Japanese officials are no doubt breathing a sigh of relief as the yen has weakened against the US dollar this year, but one leading analyst is warning that the Japanese currency is set for a “day of reckoning” that will see it drop 30-40% in value and cause major ripples for neighbouring countries such as China.

In an article published in the Chinese magazine Caixin, former Morgan Stanley chief Asian economist Andy Xie points out that Japan is presently in the grip of a sustained deflation that it has not experienced since the 1930s. As he notes, a strong yen can be justified when wages and asset prices are rising. But when wages and asset prices are falling, a strong currency can be suicidal.

“Japan’s nominal GDP peaked in 1997 and its nominal wages did too. Its property prices have declined every year since. The Nikkei rose in only four out of the last 15 years and is still close to a three-decade low.”

Xie argues that the deflationary experience hasn’t been more painful because the Japanese government has moved to pump up aggregate demand by boosting spending. As a result, Japan’s national debt has exploded. “It is expected to top ¥1000 trillion in 2012, 215% of GDP, ¥7.8 million (or roughly $US94,000) per person, and about half of net household wealth per capita.”

Because Japanese institutions and households hold most of the government’s debts “their faith in the government’s creditworthiness is the mojo for Japan’s seemingly harmless deflationary spiral”.

All the same Xie notes that even though the yield on 10-year Japanese bonds is only 1%, the Japanese government is expected to face an interest expense of ¥22.3 trillion — or one quarter of its budget — in its next fiscal year that begins in April. If the 10-year bond yield rose to 2%, the interest expenses would exceed Japan’s expected tax revenue of ¥42.3 trillion.

Xie argues that Japan’s budget deficit is too high, and that the Japanese government would have to double its tax revenues to reach a balanced budget. But because the Japanese economy is deflating, and private consumption is shrinking, a major tax hike would only cause the economy to contract further, which would shrink the tax base and require an even bigger tax increase to balance the budget. As a result, the Japanese government can only sustain its debts by borrowing more — as he notes, “this fits the definition of a particular type of Ponzi scheme”.

Despite Japan’s poor economic performance, the yen has remained strong. However, Xie argues that Japan’s trade competitiveness is now withering, and “when a trade deficit emerges, it signals the beginning of the end”.

Xie points out that Japan is now losing competitiveness in a range of industries that it used to dominate. Its car industry is now losing out to Germany, South Korea and the US.

“Japan’s automobile industry used to be competitive in cost and far superior in quality to its global competitors. But the world has changed. The yen has dropped below 110 from as high as 160 against the euro. The South Korean won was about 10 against the yen and is now 13. Cost-cutting cannot offset such a big change in exchange rates.”

Similarly, he argues that Japan’s electronics industry “is losing out big time to its Asian competitors”.

According to Xie, “Japan’s trade balance may swing into surplus from time to time, but the negative trend is irreversible. Japan will face rising trade deficits”. And because Japan will need foreign money to fund its deficits, the verdict of foreign investors will become increasingly important. “When foreigners change their views, which they surely will, the yen will crash.”

Xie argues that Japan has only one solution — a massive devaluation of the yen. “A devaluation of 40% can restore Japan’s competitiveness against Germany and South Korea, which will lay the foundation for Japan’s industrial recovery.” At the same time, a devaluation would boost Japan’s nominal GDP, and increase the government’s tax revenues.

“The day of reckoning for the yen is not distant. Japanese companies are struggling with profitability. It only gets worse from here. When a major company goes bankrupt, this may change the prevailing psychology. A weak yen consensus will emerge then.”

However, a sharp drop in the yen will deal a hefty blow to the Chinese and South Korean economies, just as the yen’s devaluation in 1996 was a major factor in triggering the 1997 Asian financial crisis.

Xie argues that South Korea’s banking system is one of the most highly leveraged in the world, due to the high level of household debts. And he sees China’s banking system as extremely vulnerable.

“China suffers from over-investment and a property bubble, as south-east Asia and South Korea did in 1997. In terms of the magnitude of leverage, China’s situation is much worse. Hence, a yen devaluation could wreak havoc to China’s economy.”

*This first appeared on Business Spectator.