One of our favorite strategists, SocGen's Dylan Grice is out with a masterful in its simplicity analysis, looking at the possibility of a funding crisis enveloping the governments of the developed world, and originating in the place where ever more people see brewing trouble: Japan. The full presentation can be found here, and while we recommend a full read, for those strapped on time, here are the cliff notes.
Risk is back: in fact, it is as if nothing ever happened. Junk spreads and the VIX are practically at the levels where we were before the first cracks in the housing bubble appeared. Is the economy really sufficiently stable to merit such risk metrics?
In answering the last question, one needs to look no further than the governments of the developed countries. In one word: insolvency. The ratio of total net liabilities, including off balance sheet, to GDP is at 400%. Greece is at 875% (the Greek finance minister once again was comforting anyone who cares to listen that the country does not have a funding crisis. We are waiting for this third promise in this regard).
Such insolvency typically can end in only one way: hyperinflation. The chart below captures the budget deficits a few years before hyperinflationary episodes in five countries during the 20th century.
Why are budgets so inflated: one word - stimulus. Or taking from the future (and funding it handsomely) to avoid political, financial and social unrest (as well as maintaining even a slim hope of a second term). The entire world now runs on one ongoing stimulus: from the US, to the UK, to the EU, to China - the spigot has been turned on. And where do look to make sure that this is a viable structure? Where else - Japan. After 20 years of off again, on again stimulus after stimulus and quantitative easing episode, the country still has deflation. Where is this alleged hyperinflation. It may very well be coming. Japan's budget deficit has been funded over the past decades with internal source of capital. Prudent Japanese savers had been buying up JGBs hand over fist due to their perceived safety. Yet something is changing - demographics (and not only in Japan, but in the US as well, as an aging baby boomer population hits retirement). The Japanese demographic decline is in full swing, with the working age population now dropping materially.
And as more and more of the domestic population enters asset run-down mode, savings decline, and existing assets are sold.
Indeed, the demographic shift is already having an impact on Japanese holdings of JGBs.
The biggest problem for Japan, however, is that it can not afford to ween itself off bond issuance. Japan's current debt service amounts to 35% of pre-bond issuance revenues, while the ratio of revenues from bond issuance to that from tax collection is expected to rise over 100% in 2010: 'tax revenues will be less important than borrowing as a source of income.'
Will foreigners agree to purchase JGBs at 1.5%. No. Due to the abovementioned structural considerations, Grice notes 'I doubt there is any yield international capital markets can find acceptable that will not bankrupt the Japanese government.'
And if wholesale selling of assets does in fact occur, this will mean very bad things for America:
This is far from just a JGB market problem. As Japan's retirees age and run down their wealth, Japan's policymakers will be forced to sell assets, including US Treasuries currently worth $750bn, or Y70 trillion 'eight months' worth of domestic financing. At nearly 10% of the outstanding US Treasury stock, this might well precipitate other government funding crises (bearing in mind that the Japanese model is the argument buttressing confidence in Western government bonds in the face of deteriorating fiscal conditions). At the very least I'd expect it to trigger an international bond market rout scary enough to spook all other asset classes.
Will 2010 be the beginning of the end of flawed Keynesian economics?
Maybe Japan's will be the crisis that wakes up the rest of the world and triggers some tough decisions on world-wide debt loads. Or maybe not - maybe the Greeks will beat them to it? or the Irish or the UK, or the US? Like banks in 2007, developed market governments today rely on sustained capital markets more than any time in their history. What if they shut?
It should be a very interesting year.
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| Grice Japan.pdf | 168.57 KB |
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