The FT had a catchy headline that really sums up the essence of the question we're raising here:
Kyle Bass bets on full-blown Japan crisis
The question is, should he be allowed to do this?
As we write, there is a battle going on in the largest financial market of the world. The outcome of this battle can easily have a devastating influence on the world economy for years, as one side simply cannot afford to lose. And for the health of the world economy and all our well-being, we better hope it doesn't.
The battle is waging in the market for Japanese Government bonds (or JGBs). Japan is the third biggest economy in the world, and has by far the biggest outstanding public debt, at 245% of GDP (this is a gross figure, the net number, detracting public assets, is considerably less).
On one side is the Bank of Japan (BoJ), the Japanese central bank. It has been cajoled by the government to double the money supply in two years, in order to get the economy out of its long-term deflationary slump. The aim is to achieve roughly 2% inflation, mostly (although unstated) to activate an inflation tax on outstanding Japanese debt, which will reduce its burden in real-terms.
This isn't as nefarious as it seems. Periods of very high debt usually end either in default, or in a combination of economic growth and inflation to slowly melt the debt away as a percentage of (nominal) GDP. The latter has been done before. Notable examples are the U.K. (after the Napoleonic wars, after WWI, then again after WWII) and the U.S. after WWII.
Default isn't an option for Japan (or for the world economy), so all our hope should be on an orderly process akin to what happened to U.K. and U.S. public debt after the WWII. In order to boost growth, the Japanese are embarking on structural reforms (or so they promise) and a currency devaluation. The latter is already way down from its peak.
Growth is supposed to be further boosted by a wealth effect through rising asset prices, and indeed, the Nikkei has been on a bit of a tear, up over 50% even after some big falls recently. Also, there is still some additional fiscal stimulus, and the prospect of inflation and higher sales tax is supposed to open the wallets of Japanese consumers.
Growth indeed seems to be accelerating, but it's a little too early to start celebrating, because a really decisive battle is waging in the Japanese bond markets. We have already introduced the main buyer, the BoJ. Betting against Japanese bonds are Western hedge funds, of which Kyle Bass's Hyman Partners is the most visible.
How's the battle going? Well, the yield on 10-year JGBs have tripled from a recent low of 0.32% just one month ago to 1%, although it has fallen back a bit at the time of writing. So it seems that the hedge funds betting against JGBs are winning, at least for now. According to Kyle Bass, the BoJ can't win, as there is an inconsistency in its objectives.
If JGB investors begin to believe that Abenomics will be successful, they will 'rationally' sell JGBs to buy foreign bonds or equities
There is indeed a degree of logic to this. Insofar Abeconomics manages to succeed in driving inflation to 2%, one could argue that bond yields, especially at the longer end, should be higher than that, otherwise real returns would be negative. So one could even argue Bass is betting on Abeconomics to succeed.
Indeed, an important plank of the program is bond buying (QE) of the BoJ, which, in the absence of any increase in inflationary expectations (or real inflation), should get rates down, not up. And even within the BoJ opinions differ about the possibility of rising inflation, as the records of a BoJ meeting on April 26 showed:
"A few" policy makers said that it's "highly uncertain whether changes in inflation expectations would lead to a rise in the actual rate of inflation," [Bloomberg]
Jury still out on that one too..
Enter Kyle Bass
Kyle Bass has been predicting a financial collapse in Japan since 2010, long before any Abeconomics emerged. And he fully understands what that means:
They will have a bond crisis in the next couple of years. A bond crisis doesn't mean spread widening. It means they lose control of rates and their currency.... Mr Bass also says he really hopes he is wrong [FT]
But he bets against JGBs anyway and so do a host of other hedge funds. While, to our knowledge, he hasn't been too specific about the nature of his bearish bond bets, one can safely assume these are highly leveraged:
He demurs on the details of his Japan bets, but the suggestion is option positions [FT]
So on the one hand, we have the BoJ and on the other hand we have Hayman Capital and other hedge funds taking on highly leveraged bets against JGB. What if the hedge funds succeed, what does that accomplish (apart from making a really big profit)? Consider this:
According to the BoJ, a 100 basis-point increase in interest rates would lead to mark-to-market losses equivalent to 20 per cent of tier-one capital for regional banks - and 10 per cent for the major banks. [FT]
The effect of a bond crash on Japanese public finances, according to Mr. Bass (via his friend John Mauldin)
if JGB interest rates rise 2% in Japan, then the government must pay almost 80% of its revenues (as currently received) just to cover the interest on its debt.
We'll spare you what happens to its pension funds (simply because we don't have data on that), but it can't be pretty. Financial markets do have useful functions, we're the last to deny that. They allocate capital, they price risk, they provide liquidity and funds where needed, but in this case, we're hard pressed to see any benefit of shorting JGBs.
The disciplinary effect of markets
If Kyle Bass and the hedge funds shorting JGBs succeed, he'll significantly contribute to wrecking the third biggest economy in the world. Do we really want that? The outcome of that is that a few men will get astronomical amounts of money, while Japan will be plunged into misery and it's very plausible that the whole world economy will suffer greatly.Is that a rational outcome?
Is that how capitalism is supposed to work? Adam Smith set out a great case for free markets, they usually create benefits for all concerned (called the static and dynamic gains from trade). We've already argued that much in the way of financial activities create little in terms of gains from trade but are essentially zero-sum activities (my loss is your win, and vice versa), and some can be even considered negative-sum games.
The best case one could make to eek out some kind of positive effect of the JGB shorting is to invoke the market discipline effect, which argues that politicians only do the right thing when forced by market forces. Indeed, this argument has been invoked in the euro crisis quite regularly, and with some justification.
Indeed, one could convincingly argue that in the case of the eurozone, short sellers of peripheral bonds were still providing a "service," as they forced governments (and, more importantly, the ECB) to act and there were still avenues for action. But in the case of Japan, there is nothing they can do that they're not already doing.
Yes, structural reforms will be good, but they have a pay-off that's slow, gradual, and years off, this won't help if Japanese public finances derail. So if the hedge funds prevail and Japan derails, the Japanese policy makers don't have any line of action or defense. Even Kyle Bass' good friend John Mauldin agrees that they are backed into "the mother of all painted-in corners."
The last thing one could argue in Kyle Bass' defense is that he didn't cause the problems, which is true, or that his shorting won't make much of a difference anyway. The latter is very doubtful. While his hedge fund isn't particularly large, we presume he takes very leveraged bets, and he's highly public about his actions, no doubt generating followers. Other hedge funds are piling on.
A Japanese implosion would be an economic (and human) catastrophe. Should capitalism work in a way that enables already very wealthy people to place bets, garner enormous profits from their possible success, when those bets don't have any other positive function but their private profits, whilst bringing the Japanese demise that much closer and with the Japanese policy makers having no alternative path of action in front of them?
It's an awkward question; we don't pretend to have the answers, but asking it is already important enough.