Getting close to a turning point on Japan's debt

21 Feb 2011 by Jim Fickett.

Investors have been predicting a rise in Japanese government bond (JGB) yields, and a crisis in government funding, for many years, yet the seemingly unsustainable has continued. So perhaps I should be wary of wading into this subject. But evidence accumulating over the last few months suggests things are finally nearing a turning point. To be concrete, I'd guess Japan will face serious funding difficulties within, say, a year or two.


Japan's gross government debt is about 200% of GDP and its net debt is roughly 100% of GDP. Both numbers are high by any standard.

That debt load is sustainable because interest rates have been extremely low.

(This and the next graph are from a Ministry of Finance newsletter, based on Bank of Japan data. Click for larger image.)

However even with very low interest rates, about 20% of government revenues goes to interest costs. That is a very fragile situation – if rates were to rise the government budget would be impossible to balance. John Dizard wrote on Sunday,

As a paper by Kyle Bass of Hayman Capital, one of the new breed of American Japan short sellers, points out: “Every 100 basis point change in the weighted average cost of capital [for the Japanese government] is roughly equal to 25 per cent of the central government’s tax revenue.”

Even now, one-fifth of government revenue goes to interest expense. Anything more than a tiny rise of interest costs would be fatal to the government’s ability to function.

Almost all of the Japanese governments financing needs have been satisfied domestically. Over the last seven years the fraction of JGBs held by foreigners has varied between 3% and 8%:

This shows that foreigners need a higher interest rate to get excited about JGBs.

The overall argument that Japan is near a turning point runs as follows:

  1. internal sources of funding are finally drying up
  2. external sources will require higher interest rates
  3. interest is already 20% of revenue; higher rates will be very disruptive

Internal funding from households is almost played out

The most important fundamental trend is household demographics. For decades Japanese households have been famous for high savings, much of which went to buy Japanese Government Bonds (JGBs) and thus fund the deficit. But as the population ages there are fewer building up savings and more spending down what was saved previously. The household savings rate has been in a declining trend since the 1980s. A year ago the Economist wrote:

as more citizens reach retirement age, Japanese households are no longer saving as they once did. As a proportion of disposable income, savings have declined from around 16% to 3% over the past 25 years. And the Government Pension Investment Fund, one of the biggest holders of government bonds, has admitted that it has no new money with which to buy more debt.

Last week Alphaville reported on a Goldman Sachs study suggesting that the household savings rate is likely to go negative this year. The change from high savings to low savings to negative savings is all one continuum, but the quarter in which the savings rate goes negative will, as usual with such things, be an important psychological event.

Internal funding from banks is unstable

As household savings has declined, the banks have taken up the slack. The Global Financial Stability Report from the IMF last October noted that recently banks have absorbed most of new issuance, but that this was fickle demand, and rising rates or other lending opportunities could cause a sudden exodus.

Last November, the Financial Times reported that the banks might be getting more cautious:

Foreign investors have long been cynical about the market, (albeit to their detriment). But today – for the first time – a growing number of Japanese investors are joining the doubters. Even some government finance and Bank of Japan officials are beginning to make cautionary noises. …

Recently, for example, Sumitomo Mitsui Banking Corp, which has a strong risk management culture, began to shift its investment strategy. Today, almost all of the bank’s holdings of JGBs are either one or two-year holdings, out of a fear that yields cannot remain at these low levels forever.

One senior government official says he believes the JGB market will remain stable for the next year or two but warns that the fiscal situation will collapse in several years. …

The Japanese government, like most other governments, essentially rigs the game to make its debt attractive. Banks are encouraged to invest in sovereign debt because they do not have to hold capital against those holdings — especially at a time when capital requirements for other exposures are set to rise dramatically. …

Mr Kanno [Masaaki Kanno, chief Japan economist for JPMorgan in Tokyo] notes that JGBs account for 65 per cent of all bank assets. Since the end of the bubble years in Japan two decades ago, the banks have increased their holdings by a factor of five. …

If yields start to rise abruptly so will losses on these portfolios, given the extent of bank holdings of JGBs. That, in turn, could damage financial stability.

With 65% of all bank assets in JGBs, (1) there is not that much capacity left, and (2) the instability that the IMF warned about looks quite frightening, especially with no capital required against these assets.

Towards the end of December, Bloomberg Business Week reported that JGBs had lost money in Q4 and banks had reduced total holdings in October as well as longer maturity holdings in November.

Japan’s banks, which bought record amounts of government debt as demand for loans dropped, are selling the bonds for the first time this year as prices tumble.

Lenders trimmed Japanese government debt holdings to 142.2 trillion yen ($1.7 trillion) as of Oct. 31 from a record 143.2 trillion yen a month earlier, Bank of Japan data show. They added bonds in each of the previous nine months … Government bonds lost 1.5 percent since Sept. 30, set for the worst quarter in seven years, indexes compiled by Bank of America Merrill Lynch show. …

The biggest banks in the world’s second-largest economy sold a net 3 trillion yen of Japanese government bonds in November, excluding short-term securities, the Japan Securities Dealers Association reported on its website.

