Monday, January 28, 2013

2013 Outlook Part 10: Japan's Government Debt Bomb Goes Off

2013 Outlook Part 1: Introduction
2013 Outlook Part 2: What Is A Bond?
2013 Outlook Part 3: How Did We Get Here?
2013 Outlook Part 4: Can You Lose Money In Bonds?
2013 Outlook Part 5: Global Debt Binge & Policy Response
2013 Outlook Part 6: United States Bubble Bond Prices
2013 Outlook Part 7: Residential Home Prices Have Not Bottomed
2013 Outlook Part 8: Commercial Real Estate Cap & Interest Rates
2013 Outlook Part 9: Chapter 2 Of The Sovereign Debt Crisis Begins
2013 Outlook Part 10: Japan's Government Debt Bomb Goes Off
2013 Outlook Part 11: Should I Buy US Stocks Today?
2013 Outlook Part 12: How To Invest

The second chapter of the sovereign debt crisis arrives during a period of maximum complacency. With the euro printing press now in full effect, many believe that we have entered a new era of growth for the global economy. This belief has priced risk assets, specifically in the bond market, at astronomically high levels. A look beyond the mainstream media headlines, however, will uncover a sleeping giant in Asia. Should this giant awaken, and I believe it soon will, it will trigger the grand finale of the 70 year debt super cycle.


During the 1980's Japan was becoming an economic powerhouse and based on their growth trajectory many anticipated them overtaking the United States as the largest economy in the world. They had a surging manufacturing base, a soaring stock market, and real estate price escalations that made the recent US market look tame.

Then as the clock struck midnight on December 31, 1989 everything changed. Their soaring stock market peaked, reversed, and began to free fall. Stocks have continued to fall for the last 22 years.


The real estate market followed suit. The following chart shows that after 22 years of price declines real estate prices in Japan are still falling. The are now back to 1983 levels.


A major reason for the slow and steady decline was that the Japanese immediately created a zombie banking system in the early 1990's. They allowed banks to remove the mark to market process of their holdings meaning they could continue to operate even though the assets on their books were more underwater than the capital they had available. Had they let their banks liquidate and taken the brunt of their pain early, it is likely they would be once again challenging the US for dominance again today.

It is important to briefly note that the US has followed this same exact blue print with the landmark decision in March of 2009 to remove the mark to market regulations on the large American banks. Since then they have lurched forward as zombies and most likely will for a long period.

In addition to backing their banks the Japanese embarked on a period of large scale government spending combined with QE programs from their central bank (sound familiar?). Year after year their government debt has continued to grow. Entering 2013 their debt to GDP is approaching 240%, creating by far the worst government balance sheet in the world (Greece was at 130% debt to GDP when their crisis began).

The question is not whether or not this is an unsustainable situation, but more importantly, how have they been able to continue this process for so long? The interest rates on their government debt are the lowest in the world. How is that possible?

Once the twin bubbles of stocks and real estate burst in 1990 there was still a strong manufacturing base within the country. This manufacturing machine provided Japan a large annual trade surplus - meaning they exported more goods to the rest of the world than they imported. When money comes in from trade it then enters the economic blood stream. Exporters buy goods within Japan's borders providing a stimulus for growth. The capital within the country ultimately needs to find a home. After being burnt badly in stocks and real estate Japanese citizens became extremely risk adverse and wanted to keep their capital in the safest cash markets possible. That led to them investing in Japanese government bonds.

The mentality of the last two decades has been one of deflation. Very low interest rates are not a problem in a deflationary environment, which is why their bonds have performed so well. If the cost of living is falling by 2% per year and your bonds only return 1%, that means you are getting a real rate of return of 3% annually. Investors within Japan would rather earn a 0% return on their money than watch it disappear in stocks or real estate.

The people of Japan also have a larger than average savings rate, most of which found its way into the government debt. 93.8% of Japan's debt is held internally. 95% of that 93.8% is held by institutions. This means that not only were the citizens of the country reinvesting capital back into the government bonds, but pensions and insurance companies were as well.

For decades betting against the Japanese yen and the Japanese government bond market has been called "the widow maker." Many have looked at the same numbers I am discussing here and have taken a short position, only to find interest rates continue to move lower and the yen continue to rise in price. After two decades, with many widows left around the world, it appears that everyone has thrown in the towel. People have forgotten about the trade because they just assume that things will always just continue the way they have in the past.

Why is this time different?

The following chart shows that the balance of trade in Japan beginning in 2011 has turned negative. This means that the capital that was once coming into their borders through exports (and financing a significant portion of the deficit) is now leaving. The magnitude of this change is so important that it cannot be understated.


