Japan Downgraded: Korea Needs to Avoid Deflation

You Know It's a Problem When...Japan Downgraded by Moody's
Today, Japan was downgraded from AA to AA- by Moody's, one of the two most important ratings agencies.  These agencies are widely used by global investors when they consider whether or not a country's government will be able to repay its debts.  We can debate, and there are those that would sharply criticize whether or not these ratings agencies are useful, given the fact that they have largely missed the financial crisis on a systematic basis.  Nevertheless, it is still true that investors pay attention when large changes to ratings occur, especially to economies that are the size of Japan.  While there is no imminent risk to Japan, this gesture does reflect many of the things that the Seoul Gyopo Guide has pointed out on numerous occasions.  In fact, this post, which challenges why Koreans continue to learn the Japanese language, is one of the most-read posts on the Seoul Gyopo Guide.

The Japanese Quagmire:  Deflation
Recently, this article was written about Japan (Bloomberg.com).

Their (Japanese companies) advantage may be Japan’s disadvantage. Prices in Japan as measured by the gross domestic product deflator have declined almost without interruption since 1994. That has muted the effect of falling wages and provides a cautionary tale for Federal Reserve Chairman Ben S. Bernanke, who has been lecturing on deflation’s perils as a central banker since 2002.

“It’s (deflation) extremely corrosive,” said Richard Jerram, Singapore-based head of Asian economics at Macquarie Securities Ltd. “The problem is, it’s not a spectacular problem in any given month or quarter.”

Deflation will steadily sap nominal growth, depriving the government of revenue, until one day Japan will no longer be able to finance its borrowing, Jerram said. The country will either default on a debt of about twice the size of the economy or debase its currency to reduce the real value of liabilities.

What does any of that mean?  It means that deflation, over long periods of time, can result in the inability of those with lots of debt (like Japan) to either default, or to depreciate their currency (the Yen).  Today's downgrade of Japan by Moody's reflects this problem.  The downgrade's affect alone could very bad for Korea for a variety of reasons.  First, there are many, many Japanese tourists visiting Korea (go to Myung-dong sometime, all you hear is Japanese and Chinese, it seems).  If the JPY depreciates sharply, then the Japanese will not be able to afford to visit Korea.  Second, a depreciation in the JPY will make Korean-made products more expensive on the international marketplace.  Followers of the Seoul Gyopo Guide know that Korean corporations have feasted due to Korea's relatively cheap Won, when compared to the Japanese Yen.

The Korean Problem is Different But an Easy Answer is Difficult to Find
Korea, as everyday Koreans know, faces inflation which is higher than the officially reported rate (people living in Korea are now all vigorously nodding their heads in agreement).  You know that inflation is a problem when the English-written news sites report it.  Well, that has now occurred. The problem actually is not inflation per se, but the real problem is that wages and nominal wealth (checkbook balances, stock market holdings, real estate values, etc) are not increasing at the same rate.  This has been due to a large number of different problems.  The result is that the average Korean feels poorer even though the employers (companies) continue to perform well.
The Seoul Gyopo Guide has suggested that greater amounts of equity must be owned by employees.  Korean employees have been very reluctant in the past to receive compensation in the form of stock.  The problem with this is that cash does not have the possibility of appreciating at the same rate as inflation.

Korea Needs to Avoid The Japanese Example
Some of the Japan's problems may have been unavoidable, but Korea needs to observe, and prevent some of the causes for the current situation in Japan.  First, it is clear why US Federal Reserve Chairman Bernanke has been trying to avoid deflation:  Japan has unable to escape deflation's clutches for two decades.  Second, there is the longer-term issue of an aging population, who do not spend on the newest products and who do not treasure the newest innovations.  This is a little-mentioned, but critical factor in understanding why Korea has prospered.  Young Korean consumers demand the newest features, and thus, Korea serves as a "testing ground" of sorts for the global marketplace.  While it is a blatant stereotype to suggest that Korean consumers are choosier than almost any other consumer group in the world, it may, in fact, be true.  (If a product fails in Korea, then it is likely to fail abroad.  In addition to the joint ventures that Korean companies have had with US-based entertainment companies such as Dreamworks SKG, many first-run films actually open in Korea for this reason.)  Third, Korea must avoid huge national indebtedness.  This point should be obvious, given that the IMF crisis was largely the result of the huge debt overhang in Korea.
Many aspects of life in Korea reflect Korea's reluctant jealousy of Japan.  Korea's corporate structures and methods could (although not exclusively) resemble Japan's.  Both countries are highly dependent on foreign energy resources.  Korea may not, over time, be able to avoid some of the larger forces at work in Japan, such as an aging population.  However, many of Japan's difficulties can be avoided so that Korea does not suffer from Japanese-style deflation.