Will Quantitative Easing Be Japan's Savior?
Japan is the fourth-largest economy in the world, but size and health are not synonymous. Because of an unfortunate combination of events both in and out of its control, the Japan’s economy has been a value trap for nearly two decades, but all of that might have changed.

History
By the end of World War II, Japan was in economic ruins, but it did not take long for the economy to recover. By the 1960s, real economic growth had averaged 10%, then 5% in the 1970s, and 4% in the 1980s. A mastery of advanced technology, a culturally strong work ethic, and only 1% of GDP going to defense spending fueled growth that some economists call “a miracle.”

In an eerie parallel to the United States, what transformed Japan’s high growth into one of financial emergency was a huge stock and property price bubble that blew up in the early part of the 1990s. Sometimes called the Lost Decade, the 1990s only saw average Japanese GDP growth of 0.5% compared to the United States at 2.6%. As a result, the country implemented a quantitative easing program—pumping money into the economy from 2001-2006.

SEE: The Lost Decade: Lessons From Japans Real Estate Crisis

From 2002-2007, the country saw strong economic growth, but just one year later, after the program had wound down, the country was again under economic pressure. The government again pumped money into the economy, but in 2011, a massive 9.0 earthquake, subsequent tsunami, and nuclear meltdown brought the economy down again.

The country remains in a deflationary environment due to a variety of factors. Employment is down, the population is aging, the Yen (Japan’s currency) is weakening, and there is very little immigration into the country.

Japan’s New Idea
The new idea isn’t new at all. More quantitative easing, but this time on a massive scale. The program, recently announced by the new governor of the Bank of Japan, Haruhiko Kuroda, is for a cash infusion of $1.4 trillion by the end of 2014. The hope is that this new round of QE will transform the economy from a deflationary environment to one of 2% inflation. How massive is massive? Japan’s version of quantitative easing is 60% larger than the United States’, according to the Wall Street Journal.

SEE: Quantitative Easing: What’s In A Name

But will it work? Much like in the United States, the armchair politicians and economists are hard at work debating the issue. Some believe that previous quantitative easing proved fruitless so there is no reason to believe that it will work this time. TIME magazine points out that for the program to work, there have to be strong investment opportunities. Banks have to lend the money, and consumers have to spend.
Even if it does work, Japan will be left with even more public debt. Its debt load is currently 214% of GDP with a quarter of the country’s budget going to service that debt. If this round of QE does create inflation, interest rates will rise. One estimate found that nominal GDP would have to grow by more than 6% just to keep the country’s debt load from increasing. Growth of that size, according to economists, is unsustainable over the long term.

SEE: 10 Most Indebted Nations

Others are supportive of the plan. The IMF’s Christine Lagarde said that the newly announced plan was a step in the right direction. Others applauded the effort as a big solution to a big problem.

Financial Impact
Forecasts call for the Yen to continue weakening to 105 against the U.S. dollar by the end of 2013 and 110 in 2014. According to Wolfgang Koester, FiREapps Chairman and CEO, as the yen weakens, U.S. investors receive less revenue when doing business in Japan. He said that companies like McDonald’s (NYSE: MCD) and Coach (NYSE: COH) have claimed that the volatility in international currencies are impacting earnings.
According to Coach Chairman and CEO, Lew Frankfort, “In Japan, we posted a 2% decrease in constant currency while sales in dollars were down 7% from prior year, reflecting the weaker yen.”

Market Impact
Whether or not QE in the United States aided in the economic recovery will likely be a debate that lasts for decades, but nobody argues that the markets have seen considerable appreciation since the program was announced. The Wall Street axiom, “don’t fight the Fed,” has made U.S. investors a lot of money.

Regardless of the reason behind the market rally, investors are betting that Japan’s markets will see the same effect. This has sent the most popular Japan ETF, WisdomTree Japan Hedged Equity (Arca: DXJ) up more than 6% since the BOJ announced the plan April 4. iShares MSCI Japan Index (Arca: EWJ) is up more than 4%.

Take Action
If this new round of QE does for Japanese markets what it has done for U.S. markets, a bullish position on the Japanese economy through equity, bond, or total market ETFs may be warranted. Currency traders may try to take advantage of the weakening Yen in the Forex market.

However, investing in international markets is difficult for retail investors due to the relative lack of information available. A balanced and diversified portfolio mitigates this risk to a degree but in the case of Japan, it might be best to follow the old Wall Street rule of not putting money to work in an investment you don’t fully understand. If you are well versed in international markets, you might have the Bank of Japan to thank for some large profits this time next year.


Tickers in this Article: MCD, COH, DXJ, EWJ

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