A False Dawn In The Land Of The Rising Sun

by: Lares Capital


Japanese equity market has been the top performing market, returning 33% in 2013 and 66% over a year period. Investors credit the new "Abenomics" policy, named after new Japanese Prime Minster Shinzo Abe. The core of its policy is a Japanese version of the Quantitative Easing, a massive purchase of bonds by Japanese Central bank to flood the economy with liquidity, force the asset prices up, and defeat the deflation (the new apparent "root of all evil").

I will provide ample evidence in this article that while deflation is economically harmful, it's only a symptom of a much more serious disease, which cannot be defeated by only economic or monetary means: declining and ageing population. While I have to give some credit to Abe for "trying something" compared to his feckless "status quo" predecessors, I believe that in the absence of drastic immigration reform, Japan will soon hit a point of "no return" and will become insolvent.

A short history of "Quantitative Easing" (QE)

Quantitative Easing is a translation of a Japanese term that first appeared in Bank of Japan publication in March 2001 to describe a policy of swapping bank assets for cash to inject liquidity and force banks to make loans. Bank of Japan theorized then that the excessive banks' reserves earning nothing would have to be lent into economy to earn some return. Bank of Japan already maintained the rates at near zero since 1999 but still couldn't quite win the war over deflation. It embarked on a five year quest of purchasing asset backed securities and even equities in order to spur some inflation.

Fig 1: Japanese inflation in 2001 - 2006 (Source - IMF)

Here's a brief description of the Bank of Japan thinking in 2001 according to a Cleveland Fed's research paper:

"When it introduced the quantitative easing policy, the Bank of Japan also promised to maintain the policy until the core CPI either reached zero or rose on a year-over-year basis for several months. This inflation target was stronger than the Bank's zero interest rate policy, which only promised to maintain zero interest rates until the economy showed signs of recovery. Since inflation lagged economic activity and since the Bank had a history of being hawkish on inflation, the zero interest rate policy was not a strong commitment to a positive inflation rate. In contrast, the new commitment required clear evidence that deflation had ended."

Fig 2: QE1 in 2001 - 2006 (Source: Bank of Japan)

The studies of Cleveland Fed (2008) and Bank of Japan (2007) agree that the old QE policy was mostly a failure. As soon as the QE policy ended in 2006, the deflation returned and continued until this day (only to be briefly interrupted by the commodity bubble of mid-2008).

I expect the most likely outcome will be the same this time: return to the status quo after a few years. I will try to answer in this article why QE policy failed in 2006 and why it is bound to fail again in 2013.

The real Japanese problem

Despite nearly 23 years of economic underperformance, Japan is still the third largest economy, only slightly smaller the economy of China which surpassed Japan in 2009.

Fig 3: Four largest economies as measured in USD (the data may be slightly distorted by the currency fluctuations) (Source: World Bank)

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Japan experienced tremendous economic growth in the 1950-1988 period. For a short time in the mid-80s, it seemed to be on track to become the world's largest economy. Unfortunately, "Japanese miracle" was largely driven by a short-term demographics gains where the largest proportion of the population was of prime "work age" for a couple of decades. Interestingly enough, this is exactly where China stands today with its "one child" policy, but I digress.

Fig 4: Birth per 1000 population. (Source: World Bank)

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The number of births in both US and Japan had declined in the early 70s as the results of the "sexual" and "gender" revolution when women joined the labor force en masse. However, Japanese birth rate continued its decline and today more people die in Japan than are being born.

The demographics outlook for Japan looks outright frightening: nearly a full quarter of the Japanese population is above the retirement age (65 years old) and the population is projected to decline 25% by 2050, when more than one third will be over the age of 65. The prime working age population will shrink to its 1950 level.

Fig 5: Japanese population projections (Source: Census Bureau of Japan)

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Debt overhang disaster

The demographics headwinds would probably be more manageable if Japan did not rack up tremendous debt, mostly due to an exceptionally low rate of economic growth and an ageing population requiring ever greater public outlays.