Japan recorded a trade deficit of 548 billion yen in October of 2012. From 1979 until 2012, Japan averaged a trade surplus of 635 billion yen reaching a high of 1,608 billion in September of 2007.

In addition to the balance of trade you have actual capital that can enter the country and purchase assets within those borders. The combination of those two form the current account which has also been steadily falling over the past 24 months. It is expected that the entire current account will turn negative meaning that there will be a net negative capital exodus from Japan. This will come at a time when their government needs financing more than any time in history.


Japan's PMI manufacturing index recorded a sharp contraction in December. The blue line shows the PMI manufacturing output index and the orange line shows the manufacturing production.


Their export problems have only been exacerbated by the recent conflict with China over the Senkaku islands. Up until the recent conflict China has been the only beacon of hope for their export market. Exports are up 76% to China since 2002, while they are down 30% to Europe and down 27% to the United States. The longer this problem lingers the more the trade numbers will suffer.

Many believe this is no problem because the Japanese people will continue, as they always have, to finance any and all government spending. Here is where the second major problem emerges. The Japanese population peaked recently at 129 million people. It is now at 125 million and rapidly falling as the country continues to age. The Japanese had a 15% savings rate in 1990. That number is now below 1%. The older population, which has spent a large portion of their life working and saving (by purchasing bonds), now needs that capital in order to live. To get cash to fund their daily needs they must sell the bonds in their account. This funding source, just as with the trade deficit, is now in reverse.

Who will step in to purchase Japanese government bonds at close to 0%? Remember that the world around Japan is already facing its own funding crisis. Annual government debt issuance in Japan is currently 25 times the annual tax revenue. If they cut 100% of the spending, it would take 25 years to balance their budget.

What will trigger the bomb?

Many estimate that the current account in Japan will turn completely negative by the end of 2013. This will put unimaginable strain on their financing issues.

As mentioned above, the people and institutions within Japan have been comfortable holding bonds at 1% because of the real return received through deflation. Their new prime minister, Shinzo Abe, has begun a policy of inflation targeting at 2%. This means that the Bank of Japan will provide QE at an unlimited rate until they hit the 2% target. If an investor knows they will lose 2% on their purchasing power, why would they purchase a bond at 1%? The answer is that they won't. They will sell instead.

Rising rates provide another trigger event. A large part of Japan's debt is financed through short term bonds that need to be rolled over (and re-priced). They currently pay 10.5 trillion in interest annually while they only take in 40 trillion in revenue. 25% of their entire tax collection goes to paying the interest. This comes at a time when the interest on the debt is close to 0%! What if interest rates moved up to just 2% to match the inflation target of the central bank? The interest on the debt alone would overwhelm the entire collection of taxes. Just the interest - not counting any of the actual spending, which is running close to 10% of the entire budget annually right now.

Japan's economy is currently in recession. Their plan is to lower the value of the yen in the market to stimulate trade. This will only escalate the currency war triggering a response from United States and Europe's central banks. In addition, Japan is reliant on imports for their energy needs. A lower yen will only make these imports more expensive.

I believe that within the next two years the Japanese bond market crisis will be front page news. There is an opportunity today for very patient investors to take the opposite side of the trade. My guess is that when the bond market starts to move the central bank will come with "shock and awe" to try and push yields back down. However, a central bank cannot both keep yields down and keep their currency from falling. The yen has the ability to enter free fall (depending on the level the central bank is willing to go), which could easily tip into hyperinflation. This will severely punish the savers within Japan who have been hoarding Japanese bonds. Where will there money go when it flees? We will discuss that topic in an upcoming section. Before we get there, let's take a look at the current environment in the stock market.

Up Next: 2013 Outlook: Part 11: Should I Buy Stocks Today?

h/t Kyle Bass


3 comments:

  1. Agree completely with this analysis.

    I have considered an ETF short yen but my concern is that if japan implodes, does that take down the entire global economy i.e. is this Lehman on steroids?

    Because if this is the trigger for meltdown I don't want to be in currencies at all. Would prefer PM.

    But because most of Japan's debt is held domestically, does that limit the global damage and NOT trigger another financial crisis?

    If that is the more likely outcome then I would pile into the yen short etf and wait.

    As Kyle Bass has said - it's not a matter of If but When

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  2. excellent so far!

    can you write a chapter what could/will make rates rise in more detail please?

    a chapter on how to position as an investor would also be highly appreciated.

    keep up the good work

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  3. Tuna,

    All your articles have been enjoyable to read. Now, if only the situations presented were set in a mythical planet, where one can log out from when and if desired.

    Seriously though, how does one look at investments in the face of all you have described? Hyperinflation is a pet boogey man of mine, and instinct keeps telling me that it's too late to jump into gold, in a big way.

    ReplyDelete