Submitted by Nick Ricciardi
On Japan’s Bond Market and Its Economy
Over the past few weeks there has been a new round of articles and commentaries predicting doom for Japan’s economy. Yet, as usual, Japan’s bond markets have shrugged off these fears.
Japan’s capital markets and its macro-economy are replete with confounding puzzles. But they are all rooted in two basic misconceptions that Japanese hold concerning their debt. Moreover they are understandable if analyzed from a perspective of both the public and private sectors. Doing so gives us insight into why Japan’s public debt offers the lowest yields of any nation when its debt/GDP ratio is the highest, why Japan’s corporate credit spreads are so narrow and its yield curve almost flat, why Japan’s bond prices are less volatile than those of other industrialized nations when its economy and stock market is “leveraged” to global growth, and why the yen tends to strengthen when Japan’s economy turns down.
These conundrums (to paraphrase Alan Greenspan) are inter-related. To address them let us first consider the two misconceptions.
(a) The Japanese regard their public debt as safe. Japan is the world’s most financially unconstrained nation. It has a fiat currency and full control over its money printing press. It has issued all its public debt in yen, and over 95% of it is held internally. Japan’s government – unlike Greece’s – cannot be forced to default involuntarily. Furthermore, there is near zero tolerance for voluntary default among its citizens. Hence its government bonds contain insubstantial default risk premia, despite the pricing of sovereign CDSs in London and the admonishments of rating agencies in New York.
(b) The Japanese are confident their debt will not be inflated away. 18 years of Keynesian spending to prop up its post-bubble economy has imparted a mild deflationary bias to its economy. Heterodox monetary measures (such as “helicopter money”) could swiftly reverse this, but Japanese understand that radical reflationary measures will not be on the agenda for the foreseeable future. Risk aversion of its governmental institutions, aging of its population, political gridlock, composition of its debt holders, and collective memories of its post-war hyperinflation of 1946-49 are powerful forces for maintaining purchasing power. Moreover, nearly two decades of below trend inflation have further conditioned its bondholders to discount the risk of future inflation. Hence Japan’s bonds contain inadequate inflation risk premia.
These two misconceptions are pervasive and self-fulfilling. Japanese institutions, politics, and culture will need to transform before they can be jettisoned. (All nations have misconceptions about finance; there is nothing anomalous about Japan.) Since default and inflation risk premia are almost absent, and its bonds are mostly internally held, Japan’s government bond yields effectively become the rent that Japan’s private sector (the bondholders) charges the government to hold its debt. A unified basis for resolving Japan’s macroeconomic puzzles lies in reframing them along aggregate private / public sector lines.
Consider the true cost of Japan’s government debt. Japan has just under 1000 trillion yen of government debt and a GDP of just under 500 trillion yen. Since the average maturity of its debt is slightly more than seven years, Japan pays about 75 basis points in annual interest costs. With deflation running at 50 basis points a year, Japan pays out a real yield of 1.25% per annum on its debt. This equates to a real payment of 12.5 trillion yen, or 2.5% of its GDP paid (mostly) to its beleaguered private sector. This is a very high real yield despite the “sticker shock” of 0.75% for 7-year debt. In fact 2.5% of GDP is a greater real public sector wealth transfer than that demanded by the US’s more vibrant private sector. If this amount of required wealth transfer stays constant, and Japan’s private sector outlook remains the same, then when its public debt levels double its bond yields will need to halve. However, a real 2.5% wealth transfer is probably too much going forward as Japan’s private sector outlook will most likely become bleaker.
The private sector consists of households, corporations, and banks. Due to its harsh demographics Japan’s household saving rate is expected to turn negative within the next few years, even as its consumers spend less. The nation’s annual public sector deficits of around 30 trillion yen will, therefore, flow to its firms and banks. This stream of excess corporate wealth will prevent prices of capital goods and non-residential land prices from falling, even as domestic demand for final goods falters. The corporate sector may do reasonably well in this environment, but it is hard to see how this will translate into greater optimism about the future. Since the nation no longer runs a significant trade surplus, Japan’s excess supply capacity will likely build, and the long term expectation for yen-based capital will most likely drop. This should put significant downward pressure on required real wealth transfers, and, hence, even more downward pressure on bond yields, in the coming years.
