Is Abenomics Over? I Don't Think So.

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Includes: DXJ, FXY
by: Oriental Trader

Recent volatility in the Japanese government bond (JGB) and stock markets has finally led market participants to see Abenomics for the Jedi mind-trick it (partially) is. Now many are talking about a potential crash in Japan, as I guessed would happen in the second stage of Japanese yen devaluation.

But is Abenomics truly over? As the title suggests, now that perceptions have drastically turned, I think it's time to be more sanguine (though realistic) about the prospects of Abenomics.

Debt crisis fears overblown

First off, I believe the fears of a debt crisis in Japan are vastly overblown. Debt crises take a long time to accumulate the necessary momentum. After Cyprus, the rational thing for Greeks to do would probably be to not keep money in a Greek bank except the bare minimum needed for everyday transactions, but there have been no signs of massive capital flight for now. The Chinese would probably start accumulating dollars if they were completely rational, hedging a potential credit crisis, but I don't know anyone who has shown such an inclination.

In fact, talk of a dollar and gold crisis began as early as the 1950s and numerous dollar crises occurred in the 1960s before culminating in the collapse of the Bretton Woods over a decade later. Gold bugs love pointing out how the Bretton Woods collapsed but if they invested in stocks then instead of waiting for the "inevitable" inflation, they'd have a shot at becoming Warren Buffett.

Anyway, the point is that crises take a lot of time to accumulate the necessary momentum, especially in large economies and asset classes, and people usually don't panic until their confidence has been shaken repeatedly and are given enough (negative) incentives to turn panic into action. Japan is far from that.

The numbers don't add up

More importantly, the numbers supporting an imminent debt crisis in Japan don't add up. The figures on paper look far scarier than reality. The numbers below are often from different Fiscal Years based on the latest provided data. But the general implications should be valid for the most part.

For example, an often seen chart of JGB ownership would look like this:

Source: Japanese Ministry of Finance (MoF) presentation "Japan's Debt Management and Fiscal Consolidation, " page 7 [pdf]

This would show banks and insurance companies owning 63.8% of JGBs and public pensions owning 9%. That's 73%! This would lead to conclusions such as the following:

A) Banks are going to go belly up from the JGBs

This is simply not true. Although I may have insinuated as much in my early articles, my emphasis was that investors did not fully appreciate the risk of bank balance sheets taking a substantial hit from declines in the market value of JGBs. Now that people are panicking about it, a closer scrutiny is in order.

The truth is that there are banks and "banks." What do I mean by that?

If we look closely, Japan Postal Savings and Postal Life Insurance owned 30% of JGBs in 2006 when there were 674 trillion yen total outstanding. If we assume their share hasn't changed much, this would mean banks and insurance companies excluding Postal Savings and Postal Life only own 28.7% of JGBs, about 217 billion trillion yen as of 2012.

But what is the maturity on bonds owned?

Source: Bank of Japan (BoJ) 2012 report "Global correlation among government bond markets and Japanese banks' market risk."

This estimate shows major banks and regional banks owning about 150 trillion yen JGBs. But average maturity for major banks is only 2.5 years. So this why the BoJ's own assessment of the situation claims that interest rate sensitivity for bank-owned JGBs is low, about "a 100 basis point increase in interest rates across all maturities rose the value of interest rate risk (including from loans) by around ¥500 billion at the major banks and about ¥400 billion at the regional banks in FY2010."(Source here [pdf]) The same source notes that these banks own about 30-40 trillion yen in corporate bonds, so exposure is not high there either.

The skeletons might be hidden somewhere in Postal Savings and Life Insurance, respectively reorganized into Japan Post Bank and Japan Post Insurance after 2006. They are state-owned companies and probably not as sensitive to interest rate fluctuations and are easier to influence for politicians. So they probably won't contribute to the panic in the short run and if they suffer heavy losses, they'll just be bailed out a long time in the future, when Abenomincs has hopefully reflated the economy already.

B) What's the maturity?

There are two sources for outstanding maturity that somewhat conflict. The MoF website states that for the 800 trillion JGBs outstanding as of March 2013, 572 trillion are long term (10 years or more).

However, a more detailed report provided by the MoF has another view, I think it is more accurate and the former data probably miscategorized the bonds:

Source: MoF Debt Management Report 2012 page 163

This suggests that 70% of JGBs are going to mature within 10 years, 50% within 5 years. With inflation most likely not rising too fast, the 50% maturing within 5 years should not lose too much money.

C) Who owns the toxic "tranches"?

The companies owning 20-40 year JGBs have the most to fret about. Holders of 5-year JGBs can relax as long as 2% CPI isn't achieved in the next year or two. But for 30-year JGBs, assuming a 1.5% real interest rate and 2% CPI, that's a 3.5% yield compared to 1.8% now, which is a 32% market value loss (assuming 1.8% is the coupon rate). Ouch.

Where the skeletons are hidden is a relevant matter. The total losses from subprime loans may not have justified the tremendous turbulence that followed, but market doubts over where the losses were hidden created mistrust of all major financial companies. If markets knew exactly where the bodies were, perhaps there would've been major declines in share prices, but not as much volatility or uncertainty.

Source: BoJ Review on "Japanese Life Insurance Companies' Balance-Sheet Structure and Japanese Government Bond Investment." [pdf]

According to the aforementioned review published this year, "the share of life insurance companies in the super-long-term JGB market recently exceeded 40 percent", adding up to about 40 trillion yen. However, life insurance companies have around 230 trillion yen in assets, with domestic bonds only accounting for 60% of securities assets. I will analyze the picture for insurers in the following section.

