Japan yet to come out with its losses

Just as battered investors had begun to glimpse signs of recovery in America, the next shoe has dropped with an almighty thud in Japan. Echoes are rumbling across the Far East.

The Tokyo bourse has crumbled, suffering the worst start to the year since the Second World War. The Nikkei index is down 17 per cent since Christmas, and the shares of Japanese banks are leading the slide. Mizuho Financial, Mitsubishi UFJ and Sumitomo Mitsui have all been punished as hard or even harder than those US banks at the epicentre of the sub-prime debacle.

The nagging fear is that Japan's lenders - the conduit for the world's greatest stash of savings - have taken on a far bigger chunk of mortgage securities, collateralised loans obligations and other exotica from America's structured credit boom than they have yet revealed.

Americans and Europeans have so far confessed to $130 billion of the estimated $400 billion to $500 billion of wealth that has vanished into the sub-prime hole. Somebody, somewhere, must be sitting on a vast nexus of undisclosed losses. We may find out soon enough whether the hold-outs are in Japan. The banks have to come clean under the country's strict new audit codes by the end of the tax year in March.

"We think this is where the next big problem is going to pop up," said Hans Redeker, currency chief at BNP Paribas.

"We know from Bank of Japan's lending survey that the banks are already tightening hard, so something is brewing. Right now, we are in the lull before the second storm in global markets, and Asia is going to be the source of the nasty surprises,'' he said.

Distress signal

The iTraxx Japan index measuring default risk of 50 Japanese companies saw its biggest one-day jump ever on last Thursday to 77.5. Rightly or wrongly, it is flashing a serious distress signal.

What we know is that Japan's economy - still the second biggest in the world by far - has fallen over a cliff since October. It remains joined to America's hip after all. The decoupling theory has failed its first test.

Japan's machine orders dropped 2.8 per cent in November and a further 3.2 per cent in December. January housing starts fell to the lowest in 40 years, down 18 per cent on the year. Tokyo property was off 22 per cent. Can this still be blamed purely on a change in building rules?

"Recession is a clear and present danger in Japan," said Tetsufumi Yamakawa, chief Japan economist for Goldman Sachs. "The leading indicators are deteriorating very sharply. Inventory is piling up at a rapid pace. There are clear signs of deceleration in exports of steel and semi-conductors to China," he said.

Yes, China. It turns out that the intra-Asia trade that was supposed to immunise the region against a slump is a disguised supply-chain ending up in the US market. American shoppers still make 30 per cent of global demand, just as it did a decade ago. Nothing has really changed.

"We think the Bank of Japan may have to start easing by the middle of the year," said Yamakawa.

There is not much monetary ammo left. Interest rates are 0.5 per cent. So it's back to zero, and helicopters of central bank cash, those peculiar hallmarks of Japan's past battle with deflation. The brief attempt to "normalise" Japan Inc has already failed.

We tend to forget that Japan remains the world's top creditor nation by far, the shy master of fate. The country's net foreign assets of $3,000 billion roughly match the net debts of the US.

The yen "carry trade'' - borrowing cheap in Tokyo to chase yields from New Zealand, to Brazil, Iceland, and above all Britain - has juiced the global asset boom this decade by $1,000 billion. It is perhaps the biggest liquidity pump of them all, yet it stopped pumping in August. Indeed, it is sucking the money back out again. The yen is soaring.

So far, Japan's biggest three banks have admitted to just $4.7 billion in total losses between them. The figure is rising. Mitsubishi, the biggest, has just raised its tally to 12 times the sum admitted in November. This looks like a replay of the early 1990s when fear of losing face delayed the awful news.

Hong Liang, Beijing economist for Goldman Sachs, is not much more hopeful about China's prospects this year. "The combination of a US slowdown and monetary tightening in China is never welcome, but the accumulated problems have to be resolved this year,'' she said.

China's mercantilist drive for export share is a double-edged strategy. The trade surplus has risen at $80 billion a year, increasing tenfold since 2002 while the economy has merely doubled. The result is that China is as dependent on the US economy as Mexico.

So the storm spreads East. The global watchdogs are scrambling to rewrite the script. The World Bank has cut its China growth forecast from 10.8 per cent to 9.6 per cent in 2008. Private banks are slashing deeper.

Once the striptease starts on the onset of a global downturn, it usually has a long way to run.