Friday, August 3, 2012

Next Up In Sovereign Debt Crisis: Japan Or The UK?

As I discussed earlier in the week in the $15 Trillion Adjustable Rate Loan, I think we are in the second or third inning of the global sovereign debt crisis. While the current action has been well documented and can be seen in every in almost every news story today (the rolling collapse of the European Union), I always like to think about what is coming next.
It has been my view since the sovereign debt crisis erupted that the next battles will be fought in Japan and the UK. The key questions of course are who will go first and how will these battles look compared to the current European debt crisis?

The answer to the first question can only be guessed. It is like having two neighbors that are underwater on their home and are currently not paying their mortgage. Which one will enter foreclosure first? The answer is impossible because it depends on the judgement of a third party; the banks holding the mortgage.

The same goes for two bankrupt countries such as the UK and Japan. Which one will implode first? The answer again depends on a third party: the bond market.

I remember having this discussion back in the summer and fall of 2010 with Spain and Italy. The nerds like me on the blogosphere were having an intense debate over which country would erupt first. Both countries were primed for implosion but their problems were very different in nature.

Italy had a horrendous government debt to GDP ratio (closing in on 130% looking out into 2011 at the time) while Spain had a much more mild debt to GDP ratio (standing below 70% debt to GDP at the time). However, Spain as everyone now knows today had a massively underwater banking system, a housing bubble collapsing, and local government debt issues that added to the total problem beyond just the implicit government debt in place. They also had a tougher bond/rollover schedule in 2011.

The consensus view was that Spain would go first. Then, in the summer of 2011, Italy shocked the financial nerds (the mainstream media was oblivious to any problems coming) and became the center story line with their bond yields rising rapidly. They were now "next" in the sovereign debt crisis. Italy was equally as bankrupt as Spain, but the bond market decided to move on them first.

That Spain or Italy could possibly be in trouble was of course "shocking" to the mainstream press who continued to follow the story lines in a reactionary manner and assumed that every new bailout announced was the answer to the underlying problem.

Then, after the fall, Italy moved out of the spotlight and Spain emerged as the main headline. They have stayed there since, becoming the new darling of the global sovereign debt collapse.

Now the nerds like me are having the same conversation we were back in 2010 with Japan and the UK. Ironically, they face similar comparisons as Spain and Italy in terms of their debt problem structure (the size of course is much large - the equivalent to two enormous meteors approaching the financial system).

Japan, like Italy, has a horrendous debt to GDP ratio. They actually have the worst debt to GDP ratio in the world, which will cross over 230% this year. That is not a typo. The UK, like Spain, has the worst debt to GDP ratio in the world when you take the sum of all their liabilities: (non-financial, financial, governments, households) a number now approaching 1,000% of GDP. That again is not a typo, although the numbers almost make you laugh when you think about it.

So which one will go first? I have no idea, but my money is on Japan. Because of this I have laid out an exhaustive study of their problems numerous times in the past (see below for links).

The truth is it doesn't really matter. If you know both of your neighbors cannot pay their mortgage, would you go to the bank and ask to invest some money into the debt? No, you would stay away from both pieces of debt and put your money somewhere else. This is common sense when looking at an example in the real world yet interest rates on Japanese and UK debt today stand at close to record low levels.

The second question is how will this phase of the debt crisis differ from what we are experiencing now in Europe? The answer to that can be summed up very simply: The European Central Bank (ECB) is restricted on its ability to purchase government bonds with printed money. This impairs their ability to fight off bond vigilantes as they attack the debt of the PIGS countries. Just yesterday Spanish and Italian yields rose by the most ever on a single day after the ECB announced they had no new "printing" programs in place.

The UK and Japan face no such restrictions. Their central banks have unlimited firepower to purchase, well, everything. This is already taking place now as a pre-emptive strike (warning?) against anyone who dares to challenge their bankrupt government bond markets. The following is a chart showing the Bank of England's recent balance sheet growth (a balance sheet grows when the central bank prints money to buy assets and adds those assets to their balance sheet).

The Bank of Japan is already fighting the same battle. Their central bank, along with a steady purchase of government debt, has also entered the stock market to purchase assets.

The truth is that the United States is in the same exact position as Japan and the UK but most people believe that they will be the last and final act of the debt crisis. Could they surprise the world and jump ahead into the headlines? Of course they could.

Investors today are fleeing Europe and running into the bonds and currencies of Japan, the UK, and the United States. They have moved from one bankrupt entity into another. They hope to be able to exit the burning theater when the fire starts (into the next currency choice) before the rest of the crowd.

But why would they take that chance? There are sovereign bonds in countries like Canada, Australia, New Zealand, Hong Kong, Singapore, China, and Brazil where the countries are not bankrupt. They have real economies and exports. They do not need a printing press in order to survive into the next year.

In the currency wars the ultimate winner will be gold and silver but most investors do not feel comfortable keeping 100% of their portfolio in precious metals (and they shouldn't). Short term debt of stable governments with strong currencies seems like a logical addition over a bankrupt country.

But that is just me. I usually choose not to go to the movies in a theater I know will catch on fire.

For a comprehensive review of the coming Japanese debt crisis see: Japan Government Bonds: The Storm Cloud Approaches.

h/t Sober Look


  1. Thanks for the analysis, however have you considered the possibility that there might be issues in realizing any gains (or even return of principal) from bonds in the BRICs or others?

    Even though a particular country itself might fair better relative to the big, insolvent ones, the exchange/fund/ investment vehicle you work through might go belly up, or capital controls get enacted, or some other game changer.

    A bond from Singapore,N.Z., etc is only good if it can be redeemed by you, located across the world. In other words, there's counterparty risk.

    Once the SHTF begins in earnest, all bets concerning the sanctity of markets might be off.


    1. Yes, that is an excellent point. From the perspective of a US citizen you have to worry about how far the government will go to try and "fix the problem" (which will of course make the situation much worse). So far they have followed the perfect playbook to ultimately create the worst possible scenario.

      I think it is more likely that they initially stop outflows into those assets (foreign assets in foreign currencies). This essentially means that those that have not removed their money from US borders will be trapped in. To say that money cannot be sold outside the country and brought back in would be so disastrous for the global economy that it almost seems unthinkable that they could do it. But again, everything is on the table for either party that faces this situation between 2012 - 2016. The first instinct is always to blame the "greedy speculators."

      This is another reason why you need diversification.

  2. If any of the countries mentioned above defaults, there will be no safe havens. The global financial system will go 'mad max' and collapse

    1. That's a great point, but unfortunately it doesn't make the situation any more realistic than it is. We know with simple calculations that if Japan's interest rates rise by 2% then they cannot service their debt based on current income (and as we have seen with Greece, Spain, etc, when the debt crisis hits income tends to fall significantly creating a downward spiral).

      The next logical question would be; do the financial leaders see this coming and they are already working on a strategy? Their have been discussions about the IMF getting involved with SDR's (global currency that can be printed). Some people believe that this is part of some "bigger plan."

      The issue I see with that is during the fall of 2008 it seemed to catch everyone by surprise. There was a moment where it was actually questioned that the current system would survive (few hours where the money markets froze up completely on the Thursday morning following Lehman Brothers).

      I, of course, have no answers to these questions. Only speculations.