Popular Delusions
More on Japan's brewing fiasco, and some musings on recent pushback
A few months ago I wrote about an impending government funding crisis in Japan. The pushback was so interesting I thought it worth writing up. None of you really disputed the long-term problems facing Japan but, for various reasons – which I’ll look at below – very few of you thought it was worth worrying about just now. Meanwhile, the biggest JGB holder on the planet – the Government Pension Investment Fund (GPIF) – which has already admitted it’s no longer able to roll maturing bonds, has announced that it will open credit lines so it doesn’t have to sell them to fund its obligations. With ¥213 trillion of JGBs to roll this year, or around 45% of GDP (see chart below), maybe I’m not the only one scared stiff after all!
- One of the great things about doing this job is the feedback you get from pieces you write. I have to admit I'm poor at predicting the reaction a report will generate. In a warning to anyone following the few predictions I do make, my own favourite pieces have so far tended to be the ones eliciting the least reaction, while those that have made the biggest splash have often been the ones which seemed the most obvious. Anyway, philosophically I believe in reaction more than prediction, judging the response is always more interesting.
- Broadly there are two types of "pushback" which make you think you're on to something. One is outright hostility, sometimes verging on hate mail you receive when you know you've touched a nerve (recently I've been called "dishonest" and "immoral" for holding certain views!). The other is complete apathy suggesting a broad disinterest in the topic.
- The stuff I've written on Japan's fiscal problems recently has fallen into that latter category. I should stress, it's not an apathy born of a lack of understanding of the issues - everyone acknowledges the long-term seriousness of Japan's fiscal position. 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. This is what I wanted to talk about this week.
To recap, the thesis I outlined back in January was that since Japanese households - the biggest effective drivers of JGB demand – are set to dis-save in coming years as they retire (left-hand chart below) there will soon be no one left to finance the government's nosebleed deficits at current yields. Indeed, the chart below suggests households are already running down assets. And because the interest rates which might attract international investors will inevitably blow up the budget (debt service is already 35% of government revenues at existing yields) there is a very clear and present danger that the government reverts to the wellestablished historical precedent for cash-strapped governments of currency debasement.
The most common argument I received on why I was wrong to worry was along the lines that Japan has had rising debt ratios and huge deficits for many years now. Not only have yields fallen, but the economy has struggled with deflation, not inflation.
To me this feels like "recency" bias at work, which is a type of "availability" bias by which we overweight events we find easy to imagine relative to those we don't. Japanese debt markets have been stable for such a long time it's difficult to imagine anything different, so we don't imagine anything different and predict that the future will look like the past. Now, Japan's debt markets may well remain very stable in the future and I'm very open to the strong possibility that I'm barking up the wrong tree. But "logic" like that outlined above is lazy indeed. It echoes Bernanke's now infamous 2005 conclusion that nationwide housing collapse in the US wouldn't happen because it hadn't happened before.
More thoughtful critics argued that I was ignoring the Japanese government's significant financial assets. Taking this into account shows a net debt position of closer to 100% of GDP (chart below), considerably more manageable than the 200% gross debt-to-GDP ratio and more in line with other OECD economies such as Italy and Belgium (great!).
But I'm not so convinced by this argument, or to be more accurate, I'm not so convinced the numbers underlying this argument are correct. For a start, around 40% of the assets recorded on the asset side of the Japanese government's balance sheet don't actually belong to the Japanese government. They belong to Social Security and therefore to the Japanese public. That the vehicle which owns the assets happens to be publicly owned doesn't change the fact that it is a very real liability owed to individuals who must be either paid or defaulted on. It doesn't just cancel out.
And who on earth knows what the other assets are worth anyway? The central government, for example, has funded projects deemed "socially useful" and which private markets wouldn't finance. These loans, made via direct "investments" in public sector organisations (called Fiscal Investment and Loan Program [FILP] agencies), are recorded as assets on the government balance sheet worth around 10% of GDP. Yet we know from decades of banking problems and bank recapitalisations that even the loans that markets did finance soured pretty spectacularly, so one wouldn't imagine the FILP agency loans to be of particularly high quality. Indeed, a few years ago two economists at the NBER reckoned that nearly half of the FILP agencies were insolvent. Maybe those assets are being provisioned for correctly on the government's books, but - and call me a cynic if you like - I really doubt it.
