How worried should the world be about Japan's debt situation? After all, this is still the third largest economy in the world by a considerable margin and Japanese public debt has reached almost 250% of GDP.
Efforts to reflate the Japanese economy in order to bend the inexorably rising debt/GDP curve have so far yielded little result. How is this going to end, is there anything the Japanese authorities can do to stave off a debt trap?
First, Japan gets a lot of bad rep, and some of that is deserved, but consider some stylized facts:
- It experienced the mother of all bursting bubbles, those in stocks, land and real estate were 3x the relative size of the US bubbles in 1929 and 2007.
- Banks are way more important in Japan relative to the US in getting credit to corporations and bank balance sheets were badly damaged by the bursting of the bubbles, as many of the assets served as collateral. Banks were slow to respond and this greatly inhibited credit flow to the corporate sector as a result.
- While growth has slowed since that bursting at the end of the 1980s, GDP growth per head is on a par of that in the US and Europe and Japan never experienced anything like double digit unemployment or anything resembling a depression.
- And all this against some of the strongest demographic headwinds around the world.
In a way this has been a remarkable experience, which is why we think that the "lost decades" moniker is a bit of a misnomer. Japan's main instrument has, until recently, been fiscal policy.
This is actually what theory prescribes as monetary policy becomes rather impotent in the face of deleveraging. Rather than taking out new loans, companies preferred to pay off existing loans, and the debt burden has indeed decreased substantially.
As well as the cash holdings of the Japanese corporate sector has accumulated rather exorbitant cash holdings, standing at over half of GDP:
Two policy errors have been costly though. Banks lingered for more than a decade to tackle their bad debt problems and monetary policy has been slow to react to all this.
The latter has been especially costly, as it let deflation set in, which has greatly worsened debt dynamics.
Which is where Abeconomics comes in. The three pronged approach (monetary and fiscal stimulus combined with structural reforms) was supposed to get inflation back to 2% to bend this debt curve, but this hasn't happened.
We have to admit that we expected Abeconomics to lift Japan out of its debt-deflationary cycle, just as a similar program did in the early 1930s, engineered by Finance Minister Korekiyo Takahashi.
The start was promising. Stock prices went up a lot, creating a bit of a wealth effect. The yen went down considerably, giving a boost to exports, and even some inflation started to emerge.
But then things went sour. First there was the sales tax hike (from 5% to 8%), which threw the economy into a recession. Then energy prices started to plunge, and the combined effect lowered inflation back to zero, rather than the stated 2% goal of the Bank of Japan (BoJ).
In an effort to salvage the situation, the BoJ became even bolder actions, the latest of which involved negative interest rates. We have to stress though that it seems to be lost on many commentators that the negative rates only apply to a fraction of the liquid assets banks hold at the BoJ.
Most of these continue to earn 0.1% interest, on top of that there is a tier that earns zero, only a fraction is liable to the negative (-0.1%) rate, it's basically a marginal rate to leave bank profits intact but to get the money market rate into negative territory.
But this hasn't worked out to plan, see what happened to the yen (NASDAQ:BLUE) and the Nikkei (orange) in the graph below:
It isn't entirely sure whether this was the cause for a rather spectacular yen reversal, but the timing is certainly as remarkable as it is unwelcome.
One theory is that the negative rates caused bank stocks to fall (the same happened in the eurozone), causing a general plunge in equities and a reduced appetite for foreign assets, leading to a yen surge, which causes further equity losses.
Another theory is that this is the result of the scaling back of Fed rate hikes, putting unhedged US assets of Japanese funds at risk, hence the repatriation of capital.
It could also simply be that the move to negative interest rates has been taken as a cue that the BoJ is running out of options and the Japanese tend to repatriate capital when there is trouble at home.
In any case, at the start of the year Japanese companies tend to repatriate foreign earnings so there is seasonality at work here as well.
With the prospect of another sales tax hike next year, demographic headwinds, and the yen rising, stocks also have buckled and there is no bending of the public debt curve.
Is there anything the authorities can do?
We suggested some helicopter money but in essence this is already happening. The BoJ buys up $70B of Japanese bonds, effectively monetizing the whole budget deficit.
