By Paul Azeff and Kory Bobrow
The war situation has developed not necessarily to Japan's advantage
-Japanese Emperor Hirohito, after the atomic bombing of Hiroshima and Nagasaki, announcing Japan's surrender to the allies
Japan is a bug searching for a windshield
- John Mauldin
What did Madoff and Stanford teach us? They taught us that you can keep a ridiculous Ponzi scheme going for a very long time as long as you have one ingredient: more people entering the scheme than exiting the scheme. In Japan last year, the working age population peaked. From now on, they're in an inexorable secular decline. So the rubber is meeting the road there today.
-Kyle Bass of Hayman Capital
We believe the debts of the following nations, among others, are not sustainable in the current economic environment: Greece, Italy, Japan, Ireland, Iceland, Japan, Spain, Belgium, Japan, Portugal, France, and, have we mentioned Japan?
- Kyle BassAll things flow, nothing abides. You cannot step into the same river twice, for the waters are continually flowing on. Nothing is permanent except change.
While it seems impossible to pick up a newspaper or search a news site without hearing about yet another Greek bailout/default story, we're here to tell you that it's all a sideshow, and while the main act is just about to come on, only a few forward-thinking types seem to be paying any attention. If you are searching for something to worry about, Greece should be pretty low down on your list, especially when you compare it with Japan. In comparison with Japan, Greece looks like a prudent steward of capital! Everyone is worried to death about Greece's 145% debt-to-GDP ratio? Well, Japan's is over 230%, and quickly rising! Here's another big difference: Japan is the third-largest economy in the world, and its GDP is roughly 40% larger than the GDP of all the PIIGS countries combined! Each year, Japan's debt level increases by more than the combined GDP of Greece and Portugal. So why isn't Japan on everyone's radar screen?
The answer lies in the ownership of Japanese debt. Unlike the PIIGS, whose debt is almost entirely held by foreign investors, the great majority of Japanese debt is held by Japanese entities, either individual investors, pension funds or institutions, and that means that the interest rate they pay on that debt is not as influenced by market forces. Add in an historically strong export economy (allowing them to be net importers of capital), and a loyal population that buys "Japanese first," and you have an environment that has allowed Japan to spend beyond its means without experiencing severe pain.
But all that is set to change, because of the single-greatest threat to the Japanese economy. We're not talking about tsunamis, earthquakes, nuclear meltdowns or foreign invaders. Rather, we've had a look at the aging population in Japan, and it's quite clear that things are about to get ugly.
But first, a little history is in order. If you are over 30, you may remember that in the '80s, Japan was supposed to take over the world. It sure went on a buying spree of foreign companies and real estate. You might remember reading about the backlash when a Japanese company bought the iconic Rockefeller Plaza. Or perhaps you've heard the startling fact that at the peak of the Japanese real estate bubble, the land under the Emperor's Palace was worth more than the entire State of California. And then, like all good bubbles, things turned south in a hurry. From its peak in 1989, when the notional value of the stocks listed on the Nikkei represented 44% of all global equities, the Nikkei proceeded to drop more than 70%, prompting most intelligent investors to turn to the one asset class that hadn't yet burned them: domestic bonds.
It's quite similar to what we saw happen in the U.S. when the tech bubble burst in 2001. Investors fled equities in droves, and sought out safety in an asset class where you "never" lost money, real estate. This was one of the driving forces behind the U.S. real estate bubble that finally burst in 2007. And it highlights what we believe will happen to the mindset of the Japanese investor as they start to recognize the bubble that is the Japanese debt market. Look back at the U.S. real estate market for a second: in 2001, it was the asset class that represented safety, so investors flocked to it. But by 2007, investors realized that you could, in fact, lose money on real estate, and they made a beeline for the door, all at the same time. Guess what folks? You can, in fact, lose money in the bond market too. Hopefully, this time, investors will figure it out before it's too late. The takeaway here is that yesterday's "learned response" purchase can quickly and easily become tomorrow's panic sale.
