Japan and China are eyeing each other… dangerously!

Japan and China are eyeing each other… dangerously!
Japan and China are eyeing each other… dangerously!

While investors have their eyes on the States, evolving relations between Japan and China could have major financial implications.

China is questioning, even worried. geopolitical fears, it is the economy that arouses fear: poor management of the pandemic, demographics, real estate, growing reluctance of households, even deflation… This confluence of serious problems embarrasses a power which takes refuge in growing authoritarianism. Some fear that this deleterious context will push Xi into headlong flight (Taiwan, etc.). On the same continent, the other giant, Japan is emerging from a decades-long tranquility. The destiny of the two countries, strategic “enemies” and economic and financial competitors, is closely linked. While China tries to delay, Japan is moving, and is initiating a major shift in its economic policy. The warming of relations with South Korea in 2023 is another visible symbol of this awakening. This new Japanese dynamic adds a Source of uncertainty for China. The Sino-American conflict – which is currently only a commercial and technological war – already represents a major threat to China’s internal politics.

Japan: between economic dilemmas and political responses

For several decades, Japan has been the laboratory of rich Western countries: aging of the population, falling productivity, implementation of an extravagant economic policy and difficulty in implementing structural reforms. In 2013, Prime Minister Abe, in coordination with the of Japan (BoJ), set the objective of returning to an (average) rate of 2% and subsequently launched an easing policy. quantitative and qualitative (QQE). The inflation rate had then become positive again, the yen had depreciated sharply, stock prices had risen, and the situation of businesses had improved. Better still, we had seen a virtuous drop in unemployment.

The road ahead is strewn with pitfalls for Japan. The slide of its currency, coupled with the slow decline in long-term rates attest to this.

But Abenomics has had its day and the major opposing forces have quickly regained ground. In recent years, two external shocks, the pandemic and geopolitics, have suddenly disrupted the economic context. Inflation notably reached 4%, a very high rate by Japanese standards. The response of Japanese decision-makers, slow and gradual, was nonetheless spectacular: they resolved to change. The first stage of the normalization of monetary policy in Japan took place smoothly, without a negative reaction from the markets or too strong a depreciation of the exchange rate. But the real trigger probably occurred at the start of the year when the salary increase season resulted in substantial increases, allowing the BoJ’s policy board to initiate the first stage of normalization, the monetary tightening.

The road ahead is strewn with pitfalls for Japan. The slide of its currency, coupled with the slow decline in long-term rates attest to this. First, if long-term interest rates increased sharply, it would weaken financial institutions. Certainly, an American-style scenario, like Silicon Valley Bank, seems very unlikely, most Japanese banks being well capitalized. However, their propensity to grant loans would be affected, which would ultimately weigh on growth. Second, raising rates would increase the costs of servicing the colossal national debt. Which would imply a reduction in social security spending, politically very difficult in Japan, where the median age is close to 50 years. A third risk concerns the BoJ’s profits which would become significantly negative. A deterioration of its balance sheet would, as everywhere else, be the cause of multiple tensions.

CHINA AT THE CROSSROADS

As for China, we will have to wait a few years to know if the country will succeed in turning things around on a macroeconomic level. She makes no secret of it, she needs to find a new recipe to stimulate her growth. Unleash domestic growth… However, Chinese household consumption has been very insufficient for a long time, a situation exacerbated by the pandemic. De facto, China’s contribution to global growth has fallen back to its pre-2008 levels. According to the IMF, this contribution is expected to decline further, reaching only around 22% by 2027-2028. The dividends of globalization, and of the relocation of production, are definitively giving way to the phenomenon of “friendly relocation”. This partial decoupling is a particularly rude awakening for China. What globalization has given, it is taking back.

Productivity remains! The economic theory is clear: to maintain GDP growth with fewer workers, we must extract more added value from each of them. In February, Xi defined new productive forces as those “fostered by revolutionary technological breakthroughs, innovative allocation of production factors, transformation and profound upgrading of industries.” A complex, even unattainable, project because it relies on public companies with low productivity, while the entrepreneurship of the private sector with higher productivity is subject to strong regulatory pressure. The figures are clear: the recent trend in productivity is downward.

In this context, we have been witnessing the intensification of Sino-Japanese tensions in recent weeks. The collapse of the yen endangers China’s competitiveness in external markets (particularly regional) where the two countries are competitors. The timing is bad. Is this the last straw for Beijing before a devaluation (like in 2015)? For now, Tokyo is working unilaterally to calm the bleeding. But for how long? Its chances of success are slim if we refer to monetary history. An accelerated rise in Japanese rates would not fail to cause shocks due to the repatriation of the considerable mass of Japanese capital, and the outcome of the enormous carry operations where the yen was used as a financing currency. Unless the central banks of Taiwan, Seoul (and Washington) take action…

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