A Japanese Crisis Nears

by James Gruber on August 10, 2013


A quadrillion yen debt
To tax or not to tax
The risks from Septaper
Trading it

Japan has receded from the headlines of late but that’s about to change. In the next two months, it’s expected the Prime Minister Shinzo Abe will make a decision on whether to increase Japan’s consumption tax from 5% to 8% in April next year. If approved, consumer spending will take significant hit and given that it accounts for around 60% of GDP, hopes for an economic recovery could be dashed. If the tax hike is delayed on the other hand, rating agencies are likely to downgrade Japanese debt, resulting in increased interest costs - the last thing that the massively indebted country needs. International investors would also lose faith in Japan’s turnaround strategy. Either way, it appears a lose-lose situation.

Much less talked about is the impact on Japan from possible QE tapering in the U.S.. If America decides to cut back on money printing next month, and interest rates there rise as a consequence, that would put upward pressure on rates around the world. That’s not what Japan needs given that only a small rise in rates would result in its government debt burden becoming overwhelming – interest rates increasing to just 2% would mean interest expense on government debt equating to 80% of government revenue.

Either of these events may bring forward a Japanese sovereign debt crisis. Long-time readers will know that I view such a crisis as inevitable with the government debt load so large that there are no good choices left. Keep in mind that a Japanese debt crisis would have enormous global consequences. Unlike Greece or Cyprus, Japan matters. It’s the world’s third largest economy and a key trading partner to all of the large powers. How Japan plays out for the remainder of 2013 will be of critical importance to everyone.

A quadrillion yen debt
Over the past week, Japan celebrated an unusual feat: total government debt passed the one quadrillion yen mark. That’s 1,000,000,000,000,000 yen (15 zeros if you’re counting). Of course, it’s not so daunting in U.S. dollar terms, at a measly US$10.5 trillion. Still, the debt versus the country’s GDP is 230%, the highest in the developed world. And if you add in corporate and private debt, total Japanese debt equates to 500% of GDP. 

It’s a reminder of the enormous task that Japan’s relatively new government faces: how does it reduce this staggering debt without impoverishing the country? We’re about to get a further glimpse into whether the government is heading in the right direction when preliminary GDP figures are released on Monday. Optimists, including the vast majority of economists and stock brokers, suggest that Monday’s figures will confirm that the economy is improving and the government’s policies are having an impact.

And on the surface, things do appear to be progressing:

  • Inflation has turned positive. The consumer price index (CPI) turned positive in June, +0.4% year-on-year (YoY). Core CPI, excluding more volatile items such as food and energy, was still negative however at -0.2%, though it was an improvement from the -0.4% of the prior month.

Japan CPI

  • Nominal wage growth has turned positive, +0.4% YoY in June. The unemployment rate also fell to 3.9% in June, the first time it’s been below 4% since October 2008.
Nominal wage growth
  • Exports are bouncing back, led by U.S. demand. A weaker yen has helped the cause.

  • The Japanese government is continuing to ramp up stimulus with the aim of doubling the monetary base over the next 18 months or so. 

BoJ purchases

That’s not to mention that the stock market is significantly up this year and the bond market has stabilised after some sharp volatility a few months back.

So all is rosy? Not so fast. The increase in nominal CPI has been almost solely due to higher energy costs. That’s because a weaker yen increases import costs and Japan needs a lot of energy as it isn’t self sufficient.

More importantly, it means costs are going up and wages are only keeping pace. In other words, real wages (wages less inflation) aren’t growing, stuck at 0%. With real wages going nowhere and a likely consumption tax hike on the way, it doesn’t make for a bright picture. Real wages have to start rising for Abenomics to work.

And the bigger problem is that government debt is continuing to rise. Currently at 240% of GDP, the International Monetary Fund estimates that it will get to 250% by year-end. Why is this an issue? Well, when you have government debt at 24x government revenue and interest expenses taking up 25% of government revenue, it becomes a very big issue. Rising interest expenses mean Japan has less to spend on other things, such as social security for its ageing population.

Now, the government has several choices to fix the problem. It can cut the debt, but that would induce an immediate recession or worse. Or it can seek to raise revenue and GDP. This is what the government has chosen to do.

Increasing nominal GDP (real GDP plus inflation) is easier said than done though in a country that’s been going through two decades of deflation. To give you some idea, current nominal GDP is at the same level as it was in 1995.

Without going into too finer detail, the government is trying to lift nominal GDP by increasing real GDP and inflation. Real GDP is a function of population growth plus productivity growth. Japan has a declining working age population, which makes the task extremely difficult. If you working age population declines by 1%, you roughly need a 3% increase in productivity (not achieved by many in the developed world) to get to 2% GDP growth.

That leaves inflation. And on this front, the government is going to extraordinary lengths. It’s printing 7.5 trillion yen (US$77 billion) a month to buy Japanese government bonds. The idea being that these bonds are bought off financial institutions who will then have more money to lend, thereby inducing higher inflation (more money versus goods normally results in higher prices paid for those goods).

Here’s the rub though. If the government succeeds with its aim to get inflation up to 2%, it’s likely to result in interest rates increasing to +2%. Remember those interest expenses alluded earlier? Well, if rates do rise to 2%, that would result in the interest expense on government debt being 80% of government revenue. Obviously, this would lead to a serious bond market crisis.

On the other hand, if the government doesn’t succeed in increasing real GDP or inflation, then the debt will continue to compound and interest expenses will continue to rise. At some point, the bond market will inevitably revolt.

Either way, it appears to us that Japan is at the point of no return.

Two upcoming events could prove catalysts to bring forward a crisis.

