The key to prospects for world growth in 1999 is Japan. I expect the US economy to slow during the year and the core of Europe to grow by less than 2%. So the OECD as a whole is unlikely to achieve even 1% real growth this year unless Japan picks up.
Is Japan’s deep depression showing signs of ending? No way! Monthly unemployment data have recorded successive post-war highs. Industrial output fell 8% year-on-year in October and retail sales by 5.5%. Steel production is down 11%. Capital spending fell 12% year-on-year in the third quarter of 1998 and machine tool orders were down nearly 30%. As I write, the Bank of Japan’s Tankan quarterly survey of business activity is expected to produce a record low.
The economy is in a deflationary spiral, with wholesale prices down 3.5% year on year. Department store sales are still falling by over 4% a year and overall retail sales have dropped 5.5%.
Bank reform and fiscal stimulus have done little to lift the gloom. Bank lending is still contracting at a 4% rate. As a result, the web of financing that holds the Japanese economy together is unravelling. More and more yen liquidity is being pumped into the financial system to prop up bankrupt corporations and debt-ridden banks. Less and less is being put to productive use. This year, this capital will flee and the yen will sink.
Japan is running out of time. The government is running out of money. Japanese government bond (JGB) issuance will soar over the next two years as recession undermines tax revenues. With the private sector unwilling to increase its exposure to JGBs – and the Bank of Japan (BoJ) busy underwriting the bank bail-out programme – the burden will fall on Japan’s other public institutions to take up the slack. But they won’t be able to buy all net new issuance. Yields will rise sharply undermining the financial sector’s already-weak balance sheets. Insurance companies, in particular, will diversify into higher-yielding overseas assets. The yen will fall.
Just look at the wall of money that is now being thrown at the Japanese economy to pull it out of its depression. In pure accounting terms, the BoJ has kept reserve money under control. In practice, its balance sheet has grown by the equivalent of 3.8% of GDP in the past 12 months (33% in yen terms) as it increased lending to the government’s Deposit Insurance Corporation to help the banks and bought commercial bills from corporations desperate for cheap financing.
And now there is the government’s planned bank recapitalization. Of the ¥60 trillion programme, the BoJ is to fund ¥53 trillion, or 10% of GDP. Most of this funding will end up as an expansion of reserve money. And don’t forget Japan’s foreign exchange reserves. The Ministry of Finance has lent up to ¥6 trillion (1% of GDP) of these to commercial banks as a form of cheap dollar borrowing.
All this spending is destroying Japan’s solvency as a state. Public-sector liabilities already exceed 100% of GDP. Unfunded pension liabilities are worth another 300% of GDP. Then there’s the Trust Fund Bureau (TFB). It manages the money collected by the Japanese public in the state savings and pension system. TFB assets are growing by over 6% a year and have reached ¥430 trillion – 85% of GDP. Most of these assets have been lent to quasi-government agencies to indulge pork-barrel politics. I reckon up to 30% of GDP has been lost for ever in this way.
The shrinking economy is having a predictable effect on Japan’s budget performance. Overall tax revenue is down 21% year on year and corporate tax receipts are down 21.9% in the first half of fiscal 1998.
For the current fiscal year to March 1999, the central government’s tax revenue target has been revised down to ¥57 trillion from an original estimate of ¥58.5 trillion (12% of GDP). But even this could be undershot by between ¥6 trillion and ¥8 trillion. The shortfall at local government level could be another ¥3 trillion to ¥5 trillion. So in this coming fiscal year, there will be slippage of up to ¥15 trillion. Japan’s general government budget deficit, excluding the social security surplus, could reach 10% of GDP.
To cover this a huge jump in JGB issuance will be required. Volumes will reach ¥25 trillion this fiscal year and ¥30 trillion to ¥35 trillion next year (7% of GDP). With yields below 2%, JGBs are no longer attractive to private-sector investors. So the public sector has taken them up. The government, through the pension funds, post office, TFB and the BoJ, now owns two-thirds of all its own bonds. In calendar 1997, the public sector bought 88% of new bonds.
If the private sector is unwilling to participate in budget financing, will Japan’s public sector be able to cope with funding the growing deficit? I doubt it. The BoJ already has the responsibility of underwriting the government’s bank bail-out plan. And the postal savings system has a heavy maturity schedule over the next two years, so it can’t pay up.
The TFB is unlikely to be able to absorb those new JGBs. Until 1998, the It has never increased its JGB holdings by more than ¥10 trillion in a single year and its ability to buy anything is dependent on resources being provided by the state pension and welfare system, as well as the postal savings and postal life insurance schemes. Capital from these sources is currently growing at an annual rate of just ¥20 trillion. So this year, even if the TFB were to put all its new resources into the JGB market, there would still be ¥10 trillion to ¥15 trillion in excess JGB supply.
JGBs will be caught in the crossfire of massive oversupply and dwindling private-sector appetite. Yields will rocket. Falling JGB prices will worsen the quality of public-sector assets. And it will damage the profitability of Japan’s banks and insurance companies. That will encourage the outflow of Japanese portfolio capital in search of higher returns. The yen will collapse.
David Roche is president of Indpendent Strategy, a London-based research firm.