The argument about unsustainability of Japan's astronomic figure of nearly 230% of debt to GDP ratio is often countered by the argument that the households and financial institutions have excessive savings. Looking at total debt picture still paints a grim scenario. Overall, Japan is the most indebted developed country.

Fig 6: Developed countries total debt in 2011 (Source: McKinsey Global Institute)

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Until 2000, Japanese government propensity to spend was matched by the Japanese population propensity to save. This is no longer the case today - the ageing population started spending its savings and the saving rate is below those of USA and Germany.

Fig 7: Household savings as percent of disposable income in 2010 (Source: OECD)

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The final nail in the Japanese "economic coffin" is a gradual decline of the current account (exports - imports + income from abroad), which used to help finance Japanese domestic deficits and sustain at least some GDP growth.

Fig 8: Japan current account (Source: TradingEconomics.com)

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Since the early 90s, Japan's budget has been drowning in red ink and recent "pro-growth" fiscal policies are likely to make the deficit wider at least in the short run.

Fig 9: Japan budget deficit (Source: TradingEconomics.com)

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To summarize Japanese precarious debt situation: the debt is getting larger and it will not be offset by either private household savings or strong exports.

Why QE is not a solution

The size of the new Japanese Quantitative Easing program - the first "monetary arrow" of Abenomics strategies known as "three arrows"- is truly breathtaking. Japan central banks will continue buying government debt, equities, and other "high quality" assets at a rate of ¥7 trillion yen (just over $70 billion) a month until inflation reaches 2%. Adjusting for the size of the Japanese economy, this is more than twice the size of the US QE program, which runs at $85 billion a month and has much more realistic goals (under 2.5% inflation and 6.5% unemployment). While I reserve some praise for Japanese premier minister Shinzo Abe for bravery to do "something" in a desperate situation, the basic math of a QE simply doesn't add up and it's likely to accelerate an inevitable fiscal crisis instead.

Let's first consider how much money Japan spends to support its debt and what would this debt burden look at 2% inflation:

Fig 10: Japan government revenues and expenses (Source: Japan Ministry of Finance)

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An astonishing 24.3% of the revenue is already spent on servicing existing debt compared to 7% in US and 6% in Germany.

According to an IMF working paper, Japan has one of shortest average debt maturities among the developed nations of only 5 years.

Fig 11: Average debt maturities of developed nations in 2010

The short maturity implies that most bonds have been issued with post-crisis yields of about 1%. Conservatively assuming that a new 10 year bond in the 2% inflation environment would have to be issued with at least a 2% yield compared to its current yield of 0.83%, my best guess is that the debt service spending will double within five years to become over 50% of the budget (everything else being equal).

Fig 12: Japan 10 year bond (aka JGB) yields (Source: TradingEconomics.com)

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Who will buy new Japanese bonds?

Bonds and equities are notorious for so-called "home bias" when home investors and institutions display a clear preference for investing in "home assets". Nowhere is the home bias as strong as in Japanese bonds: a whopping 95% of all Japanese bonds today are held by the Japanese entities.

Fig 13: Japanese debt ownership (Source: Bank of Japan)

In contrast, about 1/3 of US debt is held by other nations, with China and Japan leading the way with about 8% stake each. It is quite clear that other nations neither have an appetite for Japanese debt nor have a direct stake in the Japanese solvency.

To make matters worse, the largest slice of the debt pie (39%) is almost entirely held by Japanese banks, which would become immediately insolvent in case of a sovereign crisis. According to the Bank of International Settlement, Japanese banks hold 900% of their tier 1 capital in Japanese bonds.

Just as a side note, Zero Hedge dug out an interesting note from Minutes of the Meeting of JGB Market Special Participants (i.e. banks). The banks were exceptionally concerned that a mere increase in volatility in the bond yields will increase their so called Value-at-Risk (much criticized but still widely used regulatory risk measure estimating how much assets can lose over a period of time). If a volatility spikes due to a bond sell-off, the banks are forced to sell more bonds to reduce the risk, leading to even more volatility, further bond sell-off, etc.

