Japan's Scary Budget
While all over Europe, governments are forced to face up to the fact that the markets have suddenly become alert to the dangers posed by the huge debt loads carried by modern-day welfare states, Japan's government just piles on more and more debt on its existing debtberg with seeming impunity.
In Italy, Mario Monti's 'honeymoon' is already over. He just passed a fairly strict 'austerity' budget (recently denounced by the Northern League as a 'recessionary budget' – and rightly so, as it leaves the bulk of spending untouched and mostly imposes new taxes), but Italian bond yields are already back on the rise. Note here as an aside that the current level of the yield on Italy's 10 year note is not directly comparable to the time when a similar level was first reached, as the benchmark bond used by data providers has in the meantime been changed to a higher-yielding one – alas, it is the direction in which yields are heading that is relevant. Monti's real fight meanwhile is still ahead – he will have to challenge powerful vested interests as he attempts to implement structural reform.
Alas, over in Nippon, home to the second largest government bond market in the world (Italy's is the third largest), the just published budget for 2012 appears largely untouched by such concerns. A handful of prominent contrarian hedge fund managers such as Hugh Hendry and Kyle Bass are actively betting on the demise of this seeming debt perpetuum mobile. Of course, there is a saying in the hedge fund community with regards to JGB's that one needs to keep in mind here: they are referred to as 'widow-makers'. Many a fund manager has lost money betting against the JGB market – and so far JGB's show no sign of breaking down:
The 10 year JGB futures contract over the past five years: thus far the uptrend remains intact – click chart for better resolution.
However, in spite of the reputation of JGB's as 'widow-makers' and the seeming serenity with which Japan's government can keep increasing its public debt load, the time may soon come when those betting against this unsustainable dynamic will be proved right. We will show further below why that day may now finally be drawing near.
First, here is what regarding the latest budget:
“Japan’s budget for the year starting April showed the government more dependent than ever on bond sales to fund spending as Prime Minister Yoshihiko Noda struggles to tame the world’s biggest public debt burden.
The government will sell 44.2 trillion yen ($566 billion) of new bonds to fund 90.3 trillion yen of spending, raising the budget’s dependence on debt to an unprecedented 49 percent, a plan approved by the Cabinet in Tokyo yesterday showed. Spending will shrink for the first time in six years after the government delayed appropriations for the nation’s pension fund and used supplementary expenditure packages to pay for earthquake reconstruction.
Noda’s first budget may fail to reassure credit-rating companies and analysts monitoring his efforts to control public debt twice the size of annual economic output. The government trimmed 2.6 trillion yen from the package by allocating special bonds to delay pension funding until a planned sales-tax increase boosts revenue. “The government is trying to maintain surface appearances by playing with the numbers,” said Takahide Kiuchi, chief economist at Nomura Securities Co. in Tokyo. “This budget clearly shows Japan’s fiscal situation is worsening.”
Noda will submit the budget bill to parliament next year. The primary deficit will narrow to 24.1 trillion yen, the Finance Ministry said, equivalent to about 5.1 percent of gross domestic product. Noda aims to post a primary balance, achieved when revenue matches spending, excluding bond sales and interest payments, by 2020.
New bond issuance will surpass tax revenue for a fourth year, the government predicts. Receipts from levies have shrunk about a third after peaking at 60.1 trillion yen in 1990. “It’s very regrettable that bond sales will exceed tax revenues and that debt dependence rose to 49 percent,” Azumi told reporters in Tokyo yesterday. “I think the reliance on bonds to compile budgets is reaching its limit.”
Non-tax revenues including surplus from foreign exchange reserves halved to 3.7 trillion yen. The budget plan includes a 3.8 trillion yen special account for reconstruction spending. Expenditures in the current fiscal year’s initial budget totaled a record 92.4 trillion yen. The government had planned to cap new bond issuance at 44.3 trillion yen next year.
An aging population and reduced growth since an asset bubble popped in the early 1990s have left the nation with debt projected at a record 1 quadrillion yen this fiscal year.”
Dreadful Dreams and Japan's Peculiar Situation
As we noted a little while ago, the Japanese ministry of finance is these days the 'Ministry of Dreadful Dreams'. The 'dreadful dream' that keeps Japanese finance ministers awake at night is that interest rates may one day rise. So far, Japan's debt load has escaped the scrutiny of investors due to a peculiar quirk: its bonds are primarily held by domestic investors, many of whom are subject to 'financial repression' on account of regulations. Moreover, Japanese society is very cohesive and no-one in a position of institutional power is likely to upset the curious arrangement by which the bond market is held aloft voluntarily by selling his holdings. Alas, Japan's biggest pension fund has become an involuntary net seller of JGB's – as the ratio of retirees to the working population has passed the threshold where it has to pay out more than it receives in revenue. A similar problem could arise from the mass of individual investors, as the country's aging population has been running down its savings quite quickly in recent years – soon the personal savings rate will turn negative.
