In a global financial system, the collapse or even perceived weakness of a large economy such as Japan would be catastrophic. And Japan is not doing well. For a while now it has been coasting towards a crisis, flirting with its own financial ruin.
One way to measure what the market thinks about the risk inherent in Japan's financial instruments are Credit Default Swaps (CDS). They are insurance policies against Japan's possible default. A CDS on five-year Japanese debt have risen from 35 to 63 basis points since early September (meaning that to insure $10,000 worth of Japanese five year bonds, you recently had to pay $63).
The fact that market participants are willing to pay significantly higher prices for insurance on Japan's fiscal strength is an important cautionary tale (for comparison, the price of insurance on Germany is 21 basis points; the U.S., 22).
In 2009, Japan's budget deficit was 10% of GDP. Total government debt is close to 200% of GDP. Economic growth has been slow for years and previous stimulus plans have been failing.
The Japanese pension funds have been selling assets to meet the needs of the country's retirees, as the demographic situation in Japan is not improving. The country is aging, and with no immigration to speak of and one of the world's lowest birth rates, the elderly workers are simply not being replaced.
Typically, when a country's debt rises, interest rates it has to pay on that debt are rising as well. That makes intuitive sense: as the fiscal situation becomes more precarious, the odds of the government defaulting on its debt rise, and lenders require more compensation for their increased risk.
But in Japan, the cultural phenomenon of robust saving habits created a situation where Japanese themselves buy most of their government's debt. That has driven interest rates down from 7.1% in 1990 to 1.4% today.
Because prices have been declining, people accept low interest rates. And somehow, investors, at least so far, have not been fearful that their money might not be paid back.
What would happen if they became fearful of that? Interest rate would skyrocket, further imperiling the Japanese economy. And taxes would have to go up, making economic growth even harder to achieve.
Japan is walking down the same path other countries that have defaulted on sovereign debt have pursued before. Yet its interest rates are still low, and the Yen has risen about 10% over the last 12 months.
Japanese bonds and currency seem mispriced. Investors are not taking into account the true risk inherent in Japan's debt load and deficit. Moreover, Japan's fiscal house is on shaky grounds, and fixing it may be a truly staggering task, with global ramifications.
Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at firstname.lastname@example.org