Fig 14: Japanese bonds implied volatility (Source: ZeroHegde.com)

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Banks dumping JGB in panic when Governor of the Bank of Japan uses a wrong choice of words could be a match that sets a massive forest fire.

The end game (likely scenarios):

Best Case (10%):

Shinzo Abe has an epiphany of sorts and recognizes the real issue: declining population. He sets up "free enterprise zones" with almost unlimited immigration from neighboring Vietnam, the Philippines, Cambodia, Laos, and Thailand. Japanese manufacturing is reviewed by the introduction of new dynamic labor force just as the Chinese labor force is starting to age.

Japan returns to the dynamic growth and the period of 1989-2013 becomes known as "Great Depression". Call me an optimist, but I don't consider this completely out of the question even knowing Japanese cultural aversion towards immigration. Desperate times call for desperate actions.

Worst Case (20%):

Sovereign crisis hits full force when Japanese investors and banks start dumping Japanese bonds. Bank of Japan becomes "the buyer of last resort" providing massive unsterilized purchases of Japanese bonds effectively monetizing Japanese debt. The result is a currency collapse, uncontrolled inflation, and quick evisceration of the savings. Bank and insurance companies become insolvent.

This is essentially an Icelandic scenario of 2008 without the subsequent recovery. Japan becomes the land of "old and poor".

Likely case (69.999%):

Shinzo Abe and Bank of Japan Governor Haruhiko Kuroda "chicken out" in the face of the fast rising JGB yields. The 2006 scenario repeats itself and Japan returns to anemic growth and deflation for several more years. Eventually, the laws of financial math take effect and the "worst case" scenario (above) unfolds.

Left field case (0.001%):

The laws of math and common sense are proven not to apply to the Japanese economy. There is such a thing as a "free lunch" in a form of stimulus after all and Milton Friedman got it all wrong. Investors ignore massive Japanese debt now six times of its GDP and pile into JGB keeping rates at zero while the currency devalues. Yen gains a competitive edge over Sudanese pound, Zimbabwean dollar, and Venezuelan Bolivar. Japan discovers massive amounts of oil under Mount Fuji and replaces Saudi Arabia and Russia as the top oil exporter.

Paul Krugman wins the second Nobel Prize and New York Times initiates a hostile takeover of Google. A young Burmese mathematician discovers a "special theory of math relativity" where 2 + 2 can be 5 under some circumstances.

How to trade it

There is a good reason that shorting Japanese bonds is nicknamed a "widow maker" trade. Many an investor patiently waited for years for an inevitable collapse described in my "worst case" scenario. I can't recommend this trade outright because even though a collapse seems inevitable, the timing and the trigger are uncertain (just look at North Korea!). Markets can indeed stay longer irrational than a short seller solvent.

I also don't recommend shorting a basket of diversified Japanese equities outright. Many Japanese companies have been moving their business overseas for years. For example, according to Japanese Automobile Manufacturers Association, nearly seven out of 10 Japanese vehicles sold in the US in 2011 were built in North America. It's likely that facing skilled labor shortages, higher taxes, and energy costs, Japanese companies will continue moving business overseas. They may even indirectly benefit from a sovereign crisis, as their Japanese part of business would become more competitive due to currency devaluation. Therefore, I have trouble recommending shorting widely held indexes such as Topix 100 or Nikkei 225.

This brings me to an ideal vehicle - shorting FEFN ETF (MSCI Far East Financials Sector Index Fund). 63% of this ETF is comprised of large Japanese financial institutions whose assets will be slowly deteriorating even in the absence of an acute sovereign crisis. They have tremendous exposure to JGB and will not benefit from the currency devaluation.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in FEFN over 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.