In November, 2006, I traveled to Nagoya on a pilgrimage of sorts. I wanted to meet Takeda Wahei. Virtually unknown in the West, Takeda is the closest thing Japan has to Warren Buffett. In fact, fairly handicapped, he may even be a little better. It is one thing to make one’s reputation as an accumulator of wealth during the boomtimes of the American century, but quite another to do so amidst the lifeless deflation of post bubble Japan.
The interview with Takeda was highly memorable. We talked about a few companies that he owned and how he encouraged management through rewards and positive re-enforcement. However, he was most emphatic on the long-term outlook for the Japanese market. Japan’s history, said Takeda, is divided into a number of generation-length periods that he likened to seasons. After the debacle of WWII, Japan emerged into a spring that brought rapid growth. The growth of the 1970’s and 80’s that culminated in Japan’s bubble economy, he likened to summer. The period that began in 1990 he considered to be an autumn. “And now,” he said, “it is time for winter.”
Japan’s Debt Mountain
If there is a reason to expect about a prolonged economic winter in Japan, the most likely cause would appear to be an unsustainable level of sovereign debt. Thanks to nearly two decades of “stimulus,” Japan is burdened with debt like few other countries. Debt-to-GDP in Japan is now almost 220%. Netted against the large US dollar cash holdings Japan acquired in efforts to manage the dollar-yen exchange rate in the last decade, Japan’s net debt-to-GDP ratio is “only” 103%. But the ratio will surely grow higher. Japan’s budget deficit which had oscillated between 3% and 7% of GDP over the past five years, is running at nearly 10% in 2009.
[center]Figure 1: Fiscal Ratios for Japan and Key Comparisons
Source: IMF, Reinhart & Rogoff 2008 NBER, EU, Bank of Japan.
Note: Japanese GNP not calculated in 1945, estimated on 1944 basis. Fiscal balance includes wartime indemnities.
It is hardly noteworthy in 2009 that the world’s second largest economy doesn’t meet the criteria to have qualified for European Union membership under the Maastrict treaty. Few of the other major economies do either, these days, least of all the United States. But to the simple-minded such as myself, it does seem odd that a nation with even a couple of credit metrics which rate on par with Weimar Germany and Argentina circa 2001 can hold down a “AA” credit rating. Stranger still are 10 year Japanese Government Bond (JGB) yields of slightly less than 1.3%.
Figure 2: Gov’t Net Debt to Revenues (2009 vs. Selected Defaults)
Sources: IMF, Reinhart & Rogoff 2008 NBER, EU, BOJ
Explaining the Paper Thin Yields
Investigations into Japan’s surprisingly low long-term sovereign rates come up against some familiar explanations. Japan has a high savings rate and therefore the country is awash in excess capital. Moreover, given deflation, the JGB’s provide an attractive real yield. And finally, given that JGB debt is almost entirely domestically sourced, risk premiums that apply to other countries don’t apply to Japan.
There are on-again, off-again experiments by the Bank of Japan with quantitative easing (the purchase of its own bonds with freshly created money). Now on-again, quantitative easing seems not to have scared other market participants regarding the quality of the underlying paper. Rather, it has just added to the apparent supply imbalance that results in 10 year JGB’s clearing at a 1.3% yield.
Japan ’s population is both shrinking and aging to a point where retirement savings are being increasingly drawn down. The savings rate in Japan has declined from over 11% in 2001 to around 2% last year. And the much vaunted Japanese trade surplus has evaporated in the recession. These factors appear to call into question the sustainability of ultra-low domestic interest rates in Japan. Could quantitative easing alone maintain Japan’s yield curve?
Japan in 1945 vs. Japan in 2009
We find similarities and differences between post-war Japan and current-day Japan. In both periods we see exceptionally high sovereign debtloads, in excess of 200%. While today’s Japan has a huge balance of US Treasuries that partially offsets the gross debt, it also has a huge unfunded liability related to health and pension costs of its aging population. From my vantage point, the 1945 debt and the 2009 debtloads don’t look so dissimilar.
Both today and in 1945 the Bank of Japan funded deficits by purchasing its own bonds with freshly created money. However, the degree to which this occurred in 1945 vastly outstrips today’s pace.
And yet, curiously, the outcomes in terms of inflation and exchange rates couldn’t be more different. In 1945, winding up the printing presses propelled money to chase the day-to-day commodities which were then in short supply. Japanese inflation exceeded 500% in that year, (which partially explains why it is now so much easier to become a billionaire in Japan).
