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September 22, 2005

Re-armed Japan Threatens the Dollar
by T. Stein / S. McIntyre

September 11 th was a historic day for American foreign policy. We are, of course, talking about 9/11/05 when Japanese Prime Minister Junichiro Koizumi's Liberal Democratic Party was overwhelmingly returned to power in an early election. According to CNS News, the gutsy Koizumi "called an election more than two years ahead of schedule after his plans to privatize Japan's monolithic post office - effectively the world's largest financial institution - ran into obstacles." While this may be true, Koizumi's victory also validates Japan's strengthening ties to the United States as some analysts estimate US-Japanese relations at an all time high in terms of military cooperation.

Japan has clearly shifted away from its post-World War II pacifist stance, as Japanese so-called "Self Defense Forces" have been playing a more aggressive (albeit non-provocative) role in the region. Japanese troops have even made their way to Iraq (at America's request) to help in the reconstruction of that country's infrastructure. Additionally, the Japanese military has worked with the United States on programs ranging from missile defense to counterterrorism.

Up until the end of the Cold War, Japan's post-War role in the world was vaguely defined as an American ally against the Soviet Union. A $13 billion contribution to help finance the 1991 Gulf War was noteworthy, but such "checkbook diplomacy" was criticized and of course came without any troops. Things really didn't start to change until August of 1998 when North Korea, without any advanced warning, test launched its Taepo Dong missile (with a range of approximately 1,000 miles) over Japan. This prompted a significant reaction from a stunned Japanese defense community concerned about a new feeling of vulnerability that had fallen on Japan.

Over the past several years, there have been calls from both inside and outside of Japan to revise the constitution and transform the Self Defense Forces into a full-fledged military. The first major step towards this goal was completed when, in October 2001, the Japanese Diet passed a special anti-terrorism bill resulting in the deployment of vessels to the Indian Ocean and Arabian Sea to provide logistical support to coalition forces in Afghanistan. Fast forward to today and we see that Japan has recently repositioned significant numbers of its forces away from northern Japan towards the island of Okinawa, which is on the East China Sea. This relocation to the disputed waters of the East China Sea is important because it gives credence to those who see China emerging as Japan's chief rival.

While the most recent dispute has been over drilling rights, we cannot ignore the bigger picture when it comes to a Sino-Japanese rivalry. Under Koizumi, Sino-Japanese relations have deteriorated to a point where thousands of Chinese citizens have engaged in a number of anti-Japan public protests regarding atrocities that occurred sixty years ago! Additionally, Japan has become a leading defender of Taiwan, something that Beijing sees as an internal issue and therefore has subsequently warned Tokyo to mind its own business.

In addition to rivalries with North Korea and China, Japanese relations with South Korea remain strained. Even as U.S.-encouraged cooperation between South Korea and Japan has made progress, Seoul is becoming increasingly weary of a rearmed Japan. It is true that most of those Koreans who suffered war crimes at the hands of Japanese invaders have passed, but the memories remain. Japan is aware of this mistrust and therefore is in no hurry to see a reunified nuclear Korea. For a Japan surrounded by a nuclear China and a united nuclear Korea would have no choice but to acquire the same capabilities themselves.

Fortunately, relations between the Japanese, Chinese, Taiwanese and Korean business communities paradoxically continue to warm. While North Korea is indeed a threat to the region, it is the Taiwan Straits which have the greatest chances of becoming flashpoints for armed conflict. Whether ignited by a Taiwanese declaration of independence or energy insecurity, subscribers should keep focused on Chinese, Japanese and U.S. naval activities in the region. The U.S.-Japan alliance has served the region well for a number of years, but the times they are a changing.

Before we envision a scenario where Japan continues along the path of rearmament, let's examine what has already taken place according to the South Asia Analysis Group.

• Japan is upgrading airbases on islands in proximity of Senkakus and Taiwan e.g. Shimoji Shima Island.
• Japan is doubling its air-refueling capabilities for its extended Southern coverage.
• Japan is doubling its air transport fleet.
• Upgrading and expansion of AEGIS weapon systems equipped Japanese Navy ships.
• Increased air-transport lift capabilities.

The next significant step in rearmament will occur when Japan begins the development of long-range precision missiles which can attack overseas targets including enemy ballistic missile sites. Finally, Japan will acquire autonomous capabilities that are not necessarily meant to complement U.S. expeditionary warfare.

Since the U.S.-Japan alliance is in excellent shape today, the majority of East Asia analysts don't think about the long term consequences of a rearmed Japan. Most of the preoccupation among this crowd lies with the Chinese People's Liberation Army becoming a world class military power. Japan has been a helpful partner in maintaining stability in East Asia, so why worry about giving them offensive capabilities? This line of thinking is short sighted given the samurai nation's militaristic and xenophobic history. That being said, Japan may already possess the one weapon needed to bring America to its knees.

The Bank of Japan (BOJ) is often referred to as "Federal Reserve East" as it regularly coordinates its monetary policy with the American central bank. Over the last few years, the BOJ has spent considerable resources (trillions of Yen) to support the U.S. Dollar. In early 2003, Japan publicly stated that its central bank would prop up the dollar should it drop sharply following the then upcoming invasion of Iraq. The reason most commonly cited for Japanese intervention in the currency markets (i.e. buying dollars) is that Japan lives and dies by its ability to export goods, and therefore the Yen must be kept competitive with the Dollar and other currencies.

Another motive for BOJ intervention lies with the old phrase: "If you owe the bank $100,000, the bank owns you; but if you owe the bank $100 million, you own the bank." Of course $100 million is just peanuts considering that Japan holds $700 billion worth of United States Treasury debt. Any hiccup in the U.S. economy and the market value of those Treasury holdings will suffer. Japan's willingness to accept U.S. treasuries is nothing more than a gigantic vendor finance program!

The final and perhaps least-discussed reason why the BOJ has historically said "How high?" when asked to "jump" by the Fed is the geopolitical situation. As discussed above, from the end of World War II up until today, Japan has been 100% dependant on the United States for its security. This arrangement served both sides well for more than half a century but, as we have shown you, things are beginning to change. A Japan that does not rely on the United States for its security means that the BOJ will no longer feel the need to cooperate with the Fed. As a result, a rearmed Japan will realize that it has an even more powerful Dollar weapon than China (the second largest holder of U.S. Treasuries) does. Eventually, these two Asian central banks will stop accumulating treasuries and possibly begin to unload them, which could trigger a Dollar collapse. Even more threatening to the Dollar is a possible alliance among Asian countries with the desire to form their own regional currency similar to the Euro. While all of these scenarios are just talk, the common denominator among them is a Japan which no longer relies on America for its protection. The bottom line is that the more you hear about the changing role of Japan's military, the closer we are to a major Dollar devaluation.

more follows for subscribers . . .

Todd Stein & Steven McIntyre
Texas Hedge Report

Todd Stein & Steven McIntyre are internationally known analysts and editors of The Texas Hedge Report, a market newsletter that highlights under and overvalued securities in the equity, bond, currency, and commodity markets. For more information, go to http://www.texashedge.com

Copyright © 2004-2008 Todd Stein and Steven McIntyre

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