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Satyajit Das: Japan's Forgotten Debt Problem

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Japan may have no option other than a domestic default to reduce its debt levels.

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Getting Poorer Abroad

Japan's current account surplus has also allowed the government to run large budget deficits, which can be funded domestically. Since 2007, the Japanese trade account surplus has fallen sharply, turning into a deficit in 2012.

The secular factors driving the fall include an appreciating yen and slower global growth, which has reduced demand for Japanese products such as cars and consumer electronics. In late 2012, territorial disputes with China exacerbated the decline in exports. It also reflects the impact of the Tohoku earthquake and tsunami as well as the subsequent decision to shut down Japanese nuclear power generators, which increased energy imports, especially liquid natural gas.

Deep-seated structural factors also underlie changes in the trade account. Since the 1980s, rising costs and the higher yen have driven Japanese firms to relocate some production facilities overseas, taking advantage of lower labor costs and circumventing trade barriers. More advanced, technologically complex and high-value manufacturing was kept in Japan. But post-2007 Japanese firms have increasingly been forced to close these domestic production facilities as they have become uncompetitive.

The combination of falling exports, lower saving rates, and declining corporate earnings and cash surpluses is likely to move the Japanese current account into deficit. In turn, this will force Japan to become a net importer of capital to finance government spending, altering the dynamics of its finances.

The Way It Ends

If Japan continues to run large budget deficits, as is likely, then the falling saving rate and reversal in its current account will make it more difficult for the government to borrow, at least at current low rates.

Ignoring foreign borrowing and debt monetization by the central bank, the stock of private sector savings limits the amount of government debt. In the case of Japan, this equates to around 250-300% of GDP. Japan's gross government debt will reach this level around 2015, although net government debt will not reach this limit until after 2020.

Even before Japan's government debt exceed household's financial assets, the declining savings rate and increasing drawing on savings by aging households will reduce inflows into JGBs, making domestic funding of the deficit more difficult.

Insurance companies and pension funds are increasingly selling their holdings or reducing purchases to fund the increase in payouts to people eligible for retirement benefits. Institutional investors -- and, to a lesser extent, retail investors -- are also increasingly investing in other assets, including foreign securities, in an effort to increase returns and diversify their portfolios.

Forecast current account deficits will complicate the government's financing task. Japan's large merchandise trade surplus has shrunk and will remain under pressure reflecting weak export demand and high imported energy costs.

Japan's large portfolio of foreign assets will cushion the effects for a time. Japan has accumulated large foreign assets totalling around US$4 trillion, making it the world's biggest net international creditor. The BoJ is the largest investor in US Treasury bonds, with holdings of around US$1 trillion. But even if net income from foreign assets (interest payments, profits, and dividends) stays constant, Japan's overall current account may move into deficit as soon as 2015.

As the drawdown on financial assets to finance retirement accelerates, Japan will initially run down its overseas investments, losing its net foreign asset position. Unless public finances improve, Japan ultimately will be forced to finance its budget deficit by borrowing overseas.

Where the marginal buyers of JGBs are foreign investors rather than domestic Japanese investors, interest rates may increase, perhaps significantly. Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan's interest payments will be an unsustainable proportion of tax receipts.

Higher interest rates will also trigger problems for Japanese banks, Japanese pension funds, and insurance companies, which also have large holdings of JGBs.

JGBs total around 24% of all bank assets, which is expected to rise to 30% by 2017. An increase in JGB yields would result in immediate mark-to-market large losses on existing holdings, although higher returns would boost income longer term. BoJ estimates that a 1% rise in rates would cause losses of US$43 billion for major banks, equivalent to 10% of Tier 1 Capital for major banks or 20% for regional banks.
No positions in stocks mentioned.

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