COVER STORY • Japanese Economy After the Olympic & Paralympic Games Tokyo 2020 • 2

WInterview with Will Denyer, US Economist at Gavekal Research Hong Kong Officeorld Economic Outlook for 2020
– Optimism with Prudence
About Policy Uncertainties

By Japan SPOTLIGHT

As political risks around the world continue, such as the US-China tech cold war, concerns about their
negative impact on the world economy are also increasing. Economic forecasts today are simply analyses
based on econometric models. Business economists are perhaps better qualified to estimate the future
trends of the economy rather than theoretical economists.
In the following interview Will Denyer, a Hong Kong based economist at consulting and researchcompany Gavekal Research, offers his insights into the current global economy and its prospects in thenear future.
(Interviewed on Oct. 28, 2019)

General Assessment ofCurrent World Economy

this is the situation today.
Interest rates get “too high” when, in realterms, they exceed the prospective rate of
JS: First of all, looking at yourreturn on capital in the US. If entrepreneurs
general assessment of the world
cannot expect to generate a return in excess of
economy and Asian economies,
their borrowing cost, they will not borrow towould you say you are somewhat
invest. Growth suffers and a recession
optimistic about both?
becomes likely. At Gavekal, we call this anegative “Wicksellian Spread”, after the late
Denyer: Yes, I am relatively optimistic on
Swedish economist Knut Wicksell who madeglobal growth in 2020. My first reason forthis simple observation. Today, the Wicksellian
optimism is that financial conditions are
spread, between the return on capital and its
generally supportive. The biggest change ofcost, is quite positive – at least in the US,
recent months has come from the United
where I have the best data; though it seems
States, where the Federal Reserve shifted fromlikely to be true in other parts of the world as
a tightening policy to easing over the course ofwell.
2019. Other major central banks have either
The second reason I am relatively optimistic
Will Denyer
maintained accommodative policy stances, oron growth outside the US is that the highlymade them even more so. Long-term interest rates are also depressedvalued US dollar gives US businesses and consumers more– not just for government bonds but also private sector borrowing
purchasing power to buy imports from the rest of the world. Already,rates. All this does not rule out a recession, but it makes it less likely.
we are seeing a gradual deterioration of the US trade balance (despite
This perhaps separates me from some other commentators; somethe support of the US shale energy boom). I expect the US dollar topeople see the recent decline in bond yields and the resulting yield
weaken from here, but it will be some time before it swings back tocurve inversions in the US and elsewhere as a sign of a looming
undervalued territory. In the meantime, this should be supportive ofrecession. That is understandable given that in the US at least an
US imports and rest of the world growth.
inverted yield curve has been a pretty good indicator of recessions one
Of course that story has been complicated by the trade war andor two years later.
Brexit uncertainty. Both of these geopolitical concerns have damaged
However, inverted yield curves do not cause recessions. Too highgrowth around the world, but more so in countries that have relatively
interest rates do. Quite often those two things happen together, hencehigh exposure to trade (such as in Europe and Asia) and to Brexit
the relatively good track record of predicting US recessions. But(which has hurt not only the United Kingdom but also its biggest
sometimes the yield curve inverts, despite interest rates across the
trading partners in Europe). While parts of the US economy have also
curve remaining relatively low. This is when we get false positives. And
been impacted, the overall US economy has relatively less exposure to
8 Japan SPOTLIGHT • January / February 2020

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COVER STORY 2

trade, and thus the US has outperformed.
Thus, my final reason for optimism for global growth, andparticularly growth outside the US, is that there seems to be tentative
signs of improvement on the trade war and Brexit fronts. It is too soon
to celebrate, but there is reason to hope for at least marginal
improvements. That would be more good news for global growth in2020.

Impact of Policy Uncertainty on the Global
EconomyJS: I am curious about your assessment of the effectof uncertainty on policy making. Today, uncertainty is
increasing, and that would be a negative factor inparticular for private investment. How would you
assess the impact of policy uncertainty on private
investment?