So, what's got us so worried about the Japanese debt market? Well, for starters, Japan is quickly painting itself into a corner. Right now, every penny of government revenue goes to pay for debt service (interest payments on the debt) and pension benefits. Think about that: if Japan wants to pave a road, build a school, or buy toilet paper for the Imperial Palace, it's all going to be paid for with borrowed money, and that's how things look with long-term interest rates at 1%, so imagine how horrible the picture would look if interest rates, and thus debt service costs, were substantially higher?
The pool of Japanese bond buyers is drying up quickly, as well. Already, the share of Japanese debt that has to be funded outside its own borders has doubled, with fully 20% of its short-term debt now being financed by outsiders. And starting this year, the first wave of Japan's Baby Boomers turn 65, making them eligible to start collecting their pension, which means that instead of accumulating wealth and buying bonds to save for retirement, a greater and greater portion of the population will now become net sellers of bonds to finance their retirement needs. And at the same time, as the number of people in retirement continues to mount, the government will experience a squeeze on both ends: income tax revenue will decrease, while the amount paid out in retirement benefits increases.
In fact, the first cracks in the armor are starting to appear already: The Japanese Public Pension Fund has recently stated that it will become net sellers of government bonds this year. Several ratings agencies have already put Japan on watch for downgrades, which normally means that investors start to demand a greater return. They are already rated AA-, which means they may soon be in single-A territory. Even the IMF has started to worry, pointing out that the Japanese debt situation could quickly become unsustainable if rates were to rise.
So what happens next?
The way we see it, Japan has no choice but to sell more bonds to foreigners. It can't cut the debt service costs because it would then essentially be in default, and would lose access to the capital markets; it can't reduce retirement costs, because even if it tried, the retirees would have no choice but to make up the shortfall by, you got it, selling more bonds. In technical financial market terms, we call this a Catch-22.
What happens when Japan starts trying to sell more bonds to foreigners? Put simply, it is going to ask for a much higher rate of return. Would the same funds and institutions demanding 7% on Italian and Greek 10-year bonds really be interested in lending Japan money at 2%, especially since their financial situation is in many ways worse? Would it surprise you to learn that 2% is fully double what those 10-year bonds yield currently? In fact, adding to investor's complacency, 10-year rates haven't been above 2% since 1997.
The fact that the yen has remained remarkably strong is also causing a significant drag on the export-driven economy. Imagine what happens if rates go higher still. Over the next few months, as the post-tsunami reconstruction efforts start to bear fruit, we expect to see some seemingly positive economic indicators out of Japan. After all, it'll be in a position to decrease foreign purchases of gas and oil that made up for the lost nuclear-generated electricity. Don't be fooled by these numbers, though, as the Demographic Doomsday Device is a far more powerful force.
Shorting Japanese debt has become an investment with an "asymmetric risk profile," which in plain English means that there is more money to be made than lost. In the simplest of terms, if you "sell short" a 10-year Japanese Government Bond (JGB) yielding 1%, and the bond goes against you, your downside risk is essentially limited to roughly 10% on your money, as you could see the interest rate go and stay at 0%, which means you have lost 1% per year for 10 years. On the other hand, there is no theoretical upside limit to the interest rate demanded on the 10-year; you could see 4, 5, 6% or more, and each 1% move in that direction means roughly 10% in profits.
Already, the "smart money," those same funds that made a fortune on the bursting of the subprime and housing bubbles, have started to place their bets on higher rates in Japan's future. You may have read about the CDSs that made a small group of funds such enormous fortunes when things went south (Kyle Bass, for instance, who made $500 million in the downturn, and who is on record as saying that shorting Japanese debt is an even more compelling trade than shorting subprime)? Well, Japan's CDSs, which are essentially the cost of insurance against default, have already seen a significant move up. But these are still early days. You'll know that it's too late to act when you start reading about Japan's problems on page one of the newspaper.