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Japan is undergoing a lot of changes today and one of the most important changes to investors is Japan's fiscal situation. In a previous post almost a year ago, I analyzed the dismal fiscal situation in Japan, pointing out how their budget deficits and debt burdens are growing. I want to make an update on that as investors are focusing more and more on Japan these days.

The Ministry of Finance Japan has issued a new report on the fiscal situation which can be found here. This report is dated from December 2013.

Let's first focus on the trade and current account deficit in Japan. Both have been deteriorating rapidly in 2013. In fact, we are hitting new lows as we speak. The primary reason is that the yen has devalued a lot since 2013. As I noted earlier in other posts, the currency valuation is correlated to the deficit. If the valuation of the currency of a country goes down, that means that they will need to import products at a higher price and they will export products at a lower price. This naturally leads to a higher deficit. Evidence can be found in the soaring costs for importing oil to Japan. Oil imports basically almost doubled in price as noted in this article.

If we then move on to the budget deficits, there is a bit of light at the end of the tunnel. The deficit to outlay ratio (which gives the likelihood for hyperinflation) has come down from a peak of 62% to 48% which is an improvement, but we are still in hyperinflationary territory (ratio above 40% is hyperinflationary).

Chart 3 illustrates that the government has cut back on spending (red chart) and the budget deficits have come down (green chart). It also shows how tax revenues in Japan (blue chart) have gone up due to a rising Japanese stock market. This rise in tax revenues has decreased the budget deficits in Japan.

Now we come to the most interesting part of this analysis: the interest payments on government debt. As you know, the Japanese central bank has tried to purchase bonds and are still trying to increase bond purchases to keep interest rates low. They are succeeding in that as the yields on the 10 year treasuries of Japan are still at record lows (Chart 4). This is also a reason why many investors are buying the Japanese stock market, because bonds are not yielding much compared to stock dividends.

If we take a look at the Japanese central bank, we can see that they increased their asset purchases in 2013. They bought approximately $600 billion in assets in 2013, which is 10% of its GDP. The effect of these purchases is an almost 20% drop in the value of the yen against the dollar in that time frame. This is devastating to the middle class to say the least.

What did the Japanese government accomplish with these purchases to reduce bond yields? In short: nothing. I can illustrate that in Chart 6. As yields were suppressed to 0.6% on the 10 year Japanese treasuries, the interest payments were still going up in 2013 (blue chart). We see an increase of almost 2 trillion yen in just one year time, the biggest increase in interest payments in more than several decades. Interest payments as a percentage of tax revenues has hit a new high of 20%, which is very high. The only reason it isn't higher than this is because the tax revenues were very positive in light of the rising Japanese stock market, but I think we will see that trade reverse soon. I'm speaking of the infamous "Japanese carry trade." Because yields are so low in Japan, everyone borrows yen and then buys things with it. But when the interest suddenly goes up, people will scramble to cover. Especially when the yen (FXY) strengthens again. That would be a doomsday scenario, especially for the interest payments on Chart 6. We get a multiple hit on all fronts. Higher yields, higher yen, declining equities, higher deficits, higher interest payments, lower tax revenues. You get the picture.

Conclusion:

Looking at the fiscal situation in Japan, I would be very wary of the bullishness in the Japanese stock market (EWJ) right now. It's like picking flowers in front of an incoming train.

Source: The Deteriorating Fiscal Situation In Japan