Denyer: I think that policy uncertainty is very detrimental toinvestment. Companies like to know the rules of the game; they like tomake projections. They have an expected rate of return on expected
capital, which they have to compare to their cost of capital. The morepolicy uncertainty there is, the more margin of error there is in theirreturn on capital projections. So I do think that policy uncertainty doessignificantly weigh on investment and is a reason why I thinkinvestment in the US and elsewhere has been weaker recently than you
would expect given the accommodative financial conditions – it isabsolutely a large counter-force.
On the trade war, right now we have two elements of uncertainty.
One is the tariff uncertainty, and the second is export controls. It looks
right now like the US is potentially de-escalating the tariff war, and thatwould be a good step in the right direction. But there is also the riskthat the US ramps up the export control war. Both of those are
detrimental to investment. At the specific company or industry level,
export controls can be even worse than tariffs.
In addition to the tariff and export control wars, obviously you have
uncertainty surrounding Brexit. Recent developments suggest the riskof a no-deal Brexit has gone down, or at least been significantly
pushed back, but there is still a lot of uncertainty around that. Once
potential investors in British assets have some more clarity on what
are the rules of the game in the UK, that should be a positive forinvestment growth in the UK and also for anybody who exports to the
UK (most notably other countries in Europe). So I do think that for
Europe, a resolution to Brexit – however it is resolved – will help
businesses to plan accordingly.
Stepping back to talk a little more structurally, we could be
witnessing the start of a regime change in the global security system.
Since World War II, the US has been the dominant force in the world.
It has surely made mistakes. But generally speaking, the US has used
its military power to ensure relative peace and stability around theglobe. Critical to the global economy, the US has used its military force
to secure shipping lanes, and this underpins a lot of the globalizationthat we have seen.

That, however, is not a cheap endeavor. And the US fiscal outlook is
now deteriorating, thanks to an aging population and a pay-as-you-go
welfare system. Combine that with recent exhaustion over wars in the
Middle East and the fact that the US has found a way to extract a ton ofoil from shale, and there doesn’t seem to be a lot of appetite in the US
for continuing to be as interventionist as it was in the past, continuing
to be the police of the world to keep shipping lanes secure. There areinstead more efforts to get major powers around the world to financetheir own security and to secure their own shipping lanes and boats asthey travel around the world, and to secure their own regions. That
doesn’t necessarily need to be a disaster – there are arguments that a
multipolar world might be more secure in some ways, more equitableand better for global trade. But that is a big if, and when you have a big
regime change there is always the risk of disruption and uncertainty
during the transition, and frankly we don’t know how it is going tocome out on the other side.
So, while my base case is for relatively decent global growth in2020, there are risks.

Another Important Structural Question –Demographics
JS: You raise another structural question regarding

demographics. You say real yields will be higher due
to the change in demographic structure globally.
Could you elaborate on this point?

Denyer: I think demographics play an important role in determining
the cost of capital. We have seen a structural decline in the cost ofcapital around the world since the early 1980s. You can see that in all
major countries whether you look at real interest rates on bonds or theearnings yield in the equity markets, they have all shown a structural
decline since the early 1980s. Why? I think age demographics have a
lot to do with it, and perhaps for reasons that others may interpret
differently.
All prices are the result of the intersection between the intensity ofdemand and the willingness to supply something – and the same goesfor the cost of capital. You don’t need any statistics to tell you that aperson’s propensity to supply versus demand capital changes overtheir lifetime. When you are young, you tend to demand a lot of capitaland produce little. For example, you demand diapers, food, healthcare,education, and a roof over your head. And since you are producing
nothing at all at first, and then relatively little in the first part of yourcareer, most of this has to be financed either by gifts from yourparents or the state, or else borrowed.
Regardless, you are a net consumer of capital, and that tends to put
upward pressure on the cost of capital. It is probably not until
somewhere around your mid-30s that you start to make a lot of money
and start to hit your prime earning potential. By this point you haveprobably already finished your education and bought your first home.
You are still consuming, but now not as much as you produce. On net,
you become a saver. This means you are now a net supplier of capital,
and thus tend to have a negative influence on the cost of capital.
Japan SPOTLIGHT • January / February 2020

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People tend to be net “capital providers” between the ages of 35-64.
It is not a coincidence that a demographic bulge (known as Baby
Boomers in the US and some other parts of the world) started to reach
their mid-30s in the early 1980s. Over the last four decades, more andmore of that demographic bulge reached their peak savings years. The
result was a growing savings glut that drove down the cost of capital.
The issue now is that this demographic bulge is starting to retire, orat least pare their working hours. Meanwhile, they are starting toconsume more services like healthcare. They are becoming net
consumers of capital again, putting upward pressure on real yields. It
is not clear exactly where the turning point is, but it is somewherearound now, give or take a few years. I think this demographic change
is likely to cause a structural rise in real yields over the coming
decades.
JS: Japan has had an aging population for many years

already. Why haven’t interest rates already started torise in Japan?

