The senior government official shook his head vigorously in affirmation. “Yes, Japan’s budget deficit will grow. Yes, there will be a government bond crisis.” Then he said: “The best scenario for Japan would be an earthquake that struck the downtown headquarters of the ruling Liberal Democrats when all its senior politicians were there. Then we might get some of the reform Japan needs.”
Certainly Japan needs a political earthquake, similar to Italy’s in the early 1990s, which swept away the old politicians and their methods. Until that happens, the economy will continue to stagnate, the Nikkei will languish and the yen will be as sick as a dog.
Since the financial asset bubble burst in the late 1980s, the politicians have applied huge dollops of fiscal stimuli to avert collapse. Japan needed this like a hole in the head but supply-side reform was beyond the politicians’ ken. And being in a decade-long recession meant that more spending fuelled massive deficits.
As public debt rose, the government tried to avoid paying high interest. So Japan’s savers had to be made to keep their savings at home and invest in low-return government bonds. As foreign equities and bonds paid much better, how was this to be done?
The answer was to create “Mr Yen” in the person of finance ministry international secretary Eisuke Sakakibara. At regular intervals he would talk the yen up and scare domestic investors into staying at home. And financial institutions were forced to value their foreign investments in currency-adjusted terms. In this way, Japan’s massive domestic savings surplus was preserved and the current account surplus was not recycled abroad in capital outflows. The yen stayed strong and Japanese investment returns looked better than foreign ones (in currency-adjusted terms). The result was that Japanese government bonds (JGBs) were the world’s lowest-yielding but best-performing bond market for an unhedged Japanese investor.
|
View graph. |
||||||
But by pouring its citizens’ savings into the most unproductive sector – the state – Japan deprived itself of the means to get its economy growing productively. Doing so also deepened the black hole of the public sector balance sheet. With corporate Japan now investing again, available capital will become scarce, driving up yields. A JGB crisis will ensue.
The banks – the major suckers for the JGB scam – will suffer as they mark their holdings to market, which they must do from April. At the end of last year, the finance ministry published its first realistic statement of Japan’s public balance sheet. It shows the net worth of Japan’s public sector at minus ¥780 trillion ($6.6 trillion). That’s liabilities equivalent to 156% of GDP. This is an underestimate as it excludes local authority debt and the hidden losses that government agencies have racked up with loans to pork-barrel projects favoured by politicians.
Then, during fiscal year 2000 ending in March 2001 and fiscal year 2001 up to March 2002, ¥106 trillion of post office savings deposits mature. In the current fiscal year, of deposits maturing, only 55% have been retained as new deposits. If that rate is maintained through to March 2002, around ¥47 trillion, nearly 10% of GDP, will leave the savings system.
At the same time, the accumulation of new postal savings deposits has slowed. Indeed, the value of total postal savings accounts actually fell, which implies that new deposits have not compensated for outflows. As outflows pick up over the next year, deposits will decline further. What all this means is that postal savings flows are no longer available to fund the government’s debt.
The other negative for the government is that the appetite for long-term bonds is waning. The Italianization of Japan’s public debt is already well under way, with short-term debt now around a third of issuance. The increasingly short duration will cause the cost of public debt to explode and the budget deficit to spiral as soon as short-term rates rise.
The politicians will try to avoid their Pompeii for a while longer. One tactic is to force the Bank of Japan to increase liquidity in money markets to keep interest rates down and provide funds for the banks to buy government bonds. The BoJ has also increased the credit facility to the government’s Deposit Insurance Corporation so that it can bail out the depositors of any bankrupt banks.
The main buyers of new government paper are now the banks. But they also have to absorb shocks from bankrupt borrowers, particularly in construction. So they may soon be running scared of JGB volatility. As the Japanese economy creeps forward slowly and as mark-to-market rules keep up the pressure on the financial sector, fund flows out of JGBs and the yen will accelerate. So the earthquake’s first hit will be the JGB market.
There will also be a political effect. It’s no secret that the Liberal Democratic Party wins elections by distributing cash to gerrymandered rural constituencies through fiscal “stimuli” distributed through crooked and bankrupt construction companies. The squeeze on government finances means that they can’t do it any more. The latest supplementary fiscal package to be implemented shortly is too small to stop public construction spending falling over the next fiscal year.
That’s a critical election year for the upper house of Japan’s parliament. My guess is that the LDP-led coalition will lose its narrow majority there in July. Prime minister Yoshiro Mori has already achieved the distinction of the lowest level of popularity in opinion polls since surveys were done. He won’t survive an LDP defeat. He might even be ousted before then, as one scandal after another forces Mori’s cabinet ministers to resign.
The problem is that defeat for the LDP might not lead to significant political upheaval. The reformists in the LDP have been cowed by the collapse of Koichi Kato’s attempted political coup last year. The opposition Democratic party also seems to be riven by factional fighting. The hope remains in young LDP politicians, many the sons or daughters of the old dinosaur leaders. They are calling for change. If they can assume control of the LDP, or form alliances with other parties, that could be the starting point.
Only then will Japan reform. In the final analysis, it makes so many of the products wanted by the new global economy that it will take relatively little change in the way its corporations work to make Japanese equities attractive.
So if the earthquake comes, it will ultimately be positive. Investors should be looking to buy stocks of Japanese corporations that recognize the need for change.