Japan’s bank’s legendary insensitivity to yen-based credit risk also makes sense when examined along public / private sector lines. For the past 15 years much of Japan’s public debt has shown up in the corporate sector in the form of excess profits. This has papered over most potential credit problems. Policymakers also contribute to credit safety by opposing discontinuous change and by propping up weak firms to prevent bankruptcies. Japanese banks have also become inordinately overcapitalized as excess private sector wealth remains trapped in the banking system. These factors – unique to Japan – have conspired to keep yen credit spreads low. As Japan continues to spend far more than it taxes, corporate credit spreads will likely shrink further for most of its large corporations.
Japan’s yield curve is not as flat as it appears. Yield curves are steep in the industrialized world mostly due to inflation risk premium in North America and Australia and default risk premium in much of Europe. Since these risk premia are minimal in Japan, and natural GDP growth is lower, Japan’s curve should be flatter. Yet when you look at the yield curve in absolute terms, it really is steep. Japan pays its bondholders (i.e., its private sector) roughly 7.5 trillion yen ($90 billion, or 1.5% of its GDP) each year to finance its public debt for an average of seven years, instead of zero to finance it via overnight rates. By comparison, the US pays roughly 2.7% of its GDP per year to finance its public debt for six years, but over half of this payment represents an inflationary premium. We can expect Japan’s yield curve to flatten in the coming years as its public debt levels rise, provided Japan’s basic misconceptions about its debt remain.
Analyzing interest rate volatility along these public / private lines helps us understand the remaining puzzles. Given Japan’s Mount Fuji-sized debt, a 50 basis point move across the yield curve represents a 5 trillion yen change (or 1% of GDP) in annual financing costs of Japan’s debt, an enormous amount of wealth for Japan’s private sector to incrementally give up or receive. The same move in US rates would have less than one third the comparable impact. Japan’s greater sensitivity to rate changes means that as global economic conditions improve, yen bond yields can be expected to rise far less than those of the West; and the corresponding Japan/West yield differentials will widen. Since changes in interest rate differentials have long been the main driver of the yen, when global economic conditions turn up, the yen will likely weaken, amplifying Japan’s economic rebound and further fueling its stock market rise. Conversely, weak global economic conditions will lead to convergence of Japan/West interest yields, causing upward pressure on the yen, and downward pressure on its economy and stock markets. This explains why Japan’s equity markets are more volatile than those of other large nations while its debt markets move less. And it helps explain the seemingly perverse behavior of the yen strengthening when times are tough. A change in bond yields packs a more powerful punch in Japan than anywhere else. By appreciating the force of this punch we are then able to predict its ripple effects.
To summarize, as can often be the case in Japan, things are not as they appear. From a Japanese perspective, its bonds are cheap, its corporate credit markets are sound, its true yield curve is steep, and the yen’s tendency to strengthen in the face of economic adversity is to be expected. Japan is in the midst of a wild experiment in pushing the limits of fiat money. Incorporating the ways its public and private sectors balance will lead to insights at substantial variance with prevailing views. I see this as the key to understanding many of Japan’s macroeconomic anomalies.
I conclude with a medium-term prediction. By 2016, Japan’s long-term bonds will yield less than 1%. When Japanese policymakers undergo future campaigns to “get control of the deficits”, bond yields will spike and most likely undermine the intermittent austerity efforts. Future austerity attempts will represent extraordinary opportunities for intrepid investors to buy long term JGBs. As for the risks to this prediction, “sudden stop” behavior of investors is a risk with all debt refinancing. But this tail risk for has long been overstated for Japan’s public debt. Barring natural disaster, calamity, or war, we can expect many future fakeouts and false alarms before Japan’s bond prices truly collapse. The stakes are most likely too high, the misconceptions too large, and monetary and fiscal fixes too powerful for a bond crash to occur on its own accord anytime soon.
Nick Ricciardi is a private investor based in Kyoto. He can be reached at email@example.com