The BoJ holds 34.5% of the countries public debt of $9.3 trillion, and on the present path, this is set to rise to 50% by 2017. It already is monetizing the public debt.
But there are those that suggest that there are limits to what the BoJ can do here (from FTAphaville)
Currently, the Bank of Japan is buying just over Y80 trillion of JGBs per annum or the equivalent of three times to the rate of JGB issuance. The BoJ is approaching a shortage of JGBs for the central bank to buy, as commercial banks, pension and insurance funds have run down their holdings. Indeed, an IMF working paper that we quoted in the Japan 2016 outlook 'Portfolio rebalancing in Japan: Constraints and Implications for Quantitative Easing' that given the collateral needs of banks and the asset-liability management constraints of insurers there is a natural limit to JGB purchases.
What the BoJ is trying to do, according to Jefferies:
In this sense, we continue to believe that the BoJ's sudden policy U-turn on negative deposit rates in January was driven by the need to collapse the yield curve into negative territory as far as possible. The authorities are attempting to push bond yields down below existing nominal GDP, so that the existing debt can be converted or 'consolidated' into a perpetual zero coupon bond presumably before any 'tapering announcement'.
That would be a nifty trick. Jefferies also argues that the BoJ will shift to NGDP (nominal GDP) targeting, rather than targeting inflation, although we're not sure there will be much practical difference, considering the enormous difficulties they have met in getting anywhere close to their inflation goal (2%).
Olivier Blanchard is worried that Japan runs out of domestic investors for its debt and has to turn abroad, at much higher interest rates. He goes on to argue:
Prof Blanchard, now at the Peterson Institute in Washington, said the Bank of Japan will come under mounting political pressure to fund the budget directly, at which point the country risks lurching from deflation to an inflationary denouement.
There are a couple of arguments against this:
- At present, net interest payments are only 1% of GDP, considerably lower than the debt service of the US (which is above 3% of GDP).
- As argued above, the BoJ is already monetizing the entire budget deficit, and more, albeit not directly.
Then there is this ( Dean Baker CEPR):
but the point is that the market value of its outstanding debt would drop sharply if interest rates rose to even modest levels. If the 30-year rate got as high as 7.0 percent (lower than the U.S. rate in much of the 1990s), then the market price of the newly issued 30-year bond would drop by more than 85 percent from its current level. The way governments typically keep their books, this plunge in the market price would not affect Japan's debt to GDP ratio. But if the markets were actually troubled by the high ratio of debt to GDP, Japan could simply issue new debt to buy up old debt at a fraction of its face value. This would quickly send its debt to GDP ratio plunging.
That would still be quite an end-game though. While the debt itself would be sort of solved in the way Reagan suggested ("it's so big, it will take care of itself"), institutional investors and other holder will be less amused.
At which time Japan will have to issue a whole lot of new debt to keep these afloat. Blanchard doesn't see much use of 'helicopter' money as it doesn't make much difference whether spending is paid for by issuing zero interest bonds or money, and he's got a point there.
Blanchard (and Posen) suggests two other solutions ( FT):
- Simply keep on with QE, which will actually get more powerful as the BoJ will have to offer ever more to pry marginal holders loose from their bonds.
- Engineer a wage price spiral by raising wages 5-10%.
The latter can be kick-started by increasing the minimum wage, raising wages in the public sector and forceful intervention in the tripartite (government, unions, employers) wage negotiations that directly cover a third of the labor force but is followed much wider.
If employers won't play ball the government could withhold already promised corporate tax cuts. While there is no painless way out of the debt mess, this, in combination with continued QE could still offer a way out without producing a collapse in the Japanese bond market or even the Japanese economy, the ramifications of which would be felt widely around the globe.
Inflation would ratchet up, but this is the whole purpose, according to Blanchard:
We believe that a 5-10 per cent inflation rate for a few years would decrease net debt by 8 to 16 per cent of GDP per year and sustainably raise inflation expectations without causing major distortions.
The latter will reduce the real debt burden further and will get Japan finally out of its deflationary quagmire.
If Japan can pull something like this off it would not only eliminate one of the a great risks in the world economy, it would also offer valuable lessons on how to deal with bursting asset bubbles.
The most important lesson of course is to prevent such asset bubbles from emerging in the first place.
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