The Japanese Gamble

The chart below of the Japanese Yen has finally started looking like the sleeping trade of the century, the widow-maker, the great unwinding of the Japanese economic system may be starting to occur.  Japan is a wealthy country despite the crash in 1990 and resulting chronic deflation.  GDP per capita is multiples of that in China and in fact exceeds places like Germany.  Assets held by households and corporations domestically and abroad are in excess of $20 Trillion.  Yet as everyone knows by now, they have racked up an enormous public debt that exceeds their annual output by 230%.  That is something in excess of $12 trillion for a $5 trillion economy.  And as everyone also knows, they have historically had a very high savings rate and a massive current account surplus that have allowed them to accumulate this debt while only paying something like 75 basis points on 10 year government debt.

And there is the rub.  With something like 1.5% deflation, the real yield on the 10 year JGB is comfortably north of 2%.  Still, as they continue to borrow over HALF of their annual government expenditure, the portion of their tax revenue now required to service their debt has come to exceed 40%.   To say that again, more than 4 of every 10 yen the government raises goes to debt service alone.  Now that is not so bad, as it is essentially part of their social safety net.  The holders of many of those bonds are pension funds and the postal system, also much of which is for pensions.  The problem is that as the economy shrinks with the productive population, the revenue side must continue to contract and so if there is a positive nominal yield at all, the system cannot go on like this forever.

On December 16th Japan elected Shinso Abe who has promised loudly to both increase public expenditure and to browbeat the Bank of Japan to do whatever it takes to achieve an inflation target of 2%.  This is all in an effort to kick start the economy and turn it from its deflationary path to a growing inflationary one.  Sounds like a plan!  Of course there is the niggling issue that if they really do get inflation up 350 bips from a 1.5% deflation to 2% inflation, well then their entire yield curve will have to shift up in yield as well.  So to return to the 10 year JGB, that would mean a yield of something like 4.25%.  But at 0.75% on the ten year, their interest expense already eats up more than 40% of revenues.  Hmm.  I have read that the point at which they use 100% of revenue on interest expense is something like 2% across all their debt (all maturities blended together).  I do not know the actual numbers but it is a safe bet that the point where ALL government revenue is eaten by interest expense is well below where the yield curve will be with a 4.25% 10 year JGB (ie, 2% inflation, maintaining a 2.25% real yield).

So it appears that Abe is forcing a gamble which will either allow Japan to break on through to the other side, or will force the End Game of default.  If the result of the gamble is to get the economy growing, well then the revenue will increase – perhaps fast enough to prevent the increased interest expense from gobbling up ALL government revenue.  Or perhaps not.   Can the BoJ really buy enough JGBs to prevent the rise in yields from precipitating outright default without also causing a currency crisis?  Will the Emperor entreat the populace to accept a lower real yield to facilitate the country’s emergence from the debt trap?  Whatever happens, it appears the pieces are finally going into motion.  It promises to be an interesting year as we watch from outside.  Let us hope that they succeed.  For the consequences to the world if they fail are unpredictable but almost certainly not benign.


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