Denyer: Japan is part of a global capital market, and thus its real yields
are subject to the global demographic situation. Capital moves aroundthe globe and is competitive. Thus, while nominal interest rates differ
in various parts of the world with different levels of expected inflation,
real yields on bonds of similar quality (e.g. government bonds in the
US, Japan, Germany and the UK) tend to track each other over thelong term. If I am correct that the global demographic picture is now
nearing an inflection point, then we should see real yields in Japan,
and elsewhere, start to rise going forward.
JS: This increase in interest rates - would it lead to

inflation or not?

Denyer: It depends on how the central banks respond. If the central
banks do not recognize that the natural rate is rising because of thisdemographic shift, fail to adjust accordingly, and thus get “behind thecurve”, then you could get inflation like we got in the 1970s. In the
1960s and 1970s you had a deteriorating capital provider ratio (that isa shift toward net capital consumers), and I don’t think that the central
banks of the world appreciated that, and we had inflation. It could
happen again. But it is also possible that central banks have learned
from that experience, will not fall behind the curve, and thus will keep
inflation rates basically stable. Even if they do that, you are going tosee a rise in real and nominal interest rates. You just don’t need tohave an increase in the spread between real and nominal interest rates.
They would just rise together.

Possibility of a Currency War
JS: Regarding the possibility of a currency war, you

are not so pessimistic, is that correct?

Denyer: While I can’t rule out a currency war, I have reasons for
optimism. First, economic theory as well as experience – including the
10 Japan SPOTLIGHT • January / February 2020

experience of the 1930s – show that trade wars and currency wars
generally hurt both sides. Both countries in a trade war or currency
war are hurt. Hopefully this serves as a deterrent. President Donald
Trump has been making a lot of protectionist moves andpronouncements, and the general global view toward that action has
been negative and has continued to be negative to this day. I don’t heara lot of other countries agreeing with Trump about turning
protectionist. There are people who think Trump may be justified inusing tough negotiating tactics to try to get China to change its
practices, and some think Trump may be correct to renegotiate sometrade deals that weren’t fair, but I don’t think that the general view inthe world is that protectionism is a good thing. In fact, while there has
been this major trade dispute between the US and China, at the sametime free trade agreements have been signed between other countries.
Even the US has negotiated some new trade agreements.
The second reason for hope is more about the stick than the carrot.
The US seems more ready than ever to punish countries that it deems
to be currency manipulators; we will see how effective that is, but the
US does have quite a bit of leverage there and it should be adisincentive to currency manipulation.
People typically complain that the European Union has a hard timeagreeing to major changes. In this case it could be a benefit. With somany parties involved, it is unlikely that the euro area would adopt a
policy of active currency depreciation – especially since Germany has
bad memories of currency debasement. China has obviously shown
itself to be willing to devalue its currency in the past; however, allindications we have are that China is quite serious about trying tointernationalize the renminbi and to improve its reputation globally. If
China starts doing major currency devaluation then that is going toundermine that goal, not to mention angering the US and other global
trading partners. And so far, China has not devalued its currency. It has
allowed its currency to adjust to external shocks, such as the US
tariffs, but as far as we can tell it has not done active devaluation, andwe don’t see it on the radar right now.
These are the reasons why I don’t see us descending into aninternational currency war.
JS: You mention the internationalization of theChinese renminbi. Do you think the renminbi’s global
status is going to rise significantly?

