IPA Q3 - As the global credit crisis unfolds commentators have been drawing parallels with the bursting of the Japanese bubble, the ensuing bad-loan problem of Japanese banks and now the risk of a deflationary spiral. One of my favorites, Paul Krugman, has recently taken on a very mild tone toward the policy decisions made after the bursting of the Japanese equity- and housing bubble. He questioned whether these were really that ill-conceived under the circumstances and whether the lost decade could not have been much more painful without the measures taken. Indeed the Japanese experience seems to be highly relevant for assessing possible policy measures to deal with the aftermath of the global credit crisis, but also in assessing scenarios faced by international investors as the global economy either comes out of- or gets further bogged down in the overhang from a period of excess.

What can be gauged from the Japanese experience is that deflation, although by definition leading to higher real interest rates and increased purchasing power, leads to frustration on the part of savers who feel the impact of the low nominal rates more directly than the improvement in the basket of goods their money can buy. Thus deflation in Japan has resulted in a move from saving to investment and from domestic- towards more internationally tilted portfolios by households and institutions alike. Japan was in a unique position in that it was the only country confronting deflation earlier this decade while other developed nations experienced a goldilocks environment with modest inflation and moderate growth. This “not-too-hot, not-too-cold” state of affairs supported moderate interest rates, attracting funds from Japanese savers looking for higher interest rates than those available at home. In late 2006, the fund embodying this strategy most clearly (Kokusai’s Global Sovereign Fund, investing in government bonds of developed countries offering these moderate, but from a Japanese perspective attractive yields) reached more than USD 50bln in AUM shortly thereafter followed by Pictet’s high income equity fund which exceeded USD 25bln by mid 2007. The un-hedged nature of these investments drove down the yen and supported the currencies at the receiving end of the capital flows starting with the NZD and AUD, but also the GBP, USD and EUR (the order obviously reflecting the size of the yield advantage). Thus, the term “carry-trade” consisted of more than hedge fund borrowing in low-yielding JPY to invest in higher yielding assets that subsequently exploded as the sub-prime crisis developed into a larger credit crisis. It also included the famed “Mrs Watanabe” looking to make a respectable return on her family savings.

It is probably fair to say that the jury is still out on the question whether the aftermath of the current global credit crisis will bring the economies of developed nations into a repeat of the Japanese experience. Indeed the views are widely dispersed when it comes to the outlook for inflation or deflation. What seems clear however is that in a deflation scenario, savers in developed nations, faced with ever lower interest rates on their bank deposits and a dearth of investment opportunities in their home markets, would have little alternative than to move funds away from their home market, and developed markets in general, into emerging markets, with far-reaching implications for asset prices across the globe. Weakness of major developed market currencies vis-à-vis those of emerging markets is only one such implication, with the USD being especially vulnerable since the perceived richness of investment opportunities in the USA is a strong source of support for a currency that should otherwise be burdened by the weight of its current account- and fiscal deficits. Investment flows that would dwarf the numbers seen in the course of this decade from Japanese households would suck away liquidity from developed markets and put a lid on any stock market performance there, while emerging markets would face serious problems handling the abundance of capital flowing into their underdeveloped capital markets. Booming prices for emerging assets would lower the cost of capital for emerging market based corporations strengthening their competitive advantage versus developed market peers and reinforcing a benign spiral of value creation. Domestic prosperity in emerging markets would be enhanced, compensating for the sputtering developed market growth engine.

With Japan showing signs of deflation already, following the money trail indeed points toward investors, again, desperately seeking for yield and growth in emerging markets, in particular China. The second quarter of 2009 saw dedicated Chinese equity fund launches by Nomura, Fortis Investments and Invesco to the tune of USD 2bln. These fund offerings were snapped up by retail investors and inflows were restricted only by the capacity constraints of the QFII quota for Chinese A-shares. The market is reacting with vigor to these inflows and the positive effects of the USD 585bln stimulus package by the Chinese government, the Shanghai Composite index rising about 60% during the first half of 2009.

If - and it is a big if - developed markets would follow Japan into a deflationary trap, we ain’t seen nothing yet when it comes to the decoupling of emerging from developed markets.

Oscar Volder is an Investment Specialist at Fortis Investments in Japan