By Ron Rimkus, CFA
As noted in the first part of this series on Japan’s looming debt crisis, the economic consequences of Japan’s aging population are just beginning to manifest themselves, and dissaving - the act of spending down your life savings - isn’t the only problem that arises. Social and healthcare spending also accelerate, often placing greater and greater burdens on the government. For example, social security spending in Japan has jumped from 19.7% of the federal budget to more than 31% in the past decade (between 2000 and 2011), according to Japan’s Ministry of Finance. Already, social spending and national debt service costs are causing the federal budget deficit to grow to unwieldy heights and are clearly threatening the cash flow model that has enabled Japan’s rates to stay so low.
All of this raises the question: With a funding deficit virtually exploding in Japan right now, can the event horizon for a debt crisis be that far off?
Should the Japanese government move to curb social security benefits, it will only accelerate the need for households to fund more of their own retirement living and healthcare expenses, exacerbating the dissavings that has already begun among households. Of course, there are some positive changes which offset the negatives to a degree. A shrinking population also reduces the levels of infrastructure investment and capital formation required, so national savings are enhanced. Nevertheless, the inherent pressures of rising social security costs and rising debt and debt-service costs will require the Japanese workforce to work harder simply to maintain the status quo - in which the fiscal deficit is already 11% of GDP, as noted in Figure 1. If Japan’s current economic model is left unchanged, the fiscal deficit would skyrocket toward 20% of GDP over the next several years. And remember, there are no free lunches. Any cuts in Japan’s federal budget will have consequences elsewhere.
Figure 1: Japanese Government Revenues vs. Expenditures
Sources: Ministry of Finance, CFA Institute.
The crown jewel in Japan’s virtuous cash flow cycle of the past 22 years is its large foreign currency holdings. Due to the many years of trade surpluses, Japan’s corporations maintain vast sums of corporate savings denominated in foreign currencies. These foreign currency holdings generate substantial amounts of investment income each year. However, the control of these vast sums is concentrated in a few hands. Likewise, the bond market (and hence, interest rates) is controlled by many of these same hands. And because bonds are priced in a market, if and when the managers of this capital decide to sell, they can cause a stampede for the exit.
Moreover, what happens to the yen exchange rate if and when this capital is repatriated? Stewards of these foreign currency portfolios sell foreign currencies and buy yen - driving up the value of the yen - and worsening the competitiveness of Japanese exports. Unlike China, which uses its large foreign currency holdings to buy commodities and foreign manufacturers to control strategic assets, Japan is shrinking, so it needs little for growth. While Japan could benefit from the purchase of natural resources and other raw materials which it currently imports, its opportunity set is more limited. The greatest growth industry in Japan right now is perhaps healthcare, but healthcare is delivered locally. What strategic value could be gleaned by owning hospitals in say Vietnam or Europe? Consequently, there are limits to the strategic benefits that portfolio allocation could offer Japan.
Already, these corporate investors and banks, in particular, are becoming increasingly concerned about maintaining the status quo. Their ability and willingness are being directly challenged by the escalation of national debt service, the expansion of fiscal deficits, and the ramifications of the Fukushima disaster, as well as the current pressure on the yen exchange rate. Already, Japan’s debt service is 23% of GDP, with interest rates at 1%. What happens if and when rates rise? In short, debt service would explode and crowd out huge portions of the federal budget, as illustrated in Figure 2.
Figure 2: Japanese Debt Service and Rates: What Happens Next?
Sources: Ministry of Finance, Bank of Japan, and CFA Institute.
So, what causes rates to rise? Rates rise when the market senses a paradigm shift. Perhaps first is what corporate asset managers decide to do. Second, the general dissaving that is spawned by aging will reduce aggregate demand at a time when aggregate supply is increasing. Third, a stronger yen means fewer exports and, furthermore, the shift in energy policy after the Fukushima disaster means a downward structural shift in the current account balance. Not only does aging impact federal budgets, but it also puts downward pressure on GDP as described in Part 1. Only now, the funding surplus has become a funding deficit and the required monetization of debt is increasingly likely to lead to some inflation (although it is partly offset by the deflationary impacts of a shrinking population).
Now the bond market in Japan is well aware of how the game is played. Of course, the Bank of Japan plays a key role in all of this - in part by buying JGB’s when demand is weak, and in part by cajoling these same financial institutions to purchase JGB’s. With the tools of regulation at their backs, the BOJ does indeed wield much power. What the bond market is perhaps missing are the ongoing incremental changes that have accumulated over 22 years. Such a consistent message to the market establishes a strong belief among market participants. It’s when this belief begins to change that rates will change. So, are beliefs changing? On the margin, banks are showing more reluctance to increasing their exposure to JGB’s. And on balance, the funding deficit is becoming a large problem, changing the very economic model that has enabled Japan for so long. These changes will place increasing pressure on the BOJ to keep the status quo alive and somehow prevent the market from realizing the game has changed. Bank of Japan Governor Masaaki Shirakawa truly has the challenge of a lifetime to keep it all together.