Denyer: The US dollar is obviously the dominant reserve currency
today, followed by the euro. China has a lot of progress to make before
it challenges either of those two major currencies, but things do seemto be gradually heading in that direction.
China is doing a lot of the right things to promote global use of therenminbi. For example, it has been setting up bank branches aroundthe world; it has currency swap agreements with many central banks.
It is doing a lot of trade and international investment. These are allthings that make the renminbi more attractive to foreigners. These are
all things that increase its convenience and the stickiness of its
demand.
There are still issues that China needs to work on. Negatives include

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still having at least a partially closed capital account, although that is
opening more and more every month. Also, it is not a democracy.
China has a one-party system and there are questions about whether
this matters or not for trust in the currency. But generally speaking I
think the balance of evidence points to the renminbi gradually rising in
global status going forward.
At the same time, the US is increasingly using the dollar payment
system to achieve geopolitical aims – the so-called “weaponizing of
the US dollar”. I am not casting a broad judgment on whether the US
should do that or not, but the fact that it is doing it undermines theglobal status of the dollar. Countries, companies and people who
cannot rule out someday having a disagreement with the US
government now have to question their reliance on the US dollar. For
those not willing to take the risk of having their assets frozen or
becoming unable to make international payments, it is time to consider
alternative currencies.
At the same time, the US fiscal outlook is worsening quite
substantially. The last time we had a major change in the global
currency leadership role was when the US dollar overtook the British
pound, and this occurred in the decade following 1913. It was a resultof a number of factors, one being that World War I was very
detrimental to the fiscal outlook for the UK.
Moreover, after 1913, the US encouraged its banks to start
branching out around the world, and it had a new central banksupporting the market for trade credit. Basically, the US had re-geared
its policy structure to encourage the dollar to become a global
currency. There are a lot of similarities with what China is doing today.
For all those reasons, I expect the renminbi to gradually take market
share away from both the dollar and the euro.

Innovation Stifling Due to US-China ColdWar
JS: This US-China technology cold war would be badnews for trade and investment, but also forinnovation. Perhaps more Chinese companies will be
put on the US blacklist for a ban on trade andinvestment. That would have negative impacts oninnovation as well.

Denyer: Absolutely. It does look as though the tariff war may beeasing, while the war of export controls could linger on or even ramp
up further. One key question is: what does the US truly seek toaccomplish with its increased use of export controls? Is it really about
forced technology transfers, technology theft, and human rights
violations? If so, then there is at least the possibility that the Chinese
government and other relevant actors might change their behavior
enough to satisfy the US, and then export controls may soften.
However, if the true goal of the US is to either slow China’s
development or get China to fundamentally change the way it manages
its economy, then it becomes extremely unlikely that China will
somehow satisfy the US. In this case, the export controls are likely tostay – at least until there is a change of strategy from the US. For now,

export controls are a feature of the investment landscape, and so longas they exist, they will stifle innovation.
JS: Such stifling of innovation could have cruciallynegative impacts in other countries, as global
innovation itself could be retarded by this kind ofcold war. Would you concur?

Denyer: Absolutely. I think that there is no way that two of the threelargest economies in the world can be retarding information sharing
without that being negative for global innovation. If it were two tiny
countries then it probably wouldn’t matter, but two very large
countries putting up barriers to information sharing has to be negative
for global innovation, and that is especially true because of the waythat the US is imposing its export controls. The controls apply not only
to US-made products, but also to some products made overseas using
a sufficient amount of controlled US-origin technology. This will haveglobal ramifications.

Role of International Organizations in
Mitigating Uncertainty
JS: I believe that such policy uncertainty comes froma lack of rules and international cooperation. How
can we mitigate policy uncertainty? Could
international organizations or forums such as APEC
mitigate that kind of negative impact emanating fromthe US-China trade war?

Denyer: I concur wholeheartedly. Having free trade and clear rules of
the game encourages growth and innovation for all those involved. It
can also serve as a good example for others to follow. The US has in
the past led by example. Since World War II, the US has not only
secured global shipping lanes, as previously discussed, but also led byexample in terms of promoting free trade. The US has tended to haverelatively low import tariffs and non-tariff barriers to trade,encouraging others to follow suit. That has significantly reduced policy
uncertainty in the world, because the world could count on the US
being committed to free trade, even when others were not. That has
arguably gone away, because now the US is tired of leading by
example and is starting to use the carrot as well as the stick to try to
get behavioral change, to put it nicely. To the extent that anorganization like APEC or a country like the UK or a region like the EU
can continue to lead by example regardless of what the US and China
may do, that would lower policy uncertainty and promote global
growth.

Written with the cooperation of Joel Challender, who is a translator, interpreter,
researcher and writer specializing in Japanese disaster preparedness.

Japan SPOTLIGHT • January / February 202011