"Even if they never got anything for it, it was cheap at that price. Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims! It was easily worth fifteen million bucks to watch me put the thing over."- Charles Ponzi
While everyone is still preoccupied with Europe, I thought now might be a good time to focus on a longer term investment theme whose time has finally come; shorting the Japanese Government.
What do you do when an investment is no longer attractive on its own merits?
Simple answer, you start to market it more aggressively. Japanese government debt no longer offers the type of yields that would attract any risk/reward conscious investor. Yet, Japan has to consistently sell an ever increasing amount of this debt, and to make matters worse, cannot afford to offer higher returns. So what to do?
Hire a good Ad agency…..
Over the past few years Japan turned to running advertisements in taxis recommending the buying of JGBs. They relied on celebrities to make their point. Actors, famous news anchors, and models have all touted JGBs over the past decade.
But eventually celebrities don't do the trick. You need to get more creative. Last year Japan's Ministry of Finance rolled out a campaign with a sex appeal focus. The ads targeted men, and took the approach that Japanese Women prefer men who own JGBs. Yep, playboys are boring, bondholders are what women want.
Yet, at some point even all these ads are not enough to sell something that offers virtually no return. You need to get more creative. So, yesterday Japan's Ministry turned to gold to help move JGBs. Yes, Gold. Buy $100k + in JGBs and you get a commemorative gold coin. Well, to be clear you only get the coin if you hold the bond for three years, but you get the point. And just to make you feel better, elected officials are buying. Oh, and if this isn't enough, I forgot to throw in that you will get a thank you letter from the finance minister.
So, for those of you not familiar with the matter, you may be wondering why is the Ministry of Finance so desperate to market JGBs?
Well, let's look at some numbers. Last year the Japanese Government generated just under 50 trillion yen in actual revenue. At the same time they paid a little over 20 trillion yen in interest on outstanding debt. That's 40% of non-debt issuance revenue going to debt service with rates where they are at today. Now, last year Japan's government spent over 90 trillion yen on expenditures. So, they needed to borrow another 40 trillion plus yen to cover the shortfall.
As you can see this math does not add up. If rates where to rise to over 2%, Japan's current revenue would barely cover debt service, and borrowing needs would increase.
Now where is all this money going, can't they drastically cut spending?
57% of Japan's budgeted revenue is being spent on Social Security, and as Japan has the fastest aging population on the planet that leaves little wiggle room for austerity.
But why would Japan need to worry about bond vigilantes and Austerity, isn't their debt almost 95% internally owned?
Yes, Japan's debt is almost all held domestically, mostly by the pension funds. Up until now that has worked great, but due to Japan's aging population these funds have become net-sellers of debt and no longer net buyers. That means Japan will need to find external investors to plug the hole.
But Japan is a creditor nation with plenty of foreign reserves, they can manage right?
Japan does have over $1.2 trillion in foreign reserves of which $900+ billion is sitting in US Treasuries.
So, they could dump Treasuries if need be to plug some of the hole?
In theory yes, but in practice I doubt this would work. See, Japan dumping treasuries would strengthen the Yen, which would then reduce the value of remaining dollar assets in Japan's portfolio. So, the value of their treasuries if they were to try and exit would be lower than the current exchange rate value because the Yen would start to significantly appreciate. But knowing the Japanese, they would never let this happen. If the yen was to appreciate significantly from here it would cause a major problem for their export driven economy, and would thus just exacerbate the situation.
So, what to do?
Well, the Japanese have to know this day is coming, and I am sure while the Europe saga has unfolded they have been doing even more contingency planning. My view is that there is no way around this problem that doesn't involve significantly depreciating the Yen. The BOJ is already holding 10% of JGBs and my guess is that number will only go up. So, short yen going forward makes the most sense to me. You can do this by buying out of the money put options on the yen. You can also short JGBs at these levels.
If you are looking for more on this topic, check out what Kyle Bass has to say on the matter.