Japan’s economy has roared back to life as the radical reflation policies of premier Shinzo Abe drive a surge of consumer spending, but fears are growing that the tumbling yen could set off a broader Asian crisis.
Growth jumped to a 3.5pc rate in the first quarter, vindicating the government’s efforts to break Japan’s deflation psychology and lift the country out of its 20-year ice age. “Abe’s kickstart appears to have succeeded,” said Flemming Nielsen from Danske Bank.
Retail sales are soaring as a “wealth shock” electrifies the economy. The Nikkei index has risen has 70pc since November, with foreign hedge funds among the first to jump on the bandwagon.
The weaker yen is already delivering a powerful punch, accounting for almost half the growth. The currency has dropped 30pc against the dollar and China’s yuan since August, and 37pc against the euro.
The yen-slide - or "Enyasu" - has raised concerns that Japan is exporting deflation through a "beggar-thy-neighbour" push for export share, a claim rejected by Tokyo.
Stephanie Kretz from Lombard Odier said the falling yen looks like a replay of the mid-1990s before the onset of the East Asian crisis, when external funding dried up in a “sudden stop”.
It poses a direct threat to Malaysia, Vietnam, Thailand, Korea and others with a high trade gearing, as well as for China, though foreign debts are lower this time. She warned that the trade surpluses of these countries could evaporate, “silently planting the seeds for the next Asian crisis down the road”.
Albert Edwards from Societe General said "Enyasu" may be the catalyst that pops China’s credit bubble. He warns that loss of exchange competitiveness after years of soaring wages leaves China vulnerable to a deflationary monetary squeeze and should ring alarm bells. “This closely echoes the situation in the run-up to the 1997 Asian currency crisis.”
The G7 global powers have so far turned a blind eye to the falling yen, deeming it a side-effect of Japan’s fight against deflation. Washington has grumbled privately but broadly accepts that a revival of growth in Japan is a net gain for the world economy. However, the protests from Korea and China are growing louder.
Jean-Michel Six from Standard & Poor’s said the yen effect risks pushing the eurozone towards deflation. “Japan competes head on with Germany in the same products and this is already putting pressure on German exporters in the Chinese and US markets. Korea is very worried about the yen, and Germany should be too,” he said.
The five-year futures markets are already pricing in a higher risk of deflation in Germany than in Japan, an almost unthinkable development just months ago. Japan has been stuck in 1pc deflation for years, an effect that has slowly poisoned debt dynamics.
The centrepiece of "Abenomics" is the full mobilisation of the Bank of Japan, drawing on policies that pulled the country out of the Great Depression in the 1930s.
After years of paralysis, the new team under Governor Haruhiko Kuroda has launched quantitative easing on a vast scale, buying $1.4 trillion of bonds across the maturity curve.
The BoJ is injecting $75bn a month, almost as much as the Federal Reserve in an economy one third of the size. This has stirred talk of a “wall of money” flooding global markets, with up to $1 trillion leaking out in a revival of the yen “carry trade”.
It has not happened yet. Societe Generale said Japanese investors have repatriated money so far this year to take advantage of the boom at home, selling a net $59bn of foreign stocks.
While they have been net buyers of foreign bonds over the past three weeks, it has been in “very modest” amounts and offset by foreign inflows into Japan.
Data from Nomura shows that "Toshin" investment trusts did buy a net $3.3bn of foreign securities in April, mostly in Brazilian real, Turkish lira and Mexican pesos.
The Bank of Japan’s monetary blitz is a high-risk strategy since any suspicion that it aims to inflate away Japan’s public debt - $10 trillion, or 245pc of GDP - could upset a fragile equilibrium and cause life insurers and pension funds to slash their bond holdings. No developed country has ever before recorded such a high level of public debt. While 93pc of the bonds are held internally, this does not mean that Japan is immune to a debt crisis.
Yields on 10-year government bonds (JGBs) have doubled since Mr Kuroda unveiled his plans. They spiked to 0.92pc last week in the biggest sell-off for a decade before the BoJ intervened.
So far this appears benign. Danske Bank said rising yields should be viewed as success, since they mean the BoJ has finally convinced markets that it will defeat deflation. The plummeting cost credit default swaps used to insure against a Japanese sovereign default is a sign that investors think the policy reduces the risk of blow-up.
Junko Nishioka from RBS said danger threshold for 10-year yields is around 3pc. “That could trigger a market event,” she said.
A rise to that level risks setting off a banking crisis since Japanese lenders hold government bonds worth 80pc of GDP, with smaller regional banks most at risk.
Danske Bank said the Kuroda strategy will boost nominal GDP and therefore help to bring Japan’s debt burden under control by averting a deflationary debt-compound trap.
The yield spike is highly significant however, and may be the harbinger of a global bond rout as the cycle turns, perhaps later this year or in 2014. “It is a wake-up call. We advise keeping an eye on the Japanese bond market,” said the bank.