On the positive side of the equation, the Bank of Japan has been running a fairly conservative monetary policy in recent years after several failed experiments with 'quantitative easing'. Although it has implemented 'ZIRP' (zero interest rate policy), the money supply has been growing only very slowly, keeping the yen strong and leading to only slight increases and in some years even slight declines in consumer prices (this condition is of course a far cry from the country being 'mired in deflation' as the financial media regularly assert). The big question is for how much longer this relatively tight monetary policy stance can be kept up. The BoJ is nominally independent, but the government can revoke its independence at any time if it thinks that debt monetization is needed. If such debt monetization is coming, it will likely be pursued under the pretense that a 'fight against deflation' is needed – the BoJ may well be persuaded to adopt such a policy 'voluntarily' if threatened with the potential loss of its independence and if such a fig leaf can be used to disguise the policy's true aims (note however that the current BoJ governor Masaaki Shirakawa sounds as though he would be more likely to resign than support an inflationary policy).
As at the first quarter of 2011, only 5% of outstanding JGB's were held by foreign investors. In the meantime, foreign ownership of JGB's has once again increased somewhat, a side effect of the yen's reputation as a 'safe haven' currency. As at year end 2011, the percentage is actually at a multi-year high of 8.2% – click chart for better resolution.
The central bank's benchmark administered interest rate hovers near zero – click chart for better resolution.
The primary budget deficit is set to shrink to 5.1% of GDP in 2011, but this likely ignores the habit of adding 'supplemental budgets' as the year goes on and relies on an accounting trick as well (see further below) – click chart for better resolution.
As Bloomberg reports further:
“In a step unseen since 1947, Japan’s Cabinet has approved a fourth extra budget, to rebuild devastated northeast regions and spur growth. The nation has compiled about 20 trillion yen of the supplementary packages after the March 11 earthquake.
Japan is on “a dangerous path” as the government relies on an increased sales tax that is not certain to be enacted, said Hiroshi Miyazaki, chief economist at Shinkin Asset Management Co. in Tokyo.
The ruling coalition plans to raise the sales levy to 8 percent in October 2013 and 10 percent in 2015, Kyodo News reported Dec. 21, citing government sources. The Finance Ministry estimates each 1 percentage point increase will reap about 2.5 trillion yen of revenue.
Government spending does not 'spur growth'. If it did, Japan would have been the world's growth engine for the past two decades. In reality, every cent the government spends must be taken from the private sector and therefore can no longer be spent or invested by it. We can see what the government's spending achieves (not much) – what we can not see is what would have been achieved had the government left well enough alone and the private sector had saved, spent and invested instead. This is the 'broken window effect' – one must not only consider the obvious economic effects of a policy, but also the 'unseen' ones. Government spending is a burden, not a boon.
Like its counterparts in Europe, Japan's government tries to get its house in order not by reducing spending – apparently a completely taboo subject in Japan – but by raising taxes. This will predictably – just as it does in Europe – double the burden on the economy. Since these tax hikes are immensely unpopular in Japan, it is not necessarily likely that they will happen. Moreover, there may be no more time to take effective countermeasures against the growing debt load: the death spiral may well begin before such measures can be implemented and take effect.
Not only is Japan's debt-to-GDP ratio uncomfortably high, its tax revenues continue to decline precipitously as a percentage of government spending.
Japan's public debt to GDP ratio at 220% is the highest in the industrialized world – click chart for better resolution.
Japan's expenditures vs. tax revenues – a widening gap – and it is bound to get worse in 2012 – click chart for better resolution.
In such a situation, the level of interest rates becomes an ever growing concern. Right now, Japan's interest rates remain among the very lowest in the world. And yet, in spite of near record low interest rates, the percentage of tax revenue the government must spend on interest expenses is increasing fast.
Japan's total debt, interest payments and the interest rate on the 10 year JGB. Interest payments have begun to increase in spite of a further decline in interest rates as the debt mountain has soared into the blue yonder. Yields have in the meantime declined even further: the 10 year JGB currently yields only 98 basis points – click chart for better resolution.
Full Speed Ahead – A Powder Keg Waiting For A Spark
As the WSJ reports, Japan's latest budget with its pretense of cutting spending compared to the 2011 financial year is in fact little more than yet another exercise in 'smoke and mirrors':
“Japan is promising to cap national government borrowing next year, but only by signing an IOU and having local governments borrow instead. That's like balancing your checkbook by maxing out your credit cards and also borrowing from your parents.
The lessons of the European debt crisis appear lost on Japan's feckless leaders, who continue to use budgetary smoke and mirrors to avoid making tough decisions. A $1.2 trillion budget for the fiscal year starting in April promises to keep government bond issues below 2011's $568 billion—but only by using every trick in the book to hide the real level of borrowing.
