A month ago, we reported that the Japanese public pension fund, which holds JPY152 trillion in total reserves, would for the first time withdraw 6.4 trillion yen in order to cover pension payouts, a process which once started, eventually ends up with the "Illinois" conclusion where it has to issue bonds to pay accrued pension obligations. The reason why the Japanese pension fund is particularly important for japan is that not only does it have implications for the welfare system of the land of the rising sun, any future dispositions will explicitly affect the supply and demand of JGBs, of which pension funds have traditionally been a major buyer. Not only that, but as Dylan Grice reminded us some time ago, a liquidation process would also impair US Treasury holdings: " As Japan's retirees age and run
down their wealth, Japan's policymakers will be forced to sell assets,
including US Treasuries currently worth $750bn, or Y70 trillion "eight
months" worth of domestic financing." Today, another SocGen analyst, Takuji Okubo, presents a realistic outlook of what will happen when one takes government projections to the pension system and applies realistic assumptions. In a nutshell, instead of a build up of JPY100 trillion over the next 15 years, pension reserves will likely decline by JPY36 trillion, a swing of almost 140 trillion, or nearly $2 trillion in incremental and very marginal JGB and treasury demand actually becoming supply. And in a world in which the Fed is suddenly (allegedly) pulling out as the biggest source of sovereign paper demand, this swing factor out of Japan will have substantial implications for the bond market, especially when coupled with a Japanese economy that suddenly finds itself on the rocks.
Below we present Okubo's full note as it is a must read for everyone who still refuses to acknowledge the extremely material role of Japan in the global financial jigsaw puzzle.
Japan’s declining pension reserves
At the end of June, the Japanese government is scheduled to announce reform measures on Japan’s public pension system. No significant measures are likely to be included to improve the sustainability of the pension system this time. That is worrying, as pension reserves have already started to shrink, and the trend could accelerate. As pension funds play an important role in the JGB market, developments in public pension finance deserve close attention.
Government to propose pension reform in June
With an aging society, public pension is increasingly becoming the dominant element in Japan’s public finance. In recent years, Japan’s public pension system distributed close to JPY 50 trillion, equivalent to nearly 10% of GDP, as pension benefits. As of now, gross public pension benefits in Japan are comparable to those in Europe as a ratio to GDP. However, with further aging in the population, the size of pension benefits in Japan is likely to increase. Populations aged over 65 in Japan are projected to increase from 29.4 million in 2010 to 35.9 million in 2020. Japan’s public pension system is only partially funded, and there have been constant concerns over the sustainability of the public pension system.
Prime Minister Kan pledged at the beginning of 2011 that he would propose by the end of June a mix of reform proposals for social security, including public pension. He created a commission to provide him with proposals for reforms. The commission halted its meeting schedule in the aftermath of the earthquake, but it recently resumed its discussion.
Judging from the minutes of the commission, the commission does not seem to be making much progress though. In fact, the commission’s proposals to Prime Minister Kan could worsen, rather than improve, the sustainability of the public pension scheme. The commission is discussing expansive measures such as an increase in the pension level for lower income earners, while making little progress on measures to increase revenue or to cut benefits.
Official projection on pension finance is far too optimistic That is worrying, because we think the pension reserves would critically decline unless measures are taken either to increase revenue or to cut pension payouts. As of 2010, the public pension has JPY 152 trillion of reserves, over 30% to GDP, the majority of which is invested in JGB. According to government’s projections last made in 2009, pension reserves are projected to increase. However, the projection is made on excessively optimistic assumption.
For example, the Japanese government’s projection assumes the long-term average wage growth rate of 2.5% and investment yield of 4.1%. Both numbers seem excessively optimistic. When we replace the long-term wage growth rate to 1% and investment yield to 3%, we project reserves to decline from JPY 152 trillion in 2010 to JPY 116 trillion in 2025 (see chart below). Given the critical role the public pension fund plays in supporting the longer end of the JGB market, we suspect that such a decline in the public pension reserves would cause havoc to the JGB market at some point.
Painful reform needed to keep reserves from declining
Given that the total JGB outstanding will likely keep expanding for the foreseeable future, reforms must be taken to keep pension reserves from declining. What could these reforms be? For example, housewives and house husbands (although the latter is still rare in Japan) are currently exempt from paying a premium into the national pension system. That needs to be changed. Raising the starting age on when a person can receive pension benefits should also be on the agenda. In our view, the balance of the adjustments needed mostly fall on the revenue enhancement measures, as the level of pension benefits in Japan is not particularly high. Prime Minister Kan is unlikely to deliver these reforms. However, as reforms are delayed, the reserves would keep declining. In our view, JGB market participants need to keep a much closer eye on the speed of decline in the pension reserves and the speed of reform implementation in pension finance.