Some have argued that Japan can ameliorate its budget shortfall by raising tax rates. In economics, there are no grand solutions, only trade-offs. So, it is a fallacy to think that increasing tax rates necessarily increases tax revenues to the government. Many governments and countries have tried raising tax rates and failed to increase tax revenues either due to tax avoidance or damage to economic growth (or both). Japan is currently considering a number of measures to increase taxes (including a proposal to double the national sales tax, from 5% to 10%), but it is not at all clear that these measures will grow the overall tax revenues to the federal government because of various trade-offs across the global economy. And Japan’s funding model is vulnerable to changes in behavior that emanate from changes in tax policy. For instance, what if the rise in tax rates causes capital flight from Japan and the delicate funding deficit accelerates?
Other analysts have compared Japan’s relatively low tax revenue/GDP ratio with that of other countries, claiming that there is ample room to raise taxes. However, this belies the welfare society construct that Japan has developed in the past 75 years. In contrast to the welfare state, the welfare society provides social benefits through private employers. Japan’s welfare society attempts to maintain near-total employment via liberal government loans to private companies, often circumventing the need for unemployment benefits. Also, retirement pensions come largely from personal savings and company compensation rather than as benefits from the state. So, the state has intentionally shifted the cost of its social programs to companies. Should it raise taxes on the private sector, additional pressure would be placed on corporate budgets, thereby weakening the economy.
Compounding matters, Japan’s manufacturing prowess is weakening while the country as a whole is becoming less competitive. They have lost leadership positions in a number of key industries and the rise of the yen is making exports less competitive as well. Moreover, pressured budgets make it more difficult to engage in the long-range R&D spending that had helped the country become a global leader in manufacturing. As an example, once a stalwart in consumer technology, Sony recently announced the layoff of 10,000 workers.
Since the epic global financial meltdown in 2008, the U.S. Federal Reserve has maintained an aggressive policy of depreciating the U.S. dollar. As noted in Figure 3, the yen has appreciated some 30% against its post-bubble average, as well as against the dollar, since the collapse in 2008.
Figure 3: Yen vs. US$
Sources: St. Louis Federal Reserve Bank, CFA Institute.
This recent appreciation of the yen is exacerbating all of Japan’s problems - its export products are now 30% more expensive on global markets. Its profile is similar against other major currencies. For the first time since the Japanese bubble collapsed, Japan will now need substantial alternate forms of funding to keep the government afloat. Consider Table 1, which illustrates how the funding sources of the federal government are changing and the pressures these changes will place on the Japanese bond market over the next 10 years.
Table 1: Japan Funding Surplus/Deficit Decade by Decade
Click to enlarge
The funding deficit over the 2000–10 time frame has been modestly negative and made up for with accommodative policy by the Bank of Japan. This accommodative policy has been offset by deflationary forces in Japan, so the net effect has been mild deflation. Looking forward, if this funding deficit of, say, –5% of GDP were made up for with accommodative monetary policy, then the inflationary force of this accommodative monetary policy would very likely exceed the mild deflation (say, –1% or so) that has been occurring in Japan for some time. The net result would be some mild inflation of, perhaps, 2–4% (depending on how much monetization and how much debt issuance occurs), but it would likely be enough to recalibrate the bond market’s expectations. And if JGB yields rise from 1% to just 2%, Japan’s debt service will explode. Thus, a vicious cycle of higher yields, greater fiscal deficits, greater monetization, and greater inflation will occur.
However, the status quo in Japan - if left unchanged - will see to it that the funding deficit widens materially. As debt continues climbing and GDP continues falling, the growth in the debt-to-GDP ratio accelerates. The combination of a rising yen and stagnating corporations will result in the structural trade surplus deteriorating over time (which is why the BOJ will try to get the yen to decline somewhat). Additionally, debt service and social security spending will continue growing as percentages of the federal budget - all without any increase in interest rates. So there is a widening funding deficit that must be made up for with some combination of debt issuance and/or monetization. The combination of large fiscal deficits, funding shortfalls and private sector dissaving will ensure that Japan must seek investors on the international markets. Consequently, the (natural) domestic demand base for JGBs is falling, while the government’s need for foreign investors is rising. Although some have suggested that the Bank of Japan could devalue the yen, what would happen to the cost of imports if it did? (Remember that Japan imports virtually all of its raw materials, such as energy and hard commodities.) If it chopped the yen in half and many of its input costs doubled, could its export companies be competitive? What would happen to the balance of trade (all else being equal)?
While the underlying economics will change gradually over time, the crisis will erupt when the bond market breaks from the past. When the market realizes that the status quo has changed, rates will rise and force the government’s fiscal budget to explode, creating a sequence of cascading events. Watch closely to see what the major Japanese banks do with their JGB holdings. In addition, watch pension fund managers. The stewards of capital changing their policy allocations will determine when the status quo shifts.
So, when does Japan breach the event horizon? No one can say for certain, but after 22 years of operating in limbo, the event horizon now appears to coincide with the investment horizon of investors. Perhaps the BOJ will find a devaluation of the yen too irresistible to pass up, a move that will reset Japan’s current course in one fell swoop. Or perhaps the bond market will decide for them. At any rate, one thing is clear: Change is coming to Japan.