It may not happen next week, but it will happen. It appears that Japan is on an unstoppable path to financial Armageddon.
Over the past 20+ years, the Japanese economy has unwound the excesses caused by a giant property and financial bubble. At the same time, the country's aging demographics has increased social costs while the pool of taxable labor declined. Consequently, Japan has stagnated and repeatedly dipped into deflation.
This spring, the Bank of Japan (BofJ) announced insanely aggressive monetary expansion to finally break the deflationary curse by targeting a 2% inflation rate within 2 years. Unfortunately, I believe this policy move simply shortens the time until Japan meets its fate.
While many Americans see Japan as a far-away land of little concern, this is a massive oversight. Japan's economy is the third largest in the world, Japan owns massive amounts of US Treasuries (NYSEARCA:TLT) and Japanese financial institutions are intertwined with the global market. If Greece can heat up S&P 500 (NYSEARCA:SPY) volatility (NYSEARCA:VXX) across global markets, a shock in Japan would set the global financial market ablaze.
Introducing the Vicious Japanese Debt Spiral
The next few charts will help illustrate why Japan is likely trapped in a vicious debt spiral. This first chart is the most straight forward. It highlights the cumulative growth of outstanding Japanese Government Bonds. As you can see, Japanese indebtedness has risen at an increasing rate over the years.
The speed of Japanese debt growth is partly attributable to the shifting demographic profile of the country. An aging population requires increasing amounts of social benefits. At the same time, a growing proportion of retirees means that government tax revenues decline. In addition to the demographic budget tug-of-war, the Japanese fiscal profile is stretched by numerous failed attempts at Keynesian policies meant to revitalize aggregate demand by building bridges to nowhere.
The following chart illustrates the results of this predicament. Since the height of the Japanese stock market (NYSEARCA:EWJ) in 1989, government revenues have declined while expenditures have risen. The budget gap, which was once manageable, is now massive.
Here's the good news: Fortunately for Japan, all this debt accumulated to pay for a widening budget deficit hasn't been onerously expensive. In fact, since Japan's 1989 peak, interest rates have fallen dramatically, thus lowering the cost of debt servicing. The chart below shows how total interest payments have essentially remained flat even while total debt levels skyrocketed. The graph also plots the reason why: falling interest rates.
Now the bad news: Unfortunately, the Bank of Japan's massive reflationary attempt could end the debt service advantage that has saved Japan for more than a decade.
According to a recent article:
"Japanese investors seem to be starting to buy foreign bonds gradually," said Yunosuke Ikeda, the head of foreign-exchange strategy at Nomura Securities Co. in Tokyo. "With U.S. yields likely to rise, the market is tilted toward dollar strength as the view is taking hold that an end to quantitative easing will be discussed sometime this year."
The Bank of Japan's attempt to drive inflation to 2% is a stake through the heart of the traditional buyer of Japanese Government Bonds - domestic savers and pension plans. A 2% inflation rate applied to a 0.69% 10 Year Japanese Government Bond means that investors must be willing to accept a -1.31% real return. Moreover, foreigners buying Japanese Government Bonds must be willing to accept payment in a weakening Yen or be willing to pay for the cost of hedging currency exposure.
Already, we are seeing a shift in demand for Japanese Government Bonds. Domestic investors are moving assets overseas leading to a greater reliance on foreigners to finance Japan's budget deficit. But with the prospect of negative real returns and a falling Yen, foreign investor interest is likely declining and Japanese Government Bond yields are primed to rise. This is in fact what we have been witnessing since the BofJ intervention began.
Unfortunately, rising yields means that the Japanese government must fill its budget gap with increasingly expensive debt.
Japan has no choice - as you can see in the chart below, Japan's 'Bond Dependency Ratio' (the proportion of expenditures paid for with debt) is close to 50%. In other words, to keep the Japanese economy alive the government must issue debt regardless of the cost.
Japan's rescue attempt is already self-destructing their economy. The battle to raise inflation is killing what little appeal Japanese Government Bonds once had, while Japan's dependency on debt means it has little choice but to pay the higher cost. Over 55% of the Japanese government's expenditures goes to service debt or pay for social security. With a debt dependency ratio close to 50%, Japan essentially must borrow just to pay for these non-discretionary expenses. As rates rise and the population ages these non-discretionary expenses are expected to rise, thereby increasing the amount of debt required.
Accelerating inflation expectations, rising debt costs, growing social expenditures, declining investor appetite and high dependency on borrowed money could lead to a spiral in which Japanese bond yields rise very quickly, borrowing rises dramatically and the Yen falls precipitously. This situation would be financial Armageddon for Japan as it would no longer be able to pay for its basic obligations without fully monetizing its debt. The country would default on its debt and obligations to its citizens, either outright or by way of hyperinflation. The country's economy would implode and massive financial institutions would likely collapse.
When will this happen? Nobody knows. Some would argue that it has already started, with yields up about 20% over the past month (the 10 year Japanese Government Bond yield has risen from 58bps to 69bps) and the Yen breaking through 100 per dollar.
Of course, financial Armageddon is only one theoretical possibility. Perhaps Japan discovers a way to grow out of this mess. Perhaps the BofJ's massive expansionary policy has an impact on Japan's real economy. Or maybe Japan kicks the can down the road for another decade or two. In my opinion, however, all of these theoretical alternatives are highly unlikely.
If the crisis I foresee unfolds it could make 2008 look like a blip. If such an event occurs, investors should prepare to diversify across a range of assets, such as short-term US Treasuries (NYSEARCA:SHY), gold (NYSEARCA:GLD) and US dollars (NYSEARCA:UUP). I suggest diversifying because nobody can predict which asset class will perform best during an uncharted crisis like this.
Regardless, my most important recommendation is this: keep watching Japan's ability to pay its debt, particularly as reflected by Japanese Government Bond yields. The more Japanese Government Bond yields rise, the more I would be scared of impending financial Armageddon.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Graphs sourced from Japan's Ministry of Finance. This is not advice. This is the opinion of the author. While Plan B Economics makes every effort to provide high quality information, the information is not guaranteed to be accurate and should not be relied on. Investing involves risk and you could lose all your money. Consult a professional advisor before making any investing decisions.