Trouble in the Land of the Rising Sun

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 [e-mail]

 

Comments

[greatscot]

It looks like Japan is moving to a sustainable existence. The debt to GDP ratio is troubling, but not unmanageable in the long-term.

What is un-sustainable is the US economic model requiring constant growth; in population, production, wages, fast-food portions, SUV's, houses, banks, suburbs, and energy consumption. Continuous growth is a mathematical impossibility. The 5% of the world's people (Americans) using 25% of the world's resources presently, can not increase their share of the world's resources indefinitely. Soon the bell-curve will start to trend downward and when it does, we too will be looking at an economic model much like Japan, and, to a lesser extent, Europe.

[leduck]

Is the author talking about Japan or the U.S.????

I'd rather be in Japan
They're in far better shape then us

[sonofsamphm1c]

Aging population, low birth rate, and exceptionally low immigration. They're geniuses. I think they're going to come out of it just fine.

[FreeNemo]

Will the last one left please shut off the lights before you die?

[sonofsamphm1c]

Beats asking somebody to turn out the lights when all 100s of billions of them die at once.

[Realization]

Boy, has this guy got it wrong. I take it as a good argument to raise taxes on hedge fund profits with the goal of all but eliminating such funds. One strength Japan has is that it's financial system hasn't gone totally astray. Another is that it understands the need for manufacturing. Problems, yes. But it is nowhere near collapse. We, no the other hand are a mess and largely due to people like the author.

[eyelashviper]

Thank you for such a succinct and clear response the the hedge fund guy......fanned!

[Danlantic]

$63 : $10,000 = 1 out of 159 chance of default.
$21 : $10,000 = 1 out of 476 chance of default

Not exactly Russian Roulette.

Trend watching is nothing more than trying to make up a system for winning at roulette. Toss around some graphs & numbers and you can make it appear scientific.

The Japanese already have plans to replace the aging population of workers:

http://en.wikipedia.org/wiki/Japanese_robotics

[FreeNemo]

Uh huh. And everyone knows you can tax the heck out of robots and they never complain.....

[Viper]

Well I guess we need to show them how to have a good economy with trade surpluses and a modern infrastructure, healthcare and college for everyone and a longer life and how to build cars..


Regards

[Dreamwalker420]

The Zombie banks for the past twenty-plus years have turned Japan into Thailand, just much slower. The entire global financial system fell on it's face in September 2008, so the real question is:

How long can Central Banks coordinate to continue the farce of stability?
And when exchange rates do break down, how bad does it have to get before countries begin to fight bloody battles over limted resources?

We are at an apex, where we could see the financial system continue to function for the next 50 years. As deficits balloon and investors are enriched by the social poverty they create via government mandates.

What WILL happen is a country, like Zimbaebwae (no one ever tries to spell it correctly anymore ... they change the name before it matters!) will begin to print interest-free currency.

Iran will do it? Maybe some other "rogue" state and the BIS will fight against that using the leverage of the global financial system ... maybe Japan will be the one to break the yoke of debt created by the notion of the needs of central banks.

Japan has already been fiscally independent in it's politics ... breaking most recently from "western" political thought and electing a truly representative government.

[yappnmutt]

japan is far from failing. china is committed to saving them because they need each other. that's the simple answer.

[sonoffestus]

China will also and must keep the US alive a little longer until they recoup their investment. But then again , they're keeping N. Korea alive as well and we know how well theylive in N. Korea. Once China and India's domestic consumer markets grow, the US is toast.

Right now they still need our consumers even crippled as they are. When their consumers kick in it's new ball game and we'll be playing minor league ball. You say it will never happen? It is only a matter of time.

I figure it won't happen in my lifetime, I have 20 - 25 years, but it is going to happen. If you are young,start setting yourself up now.

[LHB58]

A 40 basis point difference between the implicit default risk premium on US and Japanese government debt hardly portends a financial crisis. As this article suggests, Japan's problems have more to do with "real" factors than financial ones. These real factors boil down to one: demographics. Japanese people either have to start having more children, the country must begin to encourage immigration, or both. This is a growing problem in other western countries, particularly in the EU. You cannot sustain a welfare state with stable taxes in the long run unless your working age population is growing.

[nezumi]

This is totally not going to happen:
'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.'

The Japanese save for their old age in numbers and as consistently, so as to be unimaginable in America. They don't have the option, in their opinion, to not do that. So this would require a black swan, a very costly war or something in that price rage. An earthquake or tsunami will not do.

'What would happen if they became fearful of that? Interest rate would skyrocket, further imperiling the Japanese economy.'

The Japanese have overall faith in their government, at least as far as I know them. Although the prime minister is readily exchanged. So if the government cannot pay back the people, if they were not Japanese, with what is at stake here (their old age), they would storm the barricades. But they are, and there would also have to be massive corruption and fraud (see the post office scandal) to elicit any decisive reaction.

I heard the same argument before a few years after 1990, where Japan's credit worthiness was downgraded. Nothing bad happened then.

America might go to hell in a handbasket. That does not mean the rest of the world will.

[opama]

too big to fail