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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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To avoid the identified chain of events, Japan must address the core problems. But reductions in the budget deficit are difficult. Spending on social security accounts and interest expense now totals a major part of government spending. Increasing health and aged care costs are expected by 2025 to be around 10-12% of GDP. An aging population and shrinking workforce will continue to drive slower growth and lower tax revenues. Tax increases are politically unpopular. Reductions in the budget deficit are likely to reduce already weak economic activity, compounding the problems.

Japanese policymakers have other options. Financial repression forcing investment in low interest JGBs is one alternative. The BoJ can maintain its zero rate policy and monetize debt to finance the government. Japan can try to inflate away their debt. But ultimately, Japan may have no option other than a domestic default to reduce its debt levels.

Cassandra Does Japan

Investors and traders have repeatedly bet on a Japanese crisis, usually by short selling JGBs to benefit from higher rates. With low Japanese interest rates, the risk of the trade has always seemed limited while the potential profit large. But the bet has failed each time, giving the strategy its name – the "widow maker."

Given its large domestic savings and also the ability of the BoJ to further monetize its debt, the status quo can be maintained for a little longer. But eventually Japan's deteriorating public finances and declining ability to finance itself domestically will coincide with weakening ratings and large refinancing needs.

Japan's toxic combination of weak economic performance, large budget deficits, high and increasing levels of government debt, declining household savings, and looming current account deficits is increasingly unsustainable. Once the problems emerge, they will be difficult to contain. As economist Rudiger Dornbush once observed: "The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought."
No positions in stocks mentioned.

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