Combined with defaults on war-related obligations, the 1945 inflation had the effect of eliminating most of Japan’s debt burden. With a cleaned-up balance sheet and a rock-bottom currency, all Japan needed was an export boost from the Korean war to kick start its post-war economic “miracle.”
In 2009, for all the computer clicks the BOJ can muster, prices in Japan continue to stagnate. Japanese consumers leave the shelves of 7-11 loaded with its 20 varieties of green tea and instead park their money in savings accounts where interest rates are quoted in basis points as opposed to percentage points.
No amount of debt creates worry about the 2009 yen’s purchasing power in the capital markets either, it seems. The corpses of many hedge fund managers lie as witness to the brutal end of the unhedged carry trade.
What to Do
Why the differences? And what should investors do? The billion yen question arises again.
One of the helpful factors of 2009 is that interest costs are so low that a debt of 200% of GDP can be serviced for only 2.6% of GDP. If Japan’s sovereign debt cost 8% instead, then interest charges on the gross debt would be 16% of GDP, or slightly more than half of the country’s tax revenue. But that outcome, say the experts, is so unlikely as to be hardly worth mentioning.
Will it always be this way? Is the natural rate of interest really zero and the Japanese have only arrived at the destination earlier than the rest of us? I wonder.
I have been wrong before. There are things I do not understand in this world. Yet somehow it is hard to leave this bizarre yen valuation alone. So I will call “game on” for the yen carry trade versus government paper of better financed sovereigns. And double “game on” for buys of the hoardables – gold, silver and grains – financed by yen denominated debt.
Spring in Japan may be coming, in Takeda’s cadence. But winter beckons.
Geoff Castle
http://www.marketdepth.typepad.com
The interview with Takeda was highly memorable. We talked about a few companies that he owned and how he encouraged management through rewards and positive re-enforcement. However, he was most emphatic on the long-term outlook for the Japanese market. Japan’s history, said Takeda, is divided into a number of generation-length periods that he likened to seasons. After the debacle of WWII, Japan emerged into a spring that brought rapid growth. The growth of the 1970’s and 80’s that culminated in Japan’s bubble economy, he likened to summer. The period that began in 1990 he considered to be an autumn. “And now,” he said, “it is time for winter.”
Japan’s Debt Mountain
If there is a reason to expect about a prolonged economic winter in Japan, the most likely cause would appear to be an unsustainable level of sovereign debt. Thanks to nearly two decades of “stimulus,” Japan is burdened with debt like few other countries. Debt-to-GDP in Japan is now almost 220%. Netted against the large US dollar cash holdings Japan acquired in efforts to manage the dollar-yen exchange rate in the last decade, Japan’s net debt-to-GDP ratio is “only” 103%. But the ratio will surely grow higher. Japan’s budget deficit which had oscillated between 3% and 7% of GDP over the past five years, is running at nearly 10% in 2009.
| Country | Debt to GDP (%) | Net Debt to GDP (%) | Government Revenue As % of GDP | Fiscal balance % of GDP | Net Debt multiple of revenue |
|---|---|---|---|---|---|
| Japan (2009) | 217.2 | 103.5 | 30.6% | -9.9% | 3.4x |
| USA (2009) | 87.0 | 61.7 | 15.1% | -13.6% | 4.1x |
| UK (2009) | 62.7 | 56.7 | 38.9% | -9.8% | 1.5x |
| Germany (2009) | 79.4 | 51.2 | 44.3% | -4.7% | 1.2x |
| Italy (2009) | 115.3 | 111.8 | 46.7% | -5.4% | 2.4x |
| Canada (2009) | 75.4 | 26.1 | 14.4% | -3.4% | 1.8x |
| Japan (1945)* | 266.0 | 266.0 | n.a. | -19.4%* | n.a |
Source: IMF, Reinhart & Rogoff 2008 NBER, EU, Bank of Japan.
Note: Japanese GNP not calculated in 1945, estimated on 1944 basis. Fiscal balance includes wartime indemnities.
