Investment Manager Report
Dear Valued Investors,
When we look at investments in Asia, we try to look beyond the near term. We try to assess what is sustainable beyond the noise of media headlines. In the near term, many Asian economies seem to be on the upswing of a credit cycle, but how can growth be sustained without causing inflation? Japan poses a different question: how much of the current rally is real and how much just driven by money flows? With the passing of former British Prime Minister Margaret Thatcher, it may be useful to frame this issue in the light of her legacy.
Thatcher has been a polarizing figure; her legacy includes an outspoken defense of free markets and a confrontational political style. Personally, I have long admired her. Even as an 11-year-old, I recall my mum (who considered herself something of a socialist) angrily flinging open the curtains of my room one May morning in 1979 when Thatcher had just become prime minister, and lamenting: "Your girlfriend won!" What lessons from Thatcher’s legacy can the world draw upon today? There is evidence that “Thatcherite” policies—including liberalizing the British financial sector; privatizing state-run businesses; making labor laws less protective; and retaining a separate national currency—halted the U.K.’s decline relative to Europe. Those policies came in two forms: first, short-term policy in the style of noted economist Milton Friedman to use money supply to control inflation; second, long-term supply-side reforms to increase productive capacity. For the U.S. and Europe, where demand remains depressed, supply-side reforms offer less of a way out, since what they lack is demand, not supply. However, in much of Asia where demand is strong, supply-side reforms appear to offer greater scope for sustainable growth. Where Japan fits in is less clear.
The actual implementation of reform in Asia is patchy. China, spurred by a reformist leadership, is working to improve supply in its capital markets. This reform effort may be accelerated by the desire to liberalize trading in its currency, the renminbi. To be able to maintain a demand for China’s currency under an open capital account, Chinese officials will likely seek to generate new demand for a diverse range of Chinese financial assets. China hopes to accomplish this by developing its corporate bond market, equity mutual fund products and other financial wealth management products. This is why the country’s system of “shadow banking,” or informal lending, has been allowed to grow quickly despite concerns over excess credit formation. China is also taking another look at boosting its labor supply and making the labor market more flexible by reforming “hukou,” or its system of household registration that may impede labor migration from rural to urban areas.
In India, supply-side reforms are most needed in the government ownership of assets and in the system of price controls over various commodities. However, progress has been slow. Selling off some state-owned assets and liberalizing some price controls would allow for more private investment in the kinds of infrastructure and energy industries in which India lags far behind China in terms of development. Southeast Asia is building up its manufacturing base and the economies in this region still need to raise the productivity of workers and their spending power. At the same time, relatively young populations in these countries should start to mature over the next few decades, improving their skills and knowledge and acting as a further boost to labor supply.
Japan is somewhat different. Late last year, the likelihood that a new government would pursue aggressively loose monetary policy sparked a rally in Japan’s stock markets that so far has endured. This has struck many as absurd. How can a country grow richer by printing money? Part of Japan's problems, many economists argue, are caused either by a real rate of interest that is too low to entice businesses to invest, or by a desire to hold money in the face of falling prices that is so strong that people delay spending decisions. Raise inflationary expectations and you will cause businesses to invest and consumers to buy. Milton Friedman, one of Thatcher's own heroes, said Japan needed to print money and buy bonds: "After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately."
Is this then the beginning of Japanese outperformance? Critics raise some objections. First, consider debt. Won't rising inflation raise bond yields and increase the cost of servicing new debt? Yes, eventually. But before then, with better nominal GDP growth, Japan’s government might be in a position to cut spending, raise tax revenue and move into a primary surplus. So it would not incur much new debt at higher interest rates. Rising yields should cut the price of debt and, therefore, the debt-to-GDP ratio should fall. Success is by no means guaranteed. But this may be a way out of the debt problem. Second, inflationary expectations work best, or indeed might only work at all, if Japan is truly in a deflationary depression. This seems so obviously to have been the case for the last 20 years or so. Nevertheless, Japan has actually grown its economy at rates comparable to other developed nations, in terms of GDP per working-age population, rather than the entire population. So perhaps Japan's aging population has more to do with its slowdown than deflation? If so, printing money offers no real solution.
The reforms that corporate Japan has undertaken, primarily with regard to raised dividend payouts, still have not addressed some of the core concerns about bloated labor costs and inefficient use of capital. As it is, Japan seems to be embarking on more of a “Friedmanite” revolution than a “Thatcherite” one. Symbolically, perhaps, Japan’s reform means that the Bank of Japan is printing money to buy real estate investment trusts; in the U.K., Thatcher liberalized home ownership. In other words, Japan is pursuing a pure monetary solution without any microeconomic reform; how crucially, or if at all, the one depends upon the other is unclear.
Many countries in Asia are pursuing what could be called “Thatcherite” reforms. The greatest reforms in Asia over the past two decades have taken place outside of Japan, in China and India and Southeast Asia. Going forward, that seems likely to continue to be the case. Whether monetary stimulus in Japan is enough to kick-start a new vibrant economy and revitalize Japan's stock market, or whether it will require further reforms in the spirit of Thatcher, remains an unanswered question. Our main role, as investors, is not to try to time the monetary waves, rather to try to assess what will persist and what will remain, after the waves have dissipated.
Robert Horrocks, PhD
Chief Investment Officer
Matthews International Capital Management, LLC