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Rates on sovereign debt of Japan as an early warning for dollar debt

9 Nov 2009 by Jim Fickett.

The US Treasury is issuing debt at a record rate, and there has been a nagging concern for some time that, if investors lose their appetite for US government securities, it could drive up US interest rates and bring an end to the nascent recovery. So far this is not happening, and it is difficult to estimate how serious the danger might be. It would be nice, then, to have some early warning signs to watch. Japanese interest rates might provide such a warning sign.

In Tough times for government bonds after the credit crisis, David Roche, president of Independent Strategy, wrote on 27 Oct,

when Japan's bubble economy collapsed, it was able to run huge budget deficits and raise outstanding government debt from 60 per cent to 140 per cent of gross domestic product, while still experiencing a fall in bond yields from 8 per cent to 1 per cent. But this “miracle” was only possible because Japan's household savings were huge and invested at home. Japan did not need foreigners to fund its government deficits. Even today foreign ownership of Japanese debt is only 6 per cent compared with 50 per cent for US government paper.

But Japan's household savings rate has collapsed due to an ageing population which no longer saves. …

An unprecedented 25 per cent of current global savings will be sucked up by OECD government debt financing. …

As the US, UK and Japan will be trying to borrow the same buck in international markets, bond yields will rise when QE [Quantitative Easing] stops and there is an even modest recovery in credit demand from the private sector.

So to begin the argument,

(1) Many governments worldwide are borrowing extraordinary amounts, and will be competing for the same savings.

(2) Japan's demographics have changed, and it is unlikely that it will be able to borrow the necessary funds domestically, as it did previously.

A week ago in the Financial Times, Edward Chancellor wrote, in Japan sovereign debt crisis looms,

A debt trap appears when the rate of interest paid on government debt is higher than the economy's growth rate and the public revenues are insufficient to cover its financing charges. When this happens the fiscal position becomes unstable and the debt spirals upwards. This has been the case in Japan for several years. A bad situation has been made even worse by the global financial crisis.

Japan's national debt is fast approaching 200 per cent of GDP. … These problems are compounded by the fact that Japan's population is now shrinking. The economy's trend growth rate has fallen and tax receipts are shrinking, while welfare payments for pensioners are rising. Japan's debt trap, it seems, is structural rather than cyclical. …

While the supply of Japanese government bonds looks set to increase, the outlook for demand is not encouraging. As the population ages, Japanese pension funds are more likely to be selling bonds than buying them. The household savings rate is plunging towards zero.

So we can add,

(3) Japan might already be a tipping point where it will be difficult to ever reduce current debt.

Finally, also a week ago, Ambrose Evans-Pritchard, writing for The Telegraph, wrote in It is Japan we should be worrying about, not America.

Credit default swaps (CDS) on five-year Japanese debt have risen from 35 to 63 basis points since early September. Japan has suddenly decoupled from Germany (21), France (22), the US (22), and even Britain (47).

For credit default swap rates to rise 80% in two months suggests

(4) The investment community is starting to worry significantly about Japanese sovereign debt.

If the CDS rates are not a temporary fluke, Japanese bond rates could rise. This in turn might cause investors to start worrying a bit more about sovereign debt in general, or could start an international competition for funds that would raise rates elsewhere. In either case, a rise in Japanese rates might serve as an early warning of rate rises elsewhere.