The Costs and Benefits of Abenomics

A) The Art of Deleveraging

Source: McKinsey Global Institute "Debt and deleveraging: The global credit bubble and its economic consequences" p.43

Japan's balance sheet recession essentially transferred private debts to the public sector. But, deleveraging by governments on domestic debt has to be done either with high real GDP growth or high inflation. Can you think of an example of successful deleveraging with a 1-2% trend real GDP growth rate, 0% inflation and 200% public debt to GDP?

B) Where Their Interests Lie...(Hint: No longer in "interest")

While higher JGB yields would negatively impact banks and insurers, as long as the negative impact is phased in slowly, the gains might outweigh the losses.

Insurers as noted above are heavily invested in super long-term JGBs, but they have 20% (~34 trillion yen) of their securities assets in foreign bonds, and another 20% in domestic and foreign stocks. Assuming those foreign bonds were mostly denominated in USD, Japanese insurers have already gained 10 trillion yen in foreign bonds. Assuming they gained 30% on all stock holdings, that's another 10 trillion yen. And this is just the beginning. If the USD/JPY hits 130 and the Nikkei (NYSEARCA:DXJ) goes up another 50%, they could gain a grand total of 23 trillion yen in foreign bonds and ~30 trillion in stocks since Abenomics began, around 53 trillion yen in profits, more than enough to cancel any losses on the ~105 trillion yen of JGBs they own. A similar logic can be applied to Japan's public pension fund (which owns 9% of JGBs.)

Source: BoJ Governor Kuroda Speech on QE [pdf]

Banks will benefit from more economic and financial activity. Just imagine what another real estate speculation boom would do for banks. Net interest margins have languished in the past decade and trended lower. Booming assets and higher ROAs (from higher demand for loans) would cause bank profits to soar. The downside for major banks is small, with average maturity of JGB holdings only 2.5 years.

It's also worth mentioning that the BoJ is also focusing on increasing the maturity of bonds it owns from 3 years to 7 years, which will effectively help super long term bond holders cash out a portion of those "toxic" assets.

It appears the financial industry in Japan has far more to gain than it has to lose from Abenomics continuing. This is the exact opposite conclusion of what a cursory analysis of the situation would suggest.

The other big companies are very happy with the boost in profits from the Yen devaluation, though according to a Reuters survey, the smaller companies are not so satisfied, with a weaker yen increasing costs. But the general prosperity provided by the Abenomics shock should be enough to smooth over worries over higher import costs and win over enough of the smaller companies. After all, either Abenomics continues or it ends and Japan goes back to stagnation. The outcome is likely binary in the short run.

BoJ's Get-Out-Of-Collapse Card

The BoJ has a get-out-of-collapse card hidden in its sleeves as a last resort. It could tone down and eventually end stimulus programs, let the JPY revert back to safe haven status and allow deflationary expectations to re-anchor. This would likely undermine Abe's position and the BoJ's credibility and they probably wouldn't prefer it to happen, but it is a last resort option to restore stability if all else fails. Of course, long term trends in the Japanese economy are worrying as many contributors have argued so eloquently. But if push comes to shove, this last resort option is always there.

The existence of this last resort option can steady the BoJ and other Japanese policymakers'(except Abe) nerves. The worst-case scenario is a revert to the old stagnation, so let's pursue something more innovative for now. Hope and change, you know.

Conclusion

The yen and the yield have formed a symbiotic relationship of some sort. Lower yen leads to higher JGB yields (through higher inflation expectations and portfolio rebalancing) which has fanned fears that a crash in JGBs is imminent, ruining financial firms and sparking a general debt crisis in Japan. This has led to the BoJ attempting to calm the JGB market and speculation that Abenomics will be discarded or at least halted to stabilize the JGB market. Once the prospects for a lower yen became very unclear, the crowded short yen positions began unravelling and the Yen surged this week.

However, I attempt to prove the prevalent "Japan-on-brink-of-debt-crisis" realization shaky at best. By conducting an detailed analysis of JGB ownership and maturities, I find that an increase in JGB yields is unlikely to have a large impact on the Japanese financial sector, especially if the pace of adjustment is measured and controlled, and if such an increase is accompanied by other Abenomics successes (lower Yen, jumpstarting the domestic economy etc), it could be a net gain for major holders of the JGB. The government also needs Abenomics to successfully deleverage and other sectors benefit from the general prosperity. Simply put, the economics of the issue favor Abenomics.

Debt crises usually take momentum to cumulate in a showdown and I believe we are far from that when it comes to the JGB. In the event of impending doom, the BoJ still has the last resort option of giving up QE and going back to stagnation to stabilize JGB yields. While this may stump government deleveraging efforts, it is expedient and preferred to a full-blown debt crisis.

Market Outlook

For the next few months, I believe the USD is likely to trade in a range against the JPY (NYSE:FXY) from anywhere between 90~105. Abe is likely to try his best to keep the yen down before parliamentary elections in July, in order not to seem like he's failing and show weakness. The Federal Reserve eventually ending QE will help the dollar, but will also create volatility (in emerging markets like South Africa as I've covered before), fueling demand for the yen as a safe haven asset. The status of Abenomics will seem uncertain as policymakers and market participants attempt to grapple with the situation and form a battle plan going forward. After things become clearer, the Fed starts exiting QE in earnest, the BoJ has soaked up much of the "toxic" long-term JGBs and Japan's economy furthers its recovery, the USDJPY will enter another major bull move.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in FXY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Planning to trade USDJPY in a range. It will probably volatile and messy, but range trading will be the general idea.