But even if we assume those numbers are a fair reflection of asset value there is also the implicit assumption that the Japanese government can monetise them. But I don't think they can. Shares and equity stakes are marked at around 20% of GDP, mainly reflecting Japan Post Bank - the "jewel in the crown" - with $2.5 trillion in deposits. But last year, plans for its long-awaited privatisation were shelved, apparently for fear that on a purely private sector calculus, many small and medium-sized companies wouldn't qualify for the funding they need to stay afloat. Keeping it in public sector hands was the only way to ensure their life-support credit lines weren't cut. Of course, I may just be being cynical again, but I note that Post Bank is also a huge buyer of JGBs and doubt it was just the SMEs life support the government was worried about...
This leads nicely to the other argument worth thinking about, which runs like this: the household sector may well be retiring and less able to absorb new JGB issuance, but the corporate sector is expanding thanks to a vibrant export sector. Since corporate sector savings are as large as households' isn't it reasonable to expect them to take over as the primary source for government funding? The honest truth is that I don't know. Maybe, I guess. But my gut feeling is pretty definitively no. For one, the corporate sector doesn’t actually have as large a pool of savings as the household sector.
For another, the corporate sector - even in Japan - doesn't have anywhere near the same propensity to hoard cash (see chart above). Open the papers today, for example, and you read about Astellas Pharma going hostile on OSI, where it thinks it can buy its way out of Japanese stagnation. When companies have money, they need to spend - sorry 'invest' - it (occasionally they even need to return it to shareholders). Anyway, it looks unlikely to me that companies are going to take over from households in financing the government's deficit.
In passing, I think this is why the idea that Japan can't have a funding crisis because it runs a current account surplus might not actually stack up. I readily admit to having forgotten most of the economics I've ever done and I will happily stand corrected if any of you think I'm wrong on this, but I think that if a current account surplus is increasingly dominated by a sector (e.g. non-financial corporates) with a lower propensity to fund another sector (e.g. the domestic government), then that other sector must face problems funding its deficit. So is Japan's current account surplus even relevant for assessing the risk of a government funding crisis? Clever economists out there, let me know.
Anyway, if the corporate sector was about to suddenly increase its cash holdings, we'd expect to see the ratio of corporate sector cash relative to household sector cash begin to rise. In fact over the last five years it's been falling (2nd chart above).
So I still worry. Households are retiring and running down their wealth; non-financial corporates don't hold as much cash. So the non-financial sector (i.e. households plus nonfinancial corporates) just isn't going to be in a position to provide the financial sector with the deposits it needs to recycle into JGBs.
That leaves the foreign sector as the only candidate to fund the government's ever increasing structural deficits and explains the increased frequency of JGB roadshows we're seeing around the globe. But is it realistic to expect foreign investors to fund a likely insolvent government at 1.5% (if this week's Greek financings are a fair gauge, investors want closer to 6% to fund insolvent governments)? Anyway, debt service already accounts for 35% of the Japanese budget! Any reasonable interest rate will expose Japan's budget for the mess it is.
But why take my word for it? Why listen to the rantings of some supposed "perma-bear"; a deranged strategist working on a cold rainy island on the other side of the Eurasian continent from Tokyo, and with no great insight into the workings the JGB market or much else for that matter? Well, you shouldn't. But you might want to take Takahiro Kawase, head of Japan's $1.2tr Government Pension Investment Fund (GPIF) and the largest owner of JGBs on the planet, more seriously. He said last summer, "The big change this year for us is that there is zero new money to invest, so we may need to be a seller in the market to meet the pension benefits … our bond allocations are overweight, so we may need to reduce those a bit to raise cash.” Not to worry, though, because he doesn't think it will have much effect on the market. “… the sales are not expected to be big, as we can cover the shortfall from maturing bonds.”
How significant a problem is this? In last week's FT, Gillian Tett pointed to the importance of debt maturity in assessing fiscal breathing space. UK debt maturity, at 14 years, is one of the longest, while the US, at 5 years, is one of the shortest. In Japan, based on the Bloomberg data on the front page chart, the number is around 6, and ¥213 trillion matures in 2010.
To spell that out: we are going into a year in which the government has ¥213 trillion of bonds to roll over (chart below), and the biggest holder of JGBs is openly admitting he has no new inflows of money. I suspect he's not as confident as he's making out that this won't be a problem, and I suspect the Japanese authorities aren't either. Otherwise, they wouldn't be scrambling to arrange a new borrowing facility for the GPIF so that it doesn't have to sell JGBs to fund its pension obligations...
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