Local bond issues to fill national revenue holes, an off-budget IOU to the state pension fund and a rush to borrow more this year to fund next year's spending all come into play. That's in addition to more conventional, yet rapidly dwindling, transfers of surpluses from special budget accounts. Without Prime Minister Yoshihiko Noda's bag of tricks, the national government might have had to add at least $137 billion in debt in the fiscal year that begins April 1, 2012.
To seasoned Japan watchers, it all sounds depressingly familiar. Back in 2001, Prime Minister Junichiro Koizumi set out a plan for prefectures to issue $41 billion in "temporary fiscal countermeasure bonds." That local borrowing, which the central government eventually has to repay, allowed him to keep a campaign promise to cap national bond issues, without cutting spending too severely. A decade later, those temporary bonds are still with us, and in this year doubled to $80 billion in size.
Mr. Noda's latest round of tricks will add to Japan's already monstrous debt mountain. Furthermore, like Mr. Koizumi's temporary bonds, once started they will be difficult to stop. Come budget time next year, Tokyo will either have to cut its off-budget expenditures, bring them on budget or roll them over. There's no reason to think politicians will make better choices next year.”
In 2012, Japan will resemble Italy at least in one respect: it has a heavily front-loaded debt maturity schedule. This obviously didn't matter in 2011, but it is something to keep in mind nonetheless. One day it might matter. It currently looks like this:
Japan's debt maturity time line. The great bulge in debt rollovers in 2011 came and went without a major hitch, but there are still very large rollovers in 2012 and in the following three years – click chart for better resolution.
Another problem is beginning to appear on the horizon: Japan's perennial trade surplus seems to be on the verge of disappearing. Here is the evolution of the trade balance over the past two years:
There has been a recent proliferation of negative columns in Japan's trade balance. A fluke or a serious trend reversal? Time will tell, but this opens the possibility that Japan may require more foreign funding in the future – click chart for better resolution.
For now the current account remains in positive territory in spite of the deteriorating trade balance. Japan has been a huge exporter of capital to the world and consequently
reaps large dividend and interest income from abroad. Still, the current account does reflect the recent changes in Japan's trade balance:
Japan's current account remains in positive territory. Apart from a brief blip into negative territory following the 2008 financial crisis, this has been the normal state of affairs – click chart for better resolution.
Eventually Japan's government may be forced to choose between having to put up with a greater percentage of foreign investment in JGB's, or printing money to finance its debts (we are of course assuming that cutting spending is very low on its list of priorities). It may prove difficult to persuade a great many foreigners to buy JGB's yielding less than one percent. While the 'real return' on JGB's is certainly not bad compared to treasury bonds or UK gilts, it is nothing to write home about in absolute terms or in terms of the potential risks one incurs in buying them.
At the moment, JGB's trade like 'risk free' debt, in spite of the fact that Japan has lost its 'AAA' rating long ago and has been downgraded again this year, with further downgrades likely. Should the percentage of foreign ownership of JGB's rise significantly, the probability of a 'non-linear' debt market convulsion will rise commensurately. The Japanese government can 'financially repress' its own institutions, but not foreign investors.
Meanwhile, Japan's export industries have begun to struggle a bit due to the strong yen, but on the other hand, a strong yen seems ideally suited for a 'graying' nation engaged in decline management that needs to import virtually all the raw materials it needs.
The Japanese yen remains strong. Year-on-year growth in the Japanese true money supply TMS has slowed from 5% a quarter ago to 4.6%. The most recent quarterly money supply growth stands at a mere 0.3% annualized.
In spite of the advantages a strong currency conveys, Japan's Ministry of Finance has just announced it will increase the pace of intervention in the yen in order to bring its exchange rate down (so far, these interventions have proved entirely fruitless).
As the WSJ reports:
“The Japanese government said Tuesday it will bolster its currency market intervention war chest by ¥30 trillion ($385 billion)—the second biggest increase on record—a fresh sign of determination to prevent sharp yen rises from undermining the nation's fragile economic recovery.
"By this, we are preparing ourselves for taking decisive decisions at any moment in any situation," Finance Minister Jun Azumi said at a news conference.
The planned increase, included in a fourth extra budget approved by the government Tuesday, follows the government's aggressive intervention in the currency market in recent months.
The authorities dumped a monthly record of ¥9.092 trillion between Oct. 28 and Nov. 28, in the hope of weakening the persistently strong yen to relieve pressure on the country's export sector. The move diminished the intervention arsenal, and finance ministry officials have since been considering by how much to replenish it.
The government previously lifted the intervention fund by ¥15 trillion to ¥46 trillion through a recently enacted third extra budget for the current fiscal year ending March. But the record intervention offset much of the increase, and officials came to see the need for further increases.