It is hardly noteworthy in 2009 that the world’s second largest economy doesn’t meet the criteria to have qualified for European Union membership under the Maastrict treaty. Few of the other major economies do either, these days, least of all the United States. But to the simple-minded such as myself, it does seem odd that a nation with even a couple of credit metrics which rate on par with Weimar Germany and Argentina circa 2001 can hold down a “AA” credit rating. Stranger still are 10 year Japanese Government Bond (JGB) yields of slightly less than 1.3%.
| Country | Net Debt Multiple of Gov’t Revenues |
|---|---|
| Japan 2009 | 3.4x |
| USA 2009 | 4.1x |
| Italy 2009 | 2.4x |
| Argentina 2001 (D) | 2.6x |
| Russia 1998 (D) | 4.9x |
| Mexico 1982 (D) | 5.1x |
| Germany 1932 (D) | 2.4x |
Sources: IMF, Reinhart & Rogoff 2008 NBER, EU, BOJ
Explaining the Paper Thin Yields
Investigations into Japan’s surprisingly low long-term sovereign rates come up against some familiar explanations. Japan has a high savings rate and therefore the country is awash in excess capital. Moreover, given deflation, the JGB’s provide an attractive real yield. And finally, given that JGB debt is almost entirely domestically sourced, risk premiums that apply to other countries don’t apply to Japan.
There are on-again, off-again experiments by the Bank of Japan with quantitative easing (the purchase of its own bonds with freshly created money). Now on-again, quantitative easing seems not to have scared other market participants regarding the quality of the underlying paper. Rather, it has just added to the apparent supply imbalance that results in 10 year JGB’s clearing at a 1.3% yield.
Japan ’s population is both shrinking and aging to a point where retirement savings are being increasingly drawn down. The savings rate in Japan has declined from over 11% in 2001 to around 2% last year. And the much vaunted Japanese trade surplus has evaporated in the recession. These factors appear to call into question the sustainability of ultra-low domestic interest rates in Japan. Could quantitative easing alone maintain Japan’s yield curve?
Japan in 1945 vs. Japan in 2009
We find similarities and differences between post-war Japan and current-day Japan. In both periods we see exceptionally high sovereign debtloads, in excess of 200%. While today’s Japan has a huge balance of US Treasuries that partially offsets the gross debt, it also has a huge unfunded liability related to health and pension costs of its aging population. From my vantage point, the 1945 debt and the 2009 debtloads don’t look so dissimilar.
Both today and in 1945 the Bank of Japan funded deficits by purchasing its own bonds with freshly created money. However, the degree to which this occurred in 1945 vastly outstrips today’s pace.
And yet, curiously, the outcomes in terms of inflation and exchange rates couldn’t be more different. In 1945, winding up the printing presses propelled money to chase the day-to-day commodities which were then in short supply. Japanese inflation exceeded 500% in that year, (which partially explains why it is now so much easier to become a billionaire in Japan).
Combined with defaults on war-related obligations, the 1945 inflation had the effect of eliminating most of Japan’s debt burden. With a cleaned-up balance sheet and a rock-bottom currency, all Japan needed was an export boost from the Korean war to kick start its post-war economic “miracle.”
In 2009, for all the computer clicks the BOJ can muster, prices in Japan continue to stagnate. Japanese consumers leave the shelves of 7-11 loaded with its 20 varieties of green tea and instead park their money in savings accounts where interest rates are quoted in basis points as opposed to percentage points.
No amount of debt creates worry about the 2009 yen’s purchasing power in the capital markets either, it seems. The corpses of many hedge fund managers lie as witness to the brutal end of the unhedged carry trade.
What to Do
Why the differences? And what should investors do? The billion yen question arises again.
One of the helpful factors of 2009 is that interest costs are so low that a debt of 200% of GDP can be serviced for only 2.6% of GDP. If Japan’s sovereign debt cost 8% instead, then interest charges on the gross debt would be 16% of GDP, or slightly more than half of the country’s tax revenue. But that outcome, say the experts, is so unlikely as to be hardly worth mentioning.
Will it always be this way? Is the natural rate of interest really zero and the Japanese have only arrived at the destination earlier than the rest of us? I wonder.
I have been wrong before. There are things I do not understand in this world. Yet somehow it is hard to leave this bizarre yen valuation alone. So I will call “game on” for the yen carry trade versus government paper of better financed sovereigns. And double “game on” for buys of the hoardables – gold, silver and grains – financed by yen denominated debt.
Spring in Japan may be coming, in Takeda’s cadence. But winter beckons.
Geoff Castle
http://www.marketdepth.typepad.com
