Kyle Bass Revisited

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Includes: DBJP, DEWJ, DXJ, EWJ, EWV, EZJ, FJP, FXJP, GSJY, HEWJ, HFXJ, HGJP, HJPX, JEQ, JPN, JPNH, JPNL, JPXN
by: Richard Solomon

Originally published here on September 3, 2017.

In 2010, Hayman Capital hedge fund manager J. Kyle Bass prominently predicted the Japanese government bond market would soon implode. He cited national debt levels at twenty-four times central government tax revenues and the nation's shrinking and aging population as the underlying causes. Japanese people and institutions would seek refuge by buying other nation's sovereign debt after losing confidence in the value of Japanese government liabilities. National debt service costs would soar to unmanageable levels. Capital flight would ensue. Crisis would engulf Japan's entire financial system.

It never happened. It may never happen, should policymakers bring government finances under control by 2025. That's when economists predict pensioners will begin to spend their retirement nest eggs en masse. Around then, Japanese households will cease to be able to buy all the JGBs that the government may wish to sell.

Conventional wisdom suggests Bass was wrong at the time, because Japan owns its own debt. Indeed, Japanese people effectively own 90% of the JGB market. Said another way, Japan's financial system remains robust for so long as Japanese people are able to buy all newly issued government debt. Until then, the government can continue paying its expenses with money borrowed from Japanese citizens. Afterwards, the JGB market will be exposed to fickle foreign investors, who might want to charge a higher rate of interest than the government can afford.

Time is running out. To show why, we prepared a litmus test comparing Japanese household assets to the national debt between 1990 and 2016, with data obtained from the Bank of Japan. We included in our litmus test only Japanese financial household assets consisting of cash, bank deposits, stocks, investment trusts and non-central government bonds. We excluded illiquid household assets, comprising land, building, insurance and pensions, as these cannot be easily sold to fund bond purchases. (We also ignored the unknown value of Japan's human capital, social capital, and the nation's infrastructure.)

In 1990, liquid household financial assets provided 3.4 times national debt cover. By 2016, debt cover declined to 1.10 times. The chart suggests households are nearing their capacity to buy added national debt. It highlights that Japanese citizens cannot indefinitely be depended upon to fund budget deficits.

The BOJ's massive quantitative and qualitative easing program acts as a short-term safety value by mopping up any excess central government debt. But QQE also raises the risk of a future bond crash as national debt mounts and household assets decline. The BOJ is reaching the end of its capacity to further expand its balance sheet. All major central banks are set to unwind after an unprecedented period of extraordinary monetary expansion.

The inability of the BOJ to follow in lockstep with other central banks could trigger a bond crash of the kind predicted by Bass. To defuse the situation, policymakers should bring fiscal deficits under control before 2025.