Many analysts believe the finance ministry hasn't intervened to sell the yen since late November. If their estimate is accurate, the latest budgetary step means the finance ministry would be able to raise as much as ¥67 trillion in the financial market through short-term debt issuance to finance further yen-dumping. That would be the highest amount ever and roughly 10 times Japan's trade surplus in 2010, a finance ministry official told Dow Jones Newswires.
The ¥30 trillion increase would also mark the second largest in history after a ¥40 trillion increase in fiscal 2004 that followed Japan's historic yen-selling intervention campaign in 2003-2004, the official said. “
It should be noted here that the 'record 2003-2004 intervention' failed to work as well. As long as the BoJ prints money at a far slower pace than either the Fed or the ECB, the yen will likely remain strong (actually, in 2011 the euro area for the first time ever experienced slower money supply growth than Japan, but this is likely about to change again following the ECB's recent heavy doses of monetary pumping).
Market participants are already dismissing the effect of the planned interventions – they are likely to be used as a buying opportunity. On the other hand, should Japan's trade balance continue to deteriorate, an important psychological prop supporting the yen will be removed. As Bloomberg reports regarding current market expectations:
“There’s been no better currency in 2011 than the yen and strategists forecast more gains, even as Japan promises to intervene again in foreign-exchange markets and expands the world’s biggest debt burden.
The yen’s advance against every major currency, including a 4.1 percent climb against the dollar, illustrates the anxiety in global markets as Europe’s debt crisis stretched into a second year on the heels of the collapse of Lehman Brothers Holdings Inc. and the U.S. housing market crash. Though bond yields in Japan are the second-lowest in the world and government borrowings are double the size of the economy, foreign ownership of its debt is the highest since 2008.
Japanese officials sold at least 14.3 trillion yen ($183 billion) this year to stem gains that cut profits for exporters from Toyota Motor Corp. to Nintendo Co., and Finance Minister Jun Azumi has pledged more action. Intervention in 2012 may fail again as financial turmoil attracts investors to the world’s third-most traded currency for its low volatility.
“When avoiding losses trumps profits during a period of risk aversion, low-volatility assets are very appealing,” Masashi Murata, a currency strategist in Tokyo at Brown Brothers Harriman & Co., said in an interview on Dec. 19. “When the U.S. and Europe moved in a bad direction and people wanted to avoid risk, the yen stood as the only currency that had enough liquidity to absorb demand.”
It remains difficult to tell when exactly these long-lasting trends toward a stronger currency, lower interest rates and falling prices (including the prices of stocks) will end and reverse. The ability of Japan's government to increase its public debt without provoking a fiscal crisis has been underestimated again and again by investors. And yet, everybody knows that the current course is not sustainable. Eventually, something will have to give. As Reuters reminds us, debt issuance in 2012-2013 will hit new record highs:
“Japan plans to issue a record 149.7 trillion yen ($1.9 trillion) of government bonds (JGBs) through regular auctions in the fiscal year from next April, the Ministry of Finance said on Saturday, as the country struggles to reduce its budget deficit. The ministry will raise the monthly issuance of 10- and 20-year bonds in the next fiscal year from April and will look into resuming issuing inflation-linked bonds as it seeks to diversify its funding methods.
The plan is mostly in line with market expectations and what sources told Reuters earlier this week. The total amount of bonds to be offered through auction is 4.9 trillion yen greater than the latest plan for the current fiscal year. Analysts think the market will have little problem absorbing the increased debt sales, as many domestic investors are happy to gobble up JGBs given the lack of investment alternatives in the stagnant economy.
Foreign investors hold only 8.2 percent of Japan's debt, compared with 45.3 percent for U.S. Treasuries, even after they bought Japanese debt aggressively in July-September to escape euro zone bonds.”
It seems possible that foreign investors have been busy jumping from the fire into the frying pan. If they fled from Italian bonds into JGB's, they exchanged the bonds of a country with a 120% public debt-to-GDP ratio for those of a country with a 220% public debt-to-GDP ratio. Both countries have central banks that have declared themselves unwilling to print money to buy government debt directly, so the 'but Japan has its own printing press' excuse (which is in any case ridiculous), is not even truly applicable. Both countries have 'stagnant economies'. One wonders what the point of moving funds around between their respective bond markets is.
For the moment, Japan is evidently – and perversely – actually profiting from the sovereign debt crisis in the euro area – but obviously that is not an immutable condition.
It seems rather like a powder keg waiting for a spark.
Japan's industrial production, year-on-.year percentage change. After the volatile ups and downs of 2008-2010, it is back to stagnation (so far below the zero line) – click chart for better resolution.
Charts by: Cqcabusinessresearch.com, Viableopposition.blogspot.com, Finviz.com, Tradingeconomics.com
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