The Japanese model will crumble without hasty intervention

By:
Kanika SaigalEuromoney Skew
Published on:

Japanese bond yields are being kept low because domestic interest remains high, but how much longer will Japanese investors have to pay for the growing sovereign debt burden? Commerzbank comes to a scary conclusion.

For the past two decades, Japan has been dogged by bearish market pronouncements that the country is marching towards an imminent sovereign debt crisis thanks to its high debt burden, declining population, stalled reform agenda and anemic growth rate.

While the eurozone crisis has reinforced the risk of the negative bank-sovereign feedback loop, recent events have also underscored the allure of the printing press and limited foreign liabilities to assuage investor fears over an imminent government financing crunch.

While Japan, for now, boasts these two positive technicals, it's time to face reality: soon there will come a time when Japanese investors will no longer have the capacity to keep up with the country’s burgeoning sovereign debt troubles, concluded Commerzbank in a report published on Friday. On the current trajectory, investors have around 10 years, probably less, before the current bargain - stable yields in return for perceived safety - crumbles, say analysts at Commerzbank.

To stem the rot, the central bank will be forced to step in to prevent a sovereign debt crisis, ramping up its balance sheet to unsustainable levels and, of course, the yen will lose value, the analysts argue.
 

 
 Source: Commerzbank

Commerzbank continues:
At 205% of GDP, Japan has the highest level of debt among the OECD countries. Unfortunately the debt mountain is likely to keep on growing, because the new prime minister [Shinzo] Abe is unwilling to reduce the budget deficit – which is currently far too high at 10% of GDP – supposedly out of concern for the economy, and instead has decided on expensive stimulus programmes.”  

Japanese investors hold a staggering 90% of outstanding government debt, though:
Japanese private households directly hold only 3% of public debt. Indirectly, though, they finance a far larger percentage, since they hold financial assets mainly in the form of bank deposits as well as in pension funds and insurance policies which frequently invest their clients’ money in government bonds. As a result, domestic banks, pension funds and insurance companies own nearly three quarters of Japanese sovereign bonds.”  

The clock is ticking, says Commerzbank:
This 'Japanese model' is not sustainable in the long term. It can only function as long as public debt does not exceed the financial assets of private households and non-financial companies. If this is no longer the case, the Japanese government will have to find large numbers of foreign investors, who will however demand far higher yields in view of the high level of Japan’s sovereign debt.”  

PM Abe has announced an all-encompassing economic stimulus programme to take shape during the next 10 years, further denting the budget deficit – which stands at 10% – and triggering foreign investor fears. Meanwhile, the net financial assets of private households and non-financial companies presently add up to about 276%. And the number is due to rise at a lower rate in the coming years as spending patterns change and the savings ratio falls.

Putting the data together, Commerzbank assumes the economy will grow at an annual rate of 2% per annum for several years, while government bonds will pay an average coupon of only 1%:

“Based on these assumptions, levels of public debt are likely to continue to rise at a significantly faster rate than the financial assets of private individuals... Government debt is expected to have risen to 280% of GDP by 2022, exceeding the private financial assets of the Japanese for the first time.”  

However, Commerzbank is the first to admit that this conclusion could be too optimistic for a couple of reasons. Firstly:
“We have assumed that the interest to be paid by the state will remain constant despite the ever-rising debt ratio. This could seem realistic based on past experience. However, studies show that a higher sovereign debt level on average for all industrial countries has pushed up the risk premiums on government bonds. The interest rate increases by about 35 basis points if the debt ratio rises by 10 percentage points.”  

Secondly:
“It is not certain that the full net assets of private individuals will be available to finance public debt, as we have assumed, meaning that no flight of capital commences despite the ever-increasing sovereign debt. The Japanese population, especially companies, is already concerned about the high level of debt. Consequently, private investors are less likely to invest in sovereign bonds, the closer the country comes to a critical situation.”   

And finally:
The ageing society actually implies a lower rate of economic growth. According to official estimates, the working-age population will drop by 8% in the next 10 years. Against this backdrop, the Japanese economy should pick up in real terms by 1% per year at most.”  

In a worst case scenario, Japan’s sovereign debt could exceed private assets by 2018 rather than the initial prediction of 2022.

Sovereign debt bubble trouble, central bank toil and yen trouble:

“Rather, the Bank of Japan will step into the breach and substitute the missing private demand for public bonds by own large-scale purchases. This expansive monetary policy will produce higher inflation and severely weaken the yen in the longer term.

“The yen has already depreciated significantly since the middle of November, when it was becoming clear that Abe would be elected, and the weakness of the yen is likely to continue. The spending policy of the new government is worrying international investors and the prime minister is demanding that the Bank of Japan implement an aggressive expansionary monetary policy. The current head of the central bank, [Masaaki] Shirakawa, is due to step down in April and the man appointed by the prime minister to succeed him is likely to meet these demands. We expect to see a USD-JPY exchange rate of 96 at the end of the year.”