Weighing Up The Fiscal Scenarios
BMI View: There are few good options available to the Japanese government to address its ballooning debt load, but we believe that debt monetisation could prove to be the most costly in terms of its medium-term economic impact. The government could find itself facing high inflation, stagnating economic activity, and rising pressure on bond yields if current policies persist. We maintain our bearish view on local assets given these growing risks.
Japan's roughly 230% of GDP debt load is a major problem, which although widely acknowledged, is perhaps underappreciated. An even greater concern is the way in which the government and the Bank of Japan (BoJ) are looking to bring the debt load back to sustainable levels. In this article we will delve deeper into how Japan's indebtedness came about, the likely methods that the government will choose to bring down its debt level, and the economic and financial market implications of these policies.
Spending Is Not High Relative To OECD Averages
The first thing to note is that Japan's consolidated fiscal spending is not high relative to developed market standards. In fact, as the chart below shows, spending as a share of GDP is significantly lower than the advanced economy average. Despite building 'bridges to nowhere' in the wake of the 1990 economic bust, and having a heavy welfare burden, overall spending as a share of GDP has been far lower than average over recent years as the chart below shows.
| Spending Has Remained Below That Of Its Peers… |
|Consolidated Government Spending, % of GDP|
Tax Revenues Have Not Kept Pace
Japan's debt load stems rather from its relatively small tax base, which has failed to match spending even closely over the past decade. Tax revenues as a share of GDP have been much lower than the advanced economy average, as the chart below illustrates.
| …But Revenues Have Been Hard to Come By |
|Government Revenues, % of GDP|
One Way Wealth Transfer Has Gone On Too Long
Despite the persistently large deficits, representing a major transfer of wealth from the public sector to the private sector, there has been little attempt to correct this trend by either increasing taxes or monetising the debt (both of which would have helped to transfer resources back to the public sector). Raising taxes became difficult to push through amid weak economic growth, while the monetisation of the debt via quantitative easing was resisted by the BoJ. The widespread reliance on Keynesian stimulus policies also meant that there was little appetite to cut spending. The result has been the accumulation of huge assets by the private sector in the form of Japanese Government Bonds (JGBs).
| Deficits Have Consistently Outstripped Those Of Peers |
|Consolidated Fiscal Deficit, % of GDP|
'Borrowing From Itself' Provides Little Cause For Cheer
While it is true that Japan is 'borrowing from itself', this does not provide much in the way of a silver lining. Indeed, its financial bubble of the late 1980s was funded domestically, but this didn't prevent a subsequent bust. While on the face of it, the Japanese debt problem just entails a simple wealth transfer from households back to the government, this superficial view fails to acknowledge the economic distortions that have built up as a result of the rise in bond issuance.
Economy Hooked On Low Rates
Japan's entire production structure is based on ultra low interest rates, with businesses likely engaging in activities based on the belief that interest rates will remain low for years to come. Household finances are dependent on the perceived wealth that they hold in the form of JGBs, and any hit to this is likely to send spending patterns into a tailspin. To the extent that businesses have anticipated continued low tax rates (relative to what are actually likely to occur), and continued high social spending, we are likely to see large scale bankruptcies as attempts to transfer resources back from the private to the government sector eat into corporate profits.
| Soaring Interest Burden Is Already Baked In |
|Japan - 10-Year Government Bond Yield Versus Government Interest Payments, % of GDP|
Without a doubt, this fiscal rebalancing will act as a significant blow to businesses, and while it is difficult to predict with any accuracy, we are likely to see a recession unfold as the transfer takes place and the private sector reorganises labour and capital to align production more closely with new consumer preferences.
A Quartet Of Difficult Choices
The task facing the Japanese authorities is how to transfer this wealth while causing the least amount of economic disruption, in both the short and the long term. Below we outline the efficacy and likelihood of the various policy options at the government's disposal.
Default: An outright default on JGBs, combined with slashing government spending by enough to run a balanced budget is certainly one way of transferring resources back to the public sector. However, it would cause a total collapse in the economy in the near term and is not something that the government will consider any time soon.
Tax Hikes: A policy dominated by tax hikes would do little to address the deficit, in our view. Economic growth would suffer, and even if tax revenues rose they would not rise sufficiently to narrow the deficit substantially. With the recent increase in the sales tax, we expect little benefit in terms of revenues, while economic growth is set to stall. It seems likely that appetite for further tax hikes will be diminished if this is the case.
Spending Cuts: A policy dominated by cuts in spending would help boost the economy over the medium term, notwithstanding the near-term shock. A reduction in social spending, for example, while unpopular, would force people to re-enter the labour force, which has been in relentless decline. We believe that this would be the best outcome from an economic standpoint, as it would allow a combination of higher growth and narrower deficits. However, without quantitative easing, the economy could slip back into deflation, weighing on tax revenues, and given the rising real interest burden on the government, spending cuts alone would be unlikely to reduce the deficit. Given the lack of political will amid deteriorating demographic trends, spending cuts are unlikely to dominate the government's policy of lowering the country's debt load.
