Japan's Public Debt Problem Will Have Global Implications

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Includes: FXY, JYN, YCL, YCS
by: Tales From The Future

Summary

Once key interest rates rise again around the globe, Japan will find it hard to keep its domestic interest rates levels near zero. Domestic investors need higher yields.

Japan's debt/GDP levels are not sustainable, especially once interest rates rise. Japan would have to use huge portions of its tax revenue to just cover the debt interest payments.

Current account deficits and Japan's demographics (aging population) as well as moves by major central banks (rising interest rates by the FED) could trigger these debt events between 2015-2020.

I assume most readers on Seeking Alpha don't live in Japan and don't hold significant amounts of assets in JPY, so why should they care about Japan's public debt?

Looking at runaway public debt on a global scale as an introduction, sovereign defaults are not that uncommon. In fact, some countries in South America experienced default events up to ten times over the past 200 years:

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Why could Japan, still considered a global economic powerhouse, join this list for the first time in the near future?

The short answer is Japan's debt/GDP level well above 200%, even its net debt is among the highest in the world along with Greece:

Since 1990, public finances have deteriorated significantly. Government spending to stimulate economic activity has outstripped tax revenues, resulting in a sharp increase in Japanese government gross debt to around 240% of GDP. Net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 135%.

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Domestic interest rate levels near zero helped mask this problem since the 1990s and allowed Japanese politicians to pile on more and more debt to appease their interest groups while delaying important but painful structural reforms. [1]

That's the short answer. Instead of giving the long answer myself, let me quote investor Kyle Bass, who has been vocal on the issue for quite some time:

Beacon Reports: Japan is not Greece. It is a rich developed nation. The Japanese are educated, organized and hard working. The country's infrastructure - roads, buildings, bridges, factories, trains - are in better shape than most other developed nations. A shinkansen departs every ten minutes and they run on time. The country enjoys reserve currency status. Why should Japan be the first developed nation to mark the beginning of the end of the 70-year debt supercycle?

Kyle Bass: You need to divorce yourself from preconceived ideas. I've never met a more gentle, considerate, welcoming, thoughtful, or spiritual population in any other country in my lifetime. Japan is a beautiful country and its people are great. That's beside the point. The point is the government has mismanaged its finances to an extent where they have moved the country into a checkmate.

The reason why Japan is going to be first is that they spend 50% of their central government tax revenue on debt service alone. They are near the point where they just can't borrow anymore. Further, the Japanese would rather not admit wrongdoing: They never restructured their banks during the post late 80s - early 90s collapse. They've taken rates to zero. Their economy has continued to move along for the past 10 - 15 years because it was export based. That's changed − there is nowhere to go.

Japan's trade surplus is negative. The balance of trade is negative. The current account is moving into a negative position. The demography of the country is unstoppably rolling over. It's a multivariate equation in which everything is working against the government at the same time. Kuroda and Abe have only one way to go - and that's to go all in - which is what they did.

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Due to these circumstances, the market for debt (Japanese Government Bonds, JGBs) is already controlled in large parts by the BoJ (Bank of Japan). A recent example:

The central bank has also been buying a disproportionate amount of the most recent issues as dealers sell JGBs they buy at auction almost immediately to the BOJ to earn something, in what traders call "the BOJ trade."

At the end of March, the BOJ owned about 33% of the current No. 333 10-year bond, (...)

It's not the first time that a scarcity of JGBs caused by the BOJ has created some unusual market milestones. At the end of March, rates in one funding market briefly fell below zero for the first time, as market participants basically offered short-term cash loans at negative interest just to borrow JGBs.

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As a result, Japan's annual budget (below are 2013 figures) now uses almost 25% to just cover existing debt servicing. Also note that a substantial portion of Japan's revenues is simply coming from issuing new debt, not tax revenue (!):

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That's the status quo and it held up until today. So far, all skeptics (including Kyle Bass) have been proven wrong. Japan had no trouble growing and financing its huge debt pile thanks to two decades of very low interest rates - also because over 90% of its debt was held domestically.

That era is about to end and that's where the FED connection becomes relevant:

Once the FED and other central banks let key interest rates rise or have to raise them (very likely in 2015-2020) Japan's huge debt can no longer be financed - at the very least the unmanageable long-term outlook of that scenario will become obvious.

Japan has been lucky that patient domestic investors have been accepting ultra-low returns on JGB, that truce will not hold up forever as the population is aging and there no longer is an account surplus (for example, Japan relies on energy imports after the shutdown of most nuclear reactors after 2011, that is a major negative factor in external trade balances).

I see three likely outcomes between 2015 and 2020 once large domestic investors (such as the world's largest pension fund, GPIF) get nervous about their huge JGB holdings and will diversify more money into foreign assets and stocks:

- Massive volatility in the JPY trade (since Japanese investors still hold a lot of assets abroad) with a substantial drop of the JPY against other major currencies once the dust settles. In turn, Japanese stocks could rise to new highs, but only in nominal JPY terms.

- Turmoil in other public debt markets, especially in countries with high public and total debt levels. Japan could trigger a public debt crisis as no nation with reserve currency status experienced a similar crisis in recent years: Japan could play a similar role as Bear Stearns or Lehman Brothers back in 2008 as defining crisis trigger this time. Public debt around the world would have to be re-priced and models risk-adjusted.

- Monetary reform in Japan as a last-gap solution by the BoJ [2]. Radical ideas might be needed, such as looking at the historic direct stimulus work of the BoJ after World War II (for people interested in more details, please refer to the work of Shimomura and more recently Werner).

Summary: As I have written over the past 18 months, foreign investors should look into the JPY exchange rate and protect themselves against a further falling JPY in the coming years. The situation in Japan should be monitored carefully by all investors, even those with no exposure to Japan - especially once key interest rates start to rise in 2015 (the US FED could be an early mover). Japan is still the World's third-largest economy and a public debt or JPY currency crisis could send unprecedented shock waves through bond and stock markets across the globe.

[1] The current Japanese PM Shinzo Abe is working on yet another set of reform attempts using the "third arrow" label; most likely these efforts will again be watered down by bureaucrats and powerful lobby groups within the ruling LDP coalition.

[2] I disagree with Kyle Bass and other JGB bears on this point. While Japan may have no standard textbook options left it could resort to unconventional solutions such as monetary reform using public money creation: The BoJ would create all money in JPY and transfer it directly to the government to be spent into the real economy, basically unearthing the decades-old "Chicago Plan" and transplanting its key ideas to Japan. This daring system switch could result in a large one-time debt reduction; to have lasting effects, a renewed and much stronger BoJ would have to become a truly independent entity.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.