Harpooning oneself in the foot: The Japanese Bond Market Bubble, by Ah0707

Since the post-WW2 period Japan has had 3 financial bubbles, two of which that have popped in dramatic style. In 1989, the Nikkei 225 Stock index had risen to a peak of 38.957.44 points only to have collapsed to below 8,000 points by 2003. Around this same period, the price of Japanese Real Estate had fallen faster than an elephant after being kicked out of a plane, with prices falling by as much as 99% in Tokyo’s financial district. The combination of these bubbles popping had wiped out tens of trillions of dollars, or more than half the world’s GDP to put it into context.

These two bubble pops, however will pale in comparison to the next one coming: Japanese Bonds. To set a bit of context, the Japanese government, in order to stimulate the economy back in the early 90s, had effectively begun printing money (issuing bonds) at such a frenetic pace (and has continued unabated for the last two decades) that the amount of government bonds issued far out-stripped the amount of tax revenue they receive from Japanese citizens. At the moment Japan’s government gross debt sits at 240% of GDP (More fun if we start talking though in terms of Yen, Quadrillions of it). 

While even getting to this mark does seem logically-defying for any rational thinking human being, what made this possible up until now were three key factors: A large pool of savings, low interest rates, and a postive trade surplus (earnings from exports are greater than the costs of imports).

At face level, the following statistics could put one’s mind at ease that there is no crisis to really worry about: Japanese have $19 trillion dollars in savings and 90% of Japanese Government Bonds are held domestically, so say if China or the US were to decide to dump their holdings in Japanese Government Bonds, it would not lead to a collapse in the Japanese economy. In addition overnight cash interest rates are around 0.1% per annum, which is the lowest rate amongst all the major central banks in the world. The below link attests this:

http://www.global-rates.com/interest-rates/central-banks/central-banks.aspx

All good? Not quite.

Let us start with the savings rate: During the hey-days of the late 80s and early 90s, Japan had a savings rate of around 15 to 25%. Today it is under 3%. The two main causes are: a) declining asset prices (i.e. deflation), and b) an ageing population. We have effectively touched on the asset price collapse over the last two decades with the real estate and stock market bubbles, so we will focus on the impact of the aging population. More than 23% of Japan’s population are above the retirement age of 65 (compare that to 11.6% in 1989), and as the chart clearly shows below, there is a direct correlation between the decline in the working age population and the rate of economic growth (makes sense - less able workers, less production…). 

Apart from having a lower proportion of the population in the workforce, pension funds and insurance companies have had to start selling their Japanese Government Bond (JGB) holdings in order to payout the retirement benefits that are owed. This leads to the servicability of debt becoming more difficult (seriously who wants to put their money into savings that would only get you next to nothing in interest?). To ascertain the degree of desperation of those governing the finances of the nation, one “remedial” solution proposed by the new (but don’t know for how long) finance minster Aso Taro was to ask the elderly to “hurry up and die” http://www.guardian.co.uk/world/2013/jan/22/elderly-hurry-up-die-japanese  in order to reduce the cost of social welfare (18% of national income currently, 27% by 2025) –  what is the phone number to The Hague, please?  

Anyway moving from that slightly morbid blot now is a good time to touch on interest rates, I mean what interest rates? For about 17 or so years, the overnight cash rate in Japan has been set by the Bank of Japan (BoJ) to under 1% per annum in order to help revitalise the economy (see chart below).This has not quite worked out (check out chart previously).

Now the latest Prime Minster Shinzo Abe has promised to combat the deflation of asset prices in Japan by proposing a 2% inflation target. This would imply making assets, including Japanese Government Bonds more attractive to purchase. Now we have touched on the fact that the savings rate in Japan is now under 3%, domestic purchases would have a band-aid effect, so it would be wise to increase sales to foreign investors, but again with a declining Yen and next to nothing interest rates, what can make one more interested in purchasing bonds? One solution is to increase the yield of return on Japanese Governement Bonds, but this would imply raising interest rates. 

There is a fundamental problem to this however: Even at these low levels of interest, 25-30% of Japanese tax revenue is spent on servicing only the interest payments for the bonds. It has been calculated that if interest rates go up to as much as 2.5%-3.5% per annum, the tax revenue generated would not be enough to cover the interest payments. At the moment the Japanese tax rate is 5%, with plans to increase it to 10% by 2015, but even if all Japanese held assets were put to service the debt issued by the Japanese government and taxes were raised to 100%, it has been forecasted that it would be enough to only service the debt for another 12 years. Things look terminal at best.  

The last major point I want to look at is Japan’s trade surplus. Before the 2011 Earthquake/Fukushima disaster, Japan had maintained a positive trade balance due to high volume of exports, as well as low dependency to meet the energy requirements of the nation due to the development of nuclear reac tors.

Post Fukushima, however, nuclear reactors were shut down leading to significnat increases in energy imports, making Japan a net importer as oppose to a net exporter (see chart below). 

Combine that with a weaker yen to boost exports, increased stimulus to revitalize infrastructure (20 trillion yen promised by Shinzo Abe), falling exports to China (it’s largest export partner, and territorial disputes brewing again) and a downbeat global economy, it Is expected that the deficit will get much wider.  

So what is it that needs to be solved in Japan? Increase economic growth and increase the value of asset prices. What can be done? Government go beserk, print more money/issue more JGB at super-low interest rates and devalue Yen to increase exports. That has been the current policy to date, and clearly has not worked.. So what about stopping the money printing, raise interest rates and increase the value of the Yen? – As we have seen it is a quick step to sovereign default. How about re-starting the nuclear reactors? – Not sure if one can stomach 3-eyed fish. How about addressing xenephobic immigration policies or increasing incentives to have larger families to increase the proportion of the working age population? – Wishful thinking, but may be too late to implement as it is.   

If we put the implications in a global context, consider that Japan is the third largest economy in the world and holds $4 trillion US dollars in foreign assets. Now mix with that the crisis in the Eurozone and Helicopter Ben Bernanke continuing to go wild in the US with the never-ending “quantitative-easing” money printing, we would most likely see a crisis in the Global Financial Markets unprecedented in anyones’ time sooner rather than later.   

Ah0707 - “Guns and Food (Gold and Silver too)”