Quantitative Easing: The government is clearly choosing a policy based largely on debt monetisation to reduce the country's debt burden. The BoJ has already bought over 20% of the outstanding stock of bonds, purchasing more than the entire size of the fiscal deficit last year, and we estimate that this figure could reach as high as 28% by end-2014 under our most aggressive assumption ( see 'Growing Pressure From All Sides To Force BoJ To Raise JGB Purchases', December 19, 2013). As very few market participants expect the BoJ to sell these bonds back to the market at any point, this debt can be considered monetised already. If we therefore strip out this debt, then gross public has, in effect, already shrunk to under 190% of GDP.
| Deflation Is A Thing Of The Past |
|Japan - Core CPI, % chg y-o-y|
Beware Unintended Consequences
It is easy to see how this seems like a free lunch for the Japanese economy, particularly given the positive impact that QE has had on economic activity and risk assets over the past 18 months. The ongoing policy of inflating away the government debt load is being hailed as a major success on all fronts. However, we believe that it is doing untold damage to the real economy, which will only be felt when it is too late to reverse course:
By pressing interest rates down towards zero at every maturity, the government's urgency to cut spending is vastly diminished. With the bond market providing no signal to the government that it is spending in excess, government spending as a share of GDP is set to rise further, to the detriment of economic activity. As revenues are unlikely to match spending, this also sets the stage for a further painful wealth transfer down the road.
By the same token, this policy leads to a reduced urgency for regulatory reform. Prime Minister Shinzo Abe's 'Third Arrow' of regulatory reform has been conspicuous by its absence, and the political will for far-reaching structural reforms is likely to remain weak as long as government spending and inflation can paper over the economic cracks.
Perhaps the most concerning aspect of the current policy mix, and one which we believe is being given very little attention, is the artificial boom that is being created by deeply negative real interest rates. Real interest rates are now deeply in negative territory, and if we take the market-determined inflation expectations as imbedded in the 5-year breakeven market, real interest rates at the five year tenor are a whopping negative for the first time on record, to the tune of 2.2%. The swing from positive territory over the past two years has been unprecedented. This sends a signal to businesses that they should invest in long-term capital-intense projects, in the expectation that they will satisfy future consumer demand. Dubious investment projects are undertaken as they are seen as profitable while interest rates are low. However, as real interest rates ultimately rise, the misallocation of resources will manifest itself in a collapse in profitability and production.
| Inflation Expectations Are Rising As Expected |
|Japan - Market-Implied 5-Year Breakeven Inflation Expectations, %|
What Is The Ultimate End Game?
With no urgency to make the necessary spending cuts given the reliance on QE, we expect fiscal deficits to remain close to 10% of GDP over the coming years. The sales tax hike will take its toll on the economy, undermining growth at a time when the cyclical boom effects of QE are beginning to fade ( see ' Obvious Cracks Appearing In Japan's Recovery ', February 12). The growing expenditure burden resulting from the ageing population, meanwhile, will see government spending continue to rise as a share of GDP, resulting in continued huge debt issuance by the BoJ.
With inflation expectations rising, private sector demand for bonds is likely to plummet, leaving QE as the only option left to fund the fiscal deficit. This creation of new money by the BoJ will prove to be increasingly inflationary, and to the extent that any economic weakness caps inflationary pressures, we believe that the BoJ will see this as a signal to ramp up its debt monetisation efforts. This excessive BoJ balance sheet expansion is likely to send CPI north of 2.0% over the next 12 months, even as the economy cools.
| Inexorable Demographic Decline |
|Japan - Working Age Population Versus Dependent Population|
Although ongoing debt monetisation may chip away at the debt held by the public as the BoJ monetises more bonds than government net issuance, persistent deficits will likely mean that the only way to bring the government debt load down to sustainable levels will be to accelerate the pace of QE, with potentially drastic consequences for inflation. Indeed, any reduction in QE would put upside pressure on bond yields, which would eventually lead to a surge in interest payments from the government to bondholders, requiring yet more bond issuance.
| Can't Get Rich By Getting Poor |
|Japan - GDP As A Percentage Of US GDP|
High Inflation, Stagnant Economy, Rising Bond Yields
In our view, this will be the situation that the government and the BoJ find themselves in over the next 12-24 months: High inflation, stagnating economic activity, and rising upside pressure on bond yields. It is difficult to speculate beyond this point, but if the situation plays out as articulated above, then the government will face a choice between hugely unpopular cuts in spending, more QE and subsequent runaway inflation (or potentially hyperinflation), or some kind of debt moratorium (partial haircut) on bond obligations.
Financial Market Implications: Bearish Equities, Bearish Bonds
Given the relative optimism towards Japanese equities at present, and the relative calm in the local bond market, we believe that volatility is likely to rise greatly over the coming months and quarters. We remain convinced that the Nikkei will lose value in US dollar terms, as any yen strength would result in outsized Nikkei weakness, while it would likely take a collapse in the yen to force the overvalued Nikkei much higher. Meanwhile, we believe that JGB prices will ultimately collapse as yields head towards inflation expectations and begin to price in the non-negligible risk of default.
| Stealing Returns From The Future |
|Japan - Nikkei (Priced In US$) Versus JGB Futures|
As such, we believe that an equal volatility-weighted basket of bearish Nikkei (in US dollar terms) and bearish JGB futures will perform very strongly over the coming years. ?As the accompanying chart shows, over most of the past two decades, bond and equity prices have been inversely correlated. Higher bond prices have meant lower equity prices and higher equity prices have mean lower bond prices. This is the natural course of events as inflation and growth expectations move these markets in different directions. Since the 'Abenomics' stimulus was implemented, however, the excessive money printing has led both stocks and bonds to rise simultaneously, at the expense of future returns. With the yield on 10-year JGBs currently just 0.6%, and the yield on the Nikkei just 1.5%, any negative fiscal or inflation shock is likely to send the prices of both assets down significantly until significant risk is prices into these markets. The dynamics that played out in Italy in early 2012 could provide a template for what to expect as markets begin to fear Japan's debt load.