To tax or not to tax
The first event is a decision in the next few months on whether to increase the consumption tax from 5% to 8% in April next year. There’s widespread speculation that the Prime Minister Shinzo Abe is wavering in his commitment to the tax hike, with his economic team split on the issue.

Abe has put together a so-called team of experts to examine the economic impact from a tax increase. He’s expected to make a final decision next month.

On this issue, Abe has an unenviable task. He’d love to bring in badly-needed revenue via the tax. Extra revenue would mean more money to pay for the government’s interest expense and spending on other things too. But he doesn’t want the other expected impact from a tax increase: reduced consumption. After all, consumption is 60% of Japanese GDP.

And the history of consumption tax increases doesn’t make for pleasant reading. In 1997, Japan increased the consumption tax from 3% to 5%. Soon after, the country went into recession and debt to GDP soared. While it’s true that the Asian financial crisis at that time played significant part in the Japanese downturn, there’s also little doubt that the tax hike had an immediate and negative impact.

Japan GDP 1997

The other option is to delay the tax hike. Debt rating agencies have already hinted that such a move would likely result in a downgrade to Japanese debt ratings. The impact from that would be higher debt expenses. Not to mention more volatility in the local bond market. The move would also have the unwanted effect of international investors losing faith in the government’s turnaround program.

There is a third option though that may prove the most politically viable. That is, combining a consumption tax increase with a supplementary budget and business capital expenditure tax incentives. In essence, there would be stimulus measures to try to ease the impact from the tax increase. Whether the move would offset the tax rise is the big question. The odds are that it wouldn’t.

As you can see from the consumption tax debate, Japan has no good choices left, only less bad ones. And a final decision on the issue could well prove the catalyst for a full-blown debt crisis.

The risks from Septaper
There’s another risk to Japan’s turnaround strategy that’s received little coverage. The U.S. is expected to make a decision on whether to cut back on its QE program next month (dubbed “Septaper”). If it decides to taper the US$85 billion a month program, there is a substantive risk of rising interest rates.

The central bank has been falling over itself to explain that tapering doesn’t have to result in higher interest rates. It’s desperately trying to convince the markets of that. But the fact is that it only control short-term rates, not long-term rates. The latter is controlled by markets and they will decide the direction of those rates.

As mentioned, the risk is that rates will rise. What’s been little talked about is the impact of higher U.S. rates on the rest of the world. Rising U.S. rates would put upward pressure on rates across the globe.

That’s where Japan comes into the picture. It’s trying to produce inflation without a corresponding rise in interest rates. And as mentioned earlier, if rates rise a small amount in Japan, a debt crisis is guaranteed.

You can be sure that Japanese government officials are nervously awaiting statements on QE from Mr Bernanke in the coming weeks.

Trading it
Ok, you’re probably saying, I get it: Japan is in big trouble. But how do I make money from this? Let’s run through some of the options:

Stocks. Stocks offer some value, particularly on a cash flow basis. And they’re still remarkably depressed, down more than 60% from the highs of 1989. I know of several exceptional fund managers who are very long the Japanese stock market. But after the huge recent run-up and the enormous risks from a nearing debt crisis, stocks are unattractive, in my view.

Bonds. Shorting Japanese government bonds has been called the widow trade as so many traders have previously tried this strategy and failed. I have few doubts that a Japanese debt crisis will emerge principally via the bond market. However, the government will stop at all costs to keep bond yields low. That makes for extraordinary volatility going forward. In other words, timing this trade so that you make money will prove difficult.

The yen. Ah, the simplest way to short Japan is via shorting the yen. Government intervention is limited. The government needs a low yen for import prices to rise and induce inflation. My bet is that the government will get more than it bargains for. That is, a debt crisis will result in the yen spiralling a lot lower than it wants, and quickly.

Of course, this analysis leaves out some of the more complicated and exotic strategies to try to take advantage of a Japanese sovereign debt crisis. We’ll leave that for another day.

All the best,

James

{ 2 comments… read them below or add one }

James Gruber August 11, 2013 at 8:14 am

Tim,

Great questions. On the first issue, the average tenor of the stock of JGBs is 4 years, likely to be 4.7 years by the end of 2013. The average tenor for the total JGB market is 7 years. This is short vs other countries. The BoJ has been attempting to lengthen the average tenor during recent operations, targeting 7 years. That future endeavour obviously depends on the willingness of financial institutions to come to the party. There’s not a lot of leeway in terms in time, in my view.

On your second point, it’s true that ratings downgrades have had little impact on the US and others. You’re right: investors won’t take such a downgrade of Japanese debt in a bad way. What’s more important though is that a delay in the consumption tax hike would mean less revenue for the government mean they need it most. And, investors won’t view the government backpedalling on reform in a favourable light. That’s crucial because they’re the ones funding the government.

Some will retort that investor confidence doesn’t matter because 94% of JGBs are owned by domestic investors. But that misses two current trends. The first is the deterioration in the current account which may soon result in Japan requiring funding via overseas investors. The second is that Japan’s ageing population means pension funds are no longer net buyers of JGBs as the elderly withdraw money to fund their retirements. In other words, Japan is likely to need more international investors to fund their debt requirements going forward.

I hope that addresses your questions.

James

Tim August 10, 2013 at 11:50 pm

Hi James, a couple of questions/comments: first, i wonder what the average debt tenor of JGBs is, because obviously if its a long period, then a rate rise now will not impact the average debt coupon for quite some time, which may push a crisi further into the future, giving the economy/government more time – what’s your view? Secondly, credit rating agencies have had little impact on French, UK or US rates when they downgraded those governments, so do you think the markets will react differently if the rating agencies downgrade Japanese government debt or have the markets already taken such a downgrade into account?

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