Apocalypse, not now
Mar 11th 2010
From The Economist print edition
The alarming future for Japan's finances
CASSANDRA’S curse was that her warnings would never be believed. Doom-mongers in the Japanese government-bond market have suffered a milder fate: they were just far, far too early.
The trade has seemed obvious for years. Japan has run continuous fiscal deficits and seen its debt downgraded by the ratings agencies. With its bonds yielding between 1-2%, the downside risk of a bearish bet has been limited while the upside potential has looked huge.
But the trade has never worked. The Japanese government still enjoys the lowest borrowing costs in the world, with 20-year bonds still yielding just 2.1% and two-year bonds a remarkable 0.15%.
Why? Crucially, Japan has not been dependent on foreigners for finance. Just 4% of its bonds are owned by non-residents. Measly as those yields may be, they are still positive in real terms because of the country’s long record of deflation. Given that cash yields virtually nothing, and that the Tokyo stockmarket is around 75% below its 1989 peak, Japanese domestic investors have clearly felt that bonds were the best of a bad lot.
Stephen King, an economist at HSBC, argues that an odd process has occurred in which the size of the deficit has made businesses more cautious about the prospects for a future crisis, leading to slower growth and deflation and thus a continued appetite for government bonds.
But Dylan Grice, a strategist at Société Générale, argues that the moment of reckoning may not be far away. He cites figures showing that ¥213 trillion ($2.4 trillion) of government bonds are due to roll over this year, equivalent to 45% of the country’s GDP. Meanwhile, as more citizens reach retirement age, Japanese households are no longer saving as they once did. As a proportion of disposable income, savings have declined from around 16% to 3% over the past 25 years. And the Government Pension Investment Fund, one of the biggest holders of government bonds, has admitted that it has no new money with which to buy more debt.
Furthermore, Mr Grice argues that one of the main sources of comfort for investors—that the net debt-to-GDP ratio is a lot lower than the gross figure because of assets owned by the Japanese government—may be an illusion. He doubts the valuations of some of those assets and argues that it is impractical that others could ever be realised.
It certainly seems likely that at some point the worst fears of the bears will come to pass. Debt servicing already uses up some 35% of government revenues. Imagine what that figure would look like if Japan paid the same level of yields as Germany (or worse still, Greece). A fair chunk of Japanese debt is owned by government agencies, a financing pyramid that will eventually collapse. Historically countries with very high levels of government debt have defaulted or, more usually, inflated the problem away.
The budget deficit is forecast to be 7.8% of GDP this year. The IMF reckons that Japan would need to tighten its structural deficit by 13.4% of GDP between now and 2020 in order to bring its debt-to-GDP ratio down to 80% by 2030. That is a bigger adjustment than would be required of any other country, even allowing for the fact that the IMF set other nations a target debt-to-GDP ratio of 60%.
But given that these problems have been building for 20 years, why would they lead to a crisis now? Fitch, one of the leading rating agencies, places Japan top of the list in terms of financing flexibility. The agency uses factors such as net annual debt issuance (as a proportion of the total), size of the economy, the proportion of debt held by non-residents and the stock of financial assets to determine its rankings. By these measures Greece, Portugal and (more surprisingly) Australia are at the bottom of the table.
And the huge amount of Japanese debt rolling over this year need not be a problem. Investors will simply recycle their existing holdings. Takahira Ogawa, a sovereign analyst at Standard & Poor’s, thinks there is more scope for the Bank of Japan to buy government debt, as central banks have done elsewhere.
Of course, such measures just postpone the evil day. The crisis will surely arise when Japan becomes dependent on foreigners for finance, or if a sharp rise in inflation or a sudden slump in the currency causes domestic private investors to take fright. But since the country is still running a current-account surplus, the yen is trading at 90 to the dollar (compared with 124 in June 2007) and deflation is forecast for the rest of the year, the apocalypse seems unlikely to occur in 2010.
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