How Long Can Japan Play The Endgame?

Unlike typhoons, which come and go, the Japanese quagmire has been getting deeper and ever more perilous, but all predictions of a financial cataclysm have been premature. So far.

In fact, every time I return to Tokyo, I am amazed by how much the city has changed. Clusters of high-rise buildings have replaced run-down city blocks. They come with new streets and immaculate metro stations. Train lines have been added, others have been extended. When a crack appears in a street, they repave the street, and they do it in a labor-intensive way with too many workers watching respectfully what the few are doing. The workers aren’t low-wage immigrants but Japanese in intriguing uniforms. The healthcare system is universal. Pensions for those who retired some years ago are adequate…. But there is one issue.

Debt. Gigantic amounts. Gross national debt has reached 230% of GDP, by far the highest in the developed world. By comparison, tottering Greece just breeched 150% and the U.S. 100%. Japan’s catastrophic level of indebtedness has been made possible by factors that are unique to Japan, but some of them have begun to reverse, and the endgame has started.

When the bubble burst in 1989, government debt was minimal. As the stock market and real estate were crashing, the government passed an endless stream of stimulus packages (“supplemental budgets”). In rural areas, bridges to nowhere are visible everywhere, and so we know where some of the money went. These stimulus packages accomplished two things: minor upticks in GDP and large jumps in government debt.

Funding has never been an issue, however. Due to its institutional setup and insular psychology, Japan has been able to sell 95% of its Japanese Government Bonds (JGB) within Japan.
— Individuals hold over 50% of them in their massive household assets of 1,491 trillion yen, or $19 trillion (Bloomberg).
— Government-owned or controlled institutions hold over 40%. Among them: the Government Pension Investment Fund (GPIF), one of the largest pension funds in the world; the government-owned Post Bank, largest deposit holder in the world; and financial institutions the government can lean on.
— The Bank of Japan (BOJ) has blobs of JGBs on its balance sheet after years of Quantitative Easing.
— Foreigners hold only 5%.

Internal funding has insulated the government from the discipline of the credit markets. And if there is an uptick in yields, the BOJ goes on a buying spree. Not even the saga of serial credit-rating downgrades has had any impact on budgetary policies or yields, with red ink at record highs and yields near record lows (10-year JGB below 1%).

All this is backed by Japan’s foreign exchange reserves of over $1 trillion, a resource most countries can only dream about. Largely invested in US Treasuries, they’re the result of decades of steep trade surpluses.

But the fundamentals are changing.

Individuals stopped saving. In the 1980s, the savings rate was 15%. In the 1990s, the air hissed out of the bubble economy, and the savings rate began to descend. In 2007, it bottomed out at 1.7%, though it recovered a bit since. Downward pressure on wages decimated the earnings power of the post-bubble generation. They’re cynical about the future, doubt they will ever receive a pension, and no longer believe in the tradition of saving. They’re focused on consuming. And they save almost nothing.

“We will be a net seller” of JGBs, said Takahiro Mitani, president of the GPIF earlier this year (Bloomberg). With 30% of the population over 65, and an ever smaller number of young workers, pension payouts are accelerating while contributions are decelerating. Other funds and institutions are in a similar situation. The most reliable buyers of JGBs have become sellers.

Now this: A trade deficit. In August, it soared to ¥775 billion ($10 billion), the highest August deficit ever recorded (Japan Today). Exports were up only 0.3% from last month and 2.8% from August 2010. Ominously, shipments of electronic parts fell 16.4% due to slowing demand worldwide. Imports skyrocketed 19% year over year on a 50% jump in liquefied natural gas. It threatens to be structural, rather than a blip: The nuclear disaster and subsequent opposition to nuclear power plants have made it impossible to power up the remaining 15 nuclear plants that had been shut down before or during the earthquake. Electricity generation is being switched to fossil fuel plants.

Government deficits are on collision course with a tiny savings rate, trade deficits, and an aging population. Funding the debt internally is becoming more difficult, and the BOJ will have to maintain the printing press. There is much talk about selling to foreigners, but they’re unlikely to develop an appetite for low yielding, low-rated bonds of a country whose indebtedness is almost twice as bad as that of Europe’s punching bag du jour, Italy. And Japan can’t afford higher yields.

Efforts are underway to defer the crisis. Unlike Italy where foreign bondholders would pay for a default, Japan can’t allow itself to default. A steep price will nevertheless be exacted from the Japanese people. It will come in form of higher taxes on income and consumption (in the works), higher costs (happening), and lower wages (continuing). Entitlements will be whittled down. Some will disappear. Meanwhile, companies will be subsidized or get bailed out (happening). But these measures will only kick the can down the road—though kicking a can on the road is precisely what you don’t do in Japan.

Now, for all those who want to short JGBs: It has been a trail of tears. Central banks can do whatever they want to, and when it comes to bonds with limited trading volume, they can out-print even the most fervent shorts.

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