Satyajit Das: Japan's Forgotten Debt Problem
Japan may have no option other than a domestic default to reduce its debt levels.
Japan’s Nikkei 225 (INDEXNIKKEI:NI225) stock average rose by around 23% in 2012. Much of the increase reflects faith in the reflation strategy of second time Prime Minster Shinzo Abe to increase growth through an additional US$120 billion of public spending, create inflation to reduce the debt to GDP ratio, and devalue the yen. The strategies have all been tried before, with limited success. There is no reason to believe that this time it will different.
In the post-war period, Japan enjoyed decades of strong economic growth – around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between 1971 and 1990. Since the collapse of the Japanese debt bubble in 1989/1990, Japanese growth has been sluggish, averaging around 0.8% per annum. Nominal gross domestic product (GDP) has been largely stagnant since 1992. Japan’s economy operates far below capacity, with the output gap (the difference between actual and potential GDP) being around 5- 7%.
The Japanese stock market trades around 70-80% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. Japanese real estate prices are at the same levels as 1981. Short-term interest rates are around zero under the Bank of Japan’s (BoJ) zero interest rate policy (ZIRP), which has been in place for over a decade. 10-year Japanese government bonds yield around 1.00% per annum.
Since 1990, public finances have deteriorated significantly. Government spending to stimulate economic activity has outstripped tax revenues, resulting in a sharp increase in Japanese government gross debt to around 240% of GDP. Net debt (which excludes debt held by the government itself for monetary, pension, and other reasons) is about 135%. The US government has gross and net debt of 107% and 84%. Total gross debt (government, non-financial corporation, and consumer) is over 450% of GDP, compared to around 280% for the US.
Japan’s demographics parallel its economic decline. Japan’s population is forecast to decline from its current level of 128 million to around 90 million by 2050 and 47 million by 2100. A frequently repeated joke states that in 600 years, based on the present rate of decline, there will be 480 Japanese left.
The proportion of Japan’s population above 65 years will rise from 12% of the total population to around 23%. Japan’s workforce is expected to fall from 70% currently by around 15% over the next 20 years. For every two retirees, there will be around three working people, down from six in 1990.
According to one forecast by 2050, Japan will have a median age of 52, the oldest society ever known.
Origins of the Crisis
Japan’s post-war economic success, like that in Germany, was based on an export-driven economic model, using low costs and manufacturing competence. An under-valued yen provided Japanese exporters with a competitive advantage.
The Plaza Accord signed on September 22, 1985 called for France, West Germany, Japan, the United States, and the United Kingdom to devalue the dollar in relation to the Japanese yen and German Deutsche mark by intervening in currency markets. Between 1985 and 1987, the yen increased in value by 51% against the dollar. The higher yen adversely affected Japanese exporters. Japanese economic growth fell sharply, from 4.4% in 1985 to 2.9% in 1986.
Desperate to restore growth and offset the stronger yen, the Japanese authorities eased monetary policy with the BoJ cutting interest rates from 5% to 2.5% between January 1986 and February 1987. The lower rates led to a rapid increase in debt funded investment, driving real estate and stock prices higher. At the peak of the “bubble” economy, the 3.41 square kilometre (1.32 square miles) area of the Tokyo Imperial Palace had a theoretical value greater than all the real estate in the state of California.
Seeking to reverse the unsustainable asset price inflation, the authorities increased interest rates to 6% between 1989 and 1990, triggering the collapse of the boom. As Japan’s economic problems worsened rapidly, the government responded with large fiscal stimulus programs. The BoJ cut interest rates to zero. But the policy measures failed to revive the economy, which slid into deflation.
There was a parallel deterioration in public finances. At the time of the collapse of the bubble economy, Japan’s budget was in surplus and government gross debt was around 20% of GDP. As the Japanese economy stagnated, weak tax revenues and higher government spending to resuscitate growth created substantial budget deficits.
Japan’s total tax revenue is currently at a 24-year low. Corporate tax receipts have fallen to 50-year lows. Japan now spends more than 200 yen for every 100 yen of tax revenue received.