That is short-term data, but worrying and worth watching.

Another upward force on interest rates

Another reason to worry about rising rates has to do with overall national savings and the sources of money for investment. First a couple definitions:

gross national income (GNI) is defined as GDP + compensation of employees and property income from the rest of the world – compensation of employees and property income to the rest of the world …

gross national disposable income = GNI + current transfers from the rest of the world – current transfers to the rest of the world …

Gross saving is the difference between gross national disposable income and final consumption. Gross saving together with net capital transfers (capital transfers receivable less capital transfers payable) from the rest of the world provides the resources for investment in non-financial assets, which is called gross capital formation, i.e., for the net acquisition of fixed assets, such as residential and non-residential buildings, plants and equipments, the net acquisition of valuables and/or the increase in inventories.

In a word, gross saving, sometimes also called national savings, is worth watching because it indicates whether a country can finance long-term capital investments on its own, or rather needs to borrow internationally.

Martin Feldstein, former President of the National Bureau for Economic Research, pointed out in September that Japan's national savings rate would probably go negative soon, and that this could cause interest rates to rise.

The excess of national saving over investment not only permits Japan to be a capital exporter, but also contributes – along with the mild deflation that Japan continues to experience – to the low level of Japanese long-term interest rates. …

Japan’s ability to sustain high fiscal deficits, low interest rates, and net capital exports has been possible because of its high private saving rate, which has kept national saving positive. But, with the current low rate of household saving, the cycle of rising deficits and debt will soon make national saving negative. A shift from deflation to low inflation would accelerate this process.

In fact, in data from the national accounts for 2009, released 24 Dec 2010, it turns out that the national savings rate had already gone negative:

(This graph is based on the “National Disposable Income and its Use Account”.)

If Japan needs to borrow from the rest of the world to fund investment, it will, as Feldstein points out, likely drive interest rates higher – foreign lenders, not in a deflationary environment, and subject to exchange risk, are unlikely to be satisfied with 1.3% 10-year rates.

Comments from officials

Foreigners always think they know more than they really do, and so it is important to have evidence from natives that the situation is becoming untenable. The FT article above mentioned that Japanese banks seem to be getting worried, and quoted an unnamed government official. It is also worth noting that the Prime Minister acknowledges a very serious situation. From the BBC last summer:

Naoto Kan, in his first major speech since taking over, said Japan needed a financial restructuring to avert a Greece-style crisis.

“Our country's outstanding public debt is huge… our public finances have become the worst of any developed country,” he said.

“It is difficult to continue our fiscal policies by heavily relying on the issuance of government bonds,” said Mr Kan, Japan's former finance minister.

“Like the confusion in the eurozone triggered by Greece, there is a risk of collapse if we leave the increase of the public debt untouched and then lose the trust of the bond markets,” he said.

Recapping the main argument

The main reason the government of Japan has been able to build up a huge debt has been the strong savings culture of households. But demographic trends mean this source of savings has almost dried up – household savings are likely to go negative this year.

In the last few years, as household savings have declined, banks have taken up the slack. But 65% of all bank assets are now JGBs, so this cannot go on. Further, there are signs that banks are getting nervous about possible losses and may have started reducing exposure.

Over the last seven years, foreign holdings of JGBs have been in the range of 3-8%, showing that there is not high foreign demand at current interest rates. If domestic demand is indeed failing, interest rates will probably need to rise in order to bring in foreigners.

Another force that is likely to drive interest rates higher is that the national savings rate turned negative in 2009, meaning that foreign capital will be needed to fund capital investment such as infrastructure, business investment, and building.

Even at current interest rates, 20% of government revenues goes to interest cost. When interest rates rise, this will drive up the deficit, making it difficult to convince investors that the overall debt can ever be payed down.

Why it matters

For me, the main importance of a Japanese debt crisis is that it will finally be completely clear that post-financial crisis sovereign debt issues are not limited to peripheral economies. I would not expect this to immediately lead to a loss of confidence in US Treasuries – people find a way to believe what they want to believe, and most want to believe that the ultimate safe haven investment remains exactly that. Nevertheless, a Japanese debt crisis would certainly worry the markets, possibly leading to higher interest rates generally, a tendency towards budget tightening in other countries, and hence some nervousness around equities.

Possible bets to take advantage of a crisis directly would be shorting JGBs, buying gold, or shorting the yen versus the dollar. Dizard, cited above, writes:

This means that soon the Bank of Japan will be required to rapidly monetise the JGB stock by printing money to buy them. The government’s cost of funds will remain artificially depressed, but the strain will be taken by both the forex market and, given the difficulty with attracting yen denominated real savings, commercial interest rates in the currency. …

As Dennis Gartman, a commodities analyst and investor, says: “The fundamental ideas were worthwhile for a couple of years, but the yen kept making new highs. With the yen failing to make new highs, the [Japan short] is not only meritable, but right. You have to have both the fundamentals and technicals in place.”

I am not advocating the short. But if you are interested,

  • For a chart of the yen versus the dollar, see here.
  • There are ETFs that bet on currency pairs; see for example ProShares