The global economic recovery has been built on one single assumption: Governments are unsinkable. As long as governments can borrow money then they can stimulate the economy through monetary and fiscal policy. The flaw in this line of thinking is the same flaw that sunk the Titanic… Nothing is unsinkable.
Over the last fortnight, the global financial markets have experienced the first signs of icebergs in the water. The de facto default by Dubai and the downgrade of Greek sovereign debt both serve as warnings of what may be to come. So far, the markets have navigated the icebergs surprisingly well. The primary reason for the deft navigation was the relative size of the icebergs.
However, Q3 GDP in Japan was revised sharply lower from 4.8% to 1.3% annualized. Moreover, the GDP deflator (a measure of inflation) printed at -0.5%, implying deflation in the Japanese economy. The response to deflation and a weak GDP has been fiscal stimulus and quantitative easing.
While this two pronged approach has been the preferred prescription written by central bankers to combat the economic crisis, Japan poses some special risks. The amount of new debt needed to finance these measures will now exceed the amount of tax revenues the government will collect.
Additionally, Japanese debt as a percentage of GDP is already the highest in the developed world and is approaching 250% of GDP. Japan needs GDP growth of 3% a year to halt the climb in debt as a percentage of GDP. Adding more debt, while GDP falls has placed Japan on a dangerous course.
In 2010, the Japanese government will need to issue an additional ¥53 trillion in government debt. At the same time tax revenues are expected to drop from ¥46 trillion to ¥37 trillion.
We estimate that Japanese debt service as a percentage of tax revenues will rise to 59% in 2010. This plan works, until it doesn’t.
Currently, interest rates on 10-year Japanese government bonds are hovering around 1.5%. The Japanese have historically had a high savings rate which allowed the government to sell most of its debt to the public and banks. However, the savings rate has dropped to 2.2%, down from 11%. Moreover, the aging Japanese population has less incentive to invest in government bonds.
The Japanese must now rely on the financial markets to find the price level at which “other” investors will purchase government debt. The key element in this equation is price, or put another way, interest rates.
We estimate that if the market demands an interest rate of anything more than 3.5% then Japan will not have the revenue to service its debt. In other words, as the interest rate approaches 3.5% Japan must use all its tax revenue to pay interest on its debt.
This is an extraordinarily dangerous course Japan has chosen and it may be too late to turn its economic ship from the iceberg. Japanese government bonds yielding 3.5% is the iceberg that will sink Japan and have massive repercussions throughout the global economy.
Looking ahead to 2010, we are less concerned about financial institution defaults and more concerned about sovereign defaults, especially Japan. As long as money can be borrowed the mantra is “Damn the icebergs, full speed ahead!”
Disclosure: Short FXY
