In the summer of 2010, a little-noted milestone took place. China passed Japan to become the world’s second-largest economy. Now, Japan needs to keep an eye on the rear-view mirror. Germany and Brazil are gaining ground and may overtake the Asian country in coming decades as well.

Japan’s steady decline  — relative to other economies — can be attributed to a pair of factors: A rapidly-aging population and a too-strong currency. These two factors are crimping demand for goods and services at home, as well as foreign demand for exports.

This isn’t a new story. The Japanese economy has barely budged in the past two decades after a 40-year spurt of strong growth. Though the economic weakness has been mild, helping the country maintain full employment, cracks have begun to emerge and the pace of economic erosion may soon accelerate. 

Problem is, this is not just worrisome for Japan, but also its neighbors in Asia, along with the United States and key European trade partners. That’s why investors need to stay abreast of events in Japan. 

Short sellers have been surely aware of the troubles in the Asian country. In just the two weeks ended Oct. 31, the short interest in the iShares MSCI Japan Index fund (NYSE: EWJ), has doubled in size, to a whopping 19 million shares. 

Debt and trade: worrisome signs
To see why short sellers are piling on, you need only look at Japan’s balance sheet and its cash flow statement. On the balance sheet, you’ll find a country with a staggering amount of debt. Here in the United States, our national debt is now more than 100% of gross domestic product (GDP). In Italy, that figure has risen to 120% while in Greece, it’s up to 160%. Japan’s debt-to-GDP: roughly 230%. Japan’s government debt is now larger than all 17 Euro member nations combined.

Even if Japan’s economy doubled in size while debt stayed constant, it would still have one of the highest relative debt loads in the world. Trouble is, Japan’s economy will not be doubling in our lifetime. In fact, it’s not clear that Japan’s economy will grow much at all in coming years: Japan’s economy generated 537 trillion yen of economic activity in 2005. That figure in 2011: stuck at 537 trillion yen. China’s economy grew nearly 50% during that time. For further context, Japan’s inflation-adjusted economic size is the same size as it was — back in 1993. The fact that Japan’s population is expected to shrink in coming years will make it even harder for GDP to grow.#-ad_banner-#

Indeed, it looks as if Japan’s economy may actually be shrinking, as a too-strong currency — coupled with a trade spat with China — is crimping the export sector. Japan’s government just announced the economy shrank at a 3.5% annualized rate in the third quarter (compared with the second quarter). 

Simple math implies that a smaller economy means an even higher debt-to-GDP ratio. Of course, the government has begun to think about stimulus programs to fire up the economy, but with such high levels of debt already in place, further borrowings run real risks: What happens if global investors get spooked and become less comfortable buying Japanese bonds at ultra-low rates? Simply put, Japan’s staggering debt load would look even worse if interest rates (and expenses) sharply increase.

To avert catastrophe, the Japanese government has proposed a series of tax hikes, especially in the form of sales taxes. But those hikes would be cancelled if the economy slumps, as now appears to be the case. As it stands, fully 40% of the proposed 2013 Japanese budget will need to be funded with debt. 

Japan’s greatest strength has always been its massive export-oriented industrial sector. But that pillar of strength is now weakening. Exports fell 10% in September from a year ago, while machinery orders and industrial production also showed big drops in September. 

As is the case with companies, a country can also shore up its balance sheet (and pay down debt) by showing positive cash flows. And surely enough, a solid base of exports has enabled Japan to generate consistent trade surpluses that have brought cash in the door. Moreover, Japanese culture has been that of notorious savers. In the 1990s, many companies saved 44% of their earnings, depositing the funds in low-interest accounts that gave those companies essentially free money. In effect, a persistent trade surplus and a high savings rate have been able to offset rising fiscal deficits.

Not anymore.

First off, Japanese citizens are no longer big savers: They now save just 2% of their income. And trade surpluses now look like a thing of the past as China takes over as “the world’s factory.” In the first six months of fiscal 2013 (which ends next March), Japan generated a $40.6 billion trade deficit and is headed for its largest annual deficit on record. That rising deficit is not just due to falling exports. Japan’s imports are rising, especially in the area of energy supplies as the country steps back form nuclear power. 

To be sure, Japan’s demise has been anticipated for quite some time, but the country has managed to tread water for nearly decades. Yet the key factors holding up the economy indeed appear to be finally eroding, and Japan is now emerging as one of the world’s leading trouble spots.

Risks to Consider: Upside risks are few. Japan possesses a considerable base of assets and could start conducting fire sales to raise funds, but that creates further long-term weakness as many of these assets (such as real estate) are cash flow producers.

Action to Take –> Short sellers are anticipating an imminent crisis for Japan. They note that the current Japanese Prime Minister is getting a great deal of resistance with his fiscal plans (and if history is any guide, won’t be in that position for very long anyway). If the government enters a phase of paralysis, right at a time when vital action is needed to boost the economy and reassure global bond markets, then events could spiral out of control. 

In the interim, you may want to hedge your global market exposure by joining forces with the short sellers and target the iShares MSCJ Japan ETF.