Japan’s large pool of savings, low interest rates, and large current account surplus has allowed the build-up of government debt.
Japan has a large pool of savings, estimated at around US$19 trillion, built up through legendary frugality and thrift during the nation’s rise to prosperity after World War II. In recent years, household savings were complemented by strong corporate savings, around 8% of GDP.
Much of these savings are invested domestically. A significant amount of the savings is held as bank deposits, including large amounts with the Japanese Postal System. Japanese banks hold around 65-75% of all savings with the Japanese Postal System being the largest holder. Around 90% of all Japanese government bonds (JGBs) are held domestically.
Over the last 50 years, Japan has also run large current account surpluses, other than in 1973–1975 and 1979–1980 when high oil prices led to large falls in the trade balances. The current account surplus has resulted in Japan accumulating foreign assets of around US$4 trillion or a net foreign investment position of approximately 50% of GDP. This helped Japan avoid the need to finance its budget deficit overseas and also boosted domestic resources, increasing demand for JGBs.
Since the global financial crisis and more recent European debt crisis, Japan has been viewed as a “safe haven.” Investors went long yen and JGBs, pushing rates to their lowest levels in almost a decade and increasing foreign ownership of JGBs to around 9%, the highest level since 1979, which is the first year for which comparable data is available. These factors have helped Japan finance its budget deficit.
Airbags designed to protect occupants of a car from injury in a crash only work once. Similarly, the factors that allowed Japan to increase its government debt levels are unlikely to continue.
Following the collapse of the bubble, policymakers implemented a variety of economic stimulus programs.
Japan’s budget surplus of 2.4% in 1991 has become a chronic budget deficit, increasing from 2.5% in 1993 to about 8% by the end of the 1990s. It has remained high during the 2000s. The BoJ has tried unsuccessfully to increase inflation to reduce debt. Japanese inflation has averaged -0.2% in the 2000s, a decline from levels of 2.5% in the 1980s and 1.2% in the 1990s. The policies have failed to restore economic growth, trapping Japan in a period of economic stagnation.
Nomura economist Richard Koo argues that Japan is experiencing a “balance sheet recession,” triggered by the collapse of financial asset prices. Financially insolvent firms are reducing debt -- deleveraging -- despite low interest rates. This is evidenced by a sharp fall in investment (currently around 22% of GDP, down from 32% in 1990) and corporations becoming net savers from net borrowers.
Private consumption is weak, falling to about 57% of GDP, further reducing domestic demand. This reflects weak employment, lack of growth in income, and the aging population. Strong exports and a current account surplus have partially offset the lack of domestic demand as firms focused on overseas markets.
With investment and consumption weak, large budget deficits have supported economic activity, avoiding an even larger downturn in economic activity.
In a balance sheet recession, monetary policy is ineffective with limited demand for credit. GDP tends to decline by the amount of debt repayment and unborrowed individual savings. Government stimulus spending is the primary driver of growth.
Given the strategies that have been tried unsuccessfully before, Prime Minster Shinzo’s policies have a desperate quality. Although the measures will provide a short-term lift in economic activity, it is unlikely to create a sustainable recovery. They will increase the budget deficit and government debt levels.
Continued economic weakness, a decline in savings rates, and a reversal of the current account surplus make the Japanese government debt burden increasingly unsustainable.
Getting Poorer at Home
The Japanese government’s ability to finance spending is increasingly constrained by falling Japanese household savings rates, which have declined from between 15% and 25% in the 1980s and 1990s to under 3%, a level below the US until recently. This decline reflects decreasing income and the aging population.
Wages have fallen with average annual salaries including bonuses falling every year since 1999 and decreasing by around 12% in total. Between 1994 and 2007, labor costs as a percentage of manufacturing output declined from 73% to 49%. Japanese workers' share of GDP fell to 65% in 2007, from a peak of 73% in 1999.
The aging population further reduces the savings rate. Household surveys indicate that around a quarter of households with two people or more have no employment. In aggregate, the amount of money being paid to retirees from savings exceeds the amount of new money that is going into savings funds. This is compounded by low returns on investments, which accelerates the rundown of savings.
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.
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.”
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