When the financial world tries to anticipate the next meltdown, all eyes turn to Europe. Greece needed a bailout, then Ireland did. Talk is that Spain will follow, though the country denies that it has a problem.
But a few contrarians think everyone is looking in the wrong direction. Forget Europe, they say. Check out Japan instead. “A global fiasco is brewing in Japan,” predicted Société Générale analyst Dylan Grice in a recent report. “It’s like the Titanic has already hit the iceberg and you know it’s going to sink, you just don’t know how long it will take to go down,” said Vitaliy Katsenelson, a Denver-based money manager, in a recent interview that was printed in well-known analyst John Mauldin’s newsletter. One hedge fund analyst I spoke to recently noted that Japan has had no fewer than nine finance ministers in the last 4½ years—one of whom apparently committed suicide after resigning.
Japan was thought to possess a miracle economy before it all went to hell in the early 1990s following a spectacular real estate bust. Today the popular perception is that Japan is stagnant but stable. After the economy slowed down, the Japanese government lowered taxes and increased spending, sending deficits, and also government debt, way up. But the debt hasn’t been a problem, because Japan’s risk-averse populace—which became even more risk averse after the collapse of the technology bubble a decade ago—has sunk its considerable savings into government bonds, known colloquially as JGBs. What could be safer than government debt? As a result, the vast majority of Japanese debt is funded by its own residents—in stark contrast to the United States, which sells a sizable chunk of its debt overseas. And as deflation struck the Japanese economy, the interest rate on its outstanding debt has fallen to an average of a mere 1.5 percent.
In sum, the Japanese government has been able to increase its debt without driving borrowing costs up because of falling interest rates. That fortunate circumstance has allowed Japan to ramp up government spending even as tax revenue has dropped by nearly one-third .The not-so-lucky part is that even at today’s low interest rates, Japan’s interest on its debt is eating up a scary proportion of its tax revenue—more than 25 percent (not including the funds that come from issuing yet more debt), according to government figures. In addition, much of Japan’s debt is relatively short-term in nature, meaning that the government last year had to “roll” at least 140 trillion yen in debt (i.e., replace retiring debt with new debt) even as it issued some 50 trillion in fresh debt to fund the growing gap between what the government spent and what it took in.
As Bernie Madoff would tell you, this is a game you can play only so long. Japan’s savings rate, which was once in the mid-teens, is quickly approaching zero. Meanwhile, the country has the oldest population in the world, with basically no immigration. When people retire, what do they do? They start to withdraw money from the banking system. You begin to see the problem.
Why, you might ask, can’t Japan do what us profligate folk in the United States do—sell its debt to international investors? Well, it could, but it would likely have to pay a much higher interest rate than 1.5 percent. After all, if you were an investor, why would you buy Japanese debt yielding 1.5 percent when you could buy U.S. or German debt that paid you more? My source thinks Japan would have to pay roughly 4.5 percent interest on 10-year debt to be competitive, and he says that’s a conservative estimate. But that would create a different problem. If Japan’s interest rate merely doubled, from 1.5 percent to 3 percent, then interest expense would be more than half of the government’s tax revenues. “Any meaningful re-pricing of Japanese sovereign risk would push yields to a level the government would be unable to pay,” writes Grice.
Another way for Japan to dig itself out of this hole would be to cut spending. But already, Grice says, Japan’s tax revenues can’t cover debt service combined with social security. So where the hell do you start?
Those who believe in historical precedent point to examples like Weimar Germany and say Japan is going to swing from deflation to hyperinflation. The Bank of Japan, they say, will print yen in order to pay down debt. “Cash-strapped governments,” observes Grice, often resort to “currency debasement.” That story never ends happily.
But at least so far, the consensus is that this dire scenario won’t, can’t, happen. Indeed, it’s often said that you aren’t a real macro trader (someone who bets on global trends) until you’ve gotten burned shorting (i.e., betting against) Japan. “You’ll find 10,000 people saying I’m an idiot and that people have been saying this, and been wrong, for 15 years, and kid, shut up,” laughs my source. The Bank of Japan says the economy is improving; analysts say the government has lots of options, including raising the value-added tax or having the banking system put even more assets into government bonds. (Already, the Bank of Japan is engaged in its own form of “quantitative easing,” or purchasing government bonds, which, just as in the United States, is supposed to help the economy recover.) Japan’s relatively healthy corporate sector could take over from households in investing its surplus cash into government bonds. “Everyone acknowledges the long term seriousness of Japan’s fiscal position,” writes Grice. “But people seem almost fatigued with the idea that a country which has defied bond market logic for so long now is ever going to change.”
But just because things haven’t changed doesn’t mean they won’t. While any deterioration in Japan’s finances should, mathematically speaking, happen gradually—savers don’t yank their money out of the system all at once—modern markets have a way of accelerating underlying problems into crises with remarkable speed. If there’s a lesson we should all have learned, it’s that once fear takes hold, anything can happen. And if Japan is a problem, it’s a problem for all of us. After all, Japan is still the world’s third-largest economy. Unlike Greece and Ireland, it is simply too big to bail out, even if the world were willing to do so. China and Japan are the largest foreign holders of U.S. debt. One obvious question is, what happens here if Japan starts selling?
There’s another way in which Japan’s problems might matter, too. In some important ways, the United States is following in Japan’s footsteps—for instance by taking advantage of low interest rates to issue a slew of cheap debt. Japan’s “more profound influence might be psychological,” Grice writes. What he means is that Japan’s benign experience with debt (so far) has led other countries (notably ours) to think that it can have a worsening fiscal condition yet still pay a low interest rate on its debt. If bond markets begin to act like that notion is wrong, this story doesn’t end happily for anyone.