fast forward to today. The government continues to run large deficits that need to be financed and the outstanding debt stock is 230%/GDP, which limits the BoJ's ability to increase interest rates. Only poor choices remain for the Central Bankers and politicians.

Cutting the deficit and debt restructuring are politically impossible, whilst a return to debt/deflation is unpalatable. That leaves a continuation of existing policies of a large deficit, low interest rates and BoJ balance sheet expansion - i.e. the status quo, with further currency debasement being the least poor choice.

There has been a lot of chatter about the opportunities to be gained from investing in the Nikkei, after all, look at the extraordinary gains of the last few years, with prices recently beating the peak registered in 1990.....

Unfortunately the chart above shows the performance in Yen. To see a true "REAL" performance of an asset whose currency is devaluing, you can divide its value in its original currency by a more stable currency, say USD, or even better, by the price of Gold in that currency. Because the amount of Gold production increases by only ~1% per annum (see World Gold Council stats), its a constant that is often used as the denominator to determine "real" values.

The chart below succinctly summarises investing in Japan and very clearly explains modern finance (fiat currencies) in 1 chart. It shows the performance of the Nikkei Index in Yen (Green), in USD (Blue) and in Gold (Orange), with prices normalised to allow direct comparisons between each index. It shows how Nikkei in real terms is still far far below the 1990 peak.

The next chart below shows the Nikkei performance since 2011, when the BoJ started aggressively expanding its balance sheet, flooding the economy with a debasing Yen.

Of course this "modern finance" is not only applicable to Japan. Accounting rules hold firm everywhere there has been currency debasement. Below are a couple of revealing charts. The first shows the S&P500 index and the S&P500 index in Gold - the post 2008 rally does not look as good in such real terms:

The last chart below normalises the S&P500 and the S&P500 index in Gold at 100 from 1971, when the US abandoned the gold standard........

Do get in touch if you would like to discuss in further detail. Regards Edward

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