Japan and the debt faith crisis
James Saft is a Reuters columnist. The opinions expressed are his own.
Could Japan be the next victim of the crisis of faith in government bonds?
Despite carrying public debt more than twice the size of its economy and suffering from poor growth and an aging population, Japan’s government can still borrow money for 10 years at just over 1 percent.
The big story in global markets, perhaps even in global economics, in 2011 has been the transformation of government debt markets, which are now being driven by the realization that sovereigns can and sometimes do default.
So far that has actually been good for borrowing rates for big economies blessed with their own central banks, such as the U.S., Britain and Japan. There is a growing chance that in 2012 the wolves, having picked off Italy and others in the euro zone, move on to target the hindmost of the rest of the pack, which, given its poor medium-term fundamentals, may well be Japan.
“Recent events in other advanced economies have underscored how quickly market sentiment toward sovereigns with unsustainable fiscal imbalances can shift,” the International Monetary Fund said in a paper released last week on Japan.
In the understated bureaucratese of the IMF, that is the equivalent of shouting a warning from the rooftops.
“Higher yields could result in a withdrawal of liquidity from global capital markets, disrupt external positions and, through contagion, put upward pressure on sovereign bond yields elsewhere.”
Indeed you could argue this is exactly what is beginning to happen in Europe now, as banks and others stung by losses there move to raise capital by selling assets elsewhere.
It is not just the IMF which is warning. Ratings agency Standard & Poor’s last week complained that the new government of Prime Minister Yoshihiko Noda has not made progress in addressing the debt burden, tipping that a downgrade of its credit rating may be in the offing.
A sudden spike in yields could be driven by the delay in reforms, according to the IMF, a drop in private savings, most likely through a decline in corporate profits, a long slump in growth or, most likely, by a rapid change in what Japanese investors themselves consider to be the risks in holding their government’s IOUs.
STEADFAST SO FAR
So far, at least, most domestic holders of Japanese debt, who make up 95 percent of the investor base, appear not to have read the memo.
Japan has been able to build up this debt without paying a large price to borrow because its citizens have saved a lot and both they and the institutions they save in have a strong preference for keeping their money in Japan.
That deep, even extreme, preference is perhaps more a cultural phenomenon than it is the result of a rational analysis, and as such may persist a lot longer then the fundamentals would imply.
As well, Japan is hugely different from Italy or Greece because it has its own central bank and its own currency, allowing it far more flexibility in how it might react to a debt crisis, or even to a mild slowdown in demand for its bonds. It is important to note that by and large the yen and JGBs have behaved like safe havens in the face of European dislocation.
That said, six weeks ago Italy looked to be in pretty good shape.
The math gets ugly for Japan pretty quickly if its rates start to rise. Interest payments are modest now, only 2 percent of GDP, but an increase of just a percentage point in JGB yields would double the annual interest bill.
The circle could easily become vicious. As banks hold large amounts of JGBs, a spike in rates will deal them large capital losses, potentially making others unwilling to lend to them and forcing a sell-off of assets to raise funds. If they sell their good assets, i.e. those abroad, this will drive the yen up as they bring the money home, further suppressing economic growth and adding to overall pressure.
And you can only defy the fundamentals for so long. The IMF predicts that the decline in GDP and earthquake reconstruction will push net public debt to 160 percent by 2015. Private savings, an important source of financing for the government, has declined sharply, to only 3 percent in 2009, as Japan‘s aging population began to eat away at savings built up during their working lives. At the same time social security spending has ballooned, and now stands at about half of all government expenditures.
At some point, Japan must reform or face a crisis. The same of course is true about the U.S., the only disagreement being when those points will actually arise.
The lesson of Europe is how quickly the reckoning can come.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com)