It is hard to find fiscal situations that are worse than Japan's. The gross government debt/GDP ratio, at more than 200%, is the worst among the major developed economies. Yet yields on Japanese government bonds (JGBs) have not only been among the lowest, they have also been stable, even during the recent deterioration during the European debt crisis. This apparent contravention of the laws of economics is both an enigma for foreign investors and the reason for them to expect fiscal collapse as a result of a sharp rise in selling pressure in the JGB market. As Goldman notes, the European debt crisis has led to an increase in market sensitivity to sovereign risk in general and questions remain on when to expect the tensions in the JGB market and the fiscal deficit to reach a breaking point in Japan. In the following 14 charts, we explore the sustainability of fiscal deficit financing in Japan and Goldman addresses the JGB puzzles.
Goldman Sachs: Japan’s fiscal/JGB enigma and conceptual framework
A financial crisis can come about as a result of a lack of solvency or liquidity. Solvency is a government’s ultimate ability to pay its debts. Liquidity is concerned with the “here and now”: can a government fund its ”current” fiscal deficit in a particular fiscal year? In terms of solvency, there are massive concerns about Japan. Despite these concerns, domestic investors have poured funds into the JGB market. As a result, Japan currently has no liquidity problem at all, which may seem strange at first glance.
Even the government’s primary balance forecast, based on a growth-strategy scenario that is far more optimistic than private-sector forecasts, does not predict primary surpluses in the next ten years (it assumes a total of 5 percentage point increase in the consumption tax rate until October 2015). We conclude from this that Japan’s debt/GDP ratio can only be stabilized through deep spending cuts that will necessarily include cuts in areas such as social security, and believe this will be extremely difficult to achieve politically.
One reason why Japanese investors continue to invest in JGBs despite solvency concerns is that firms are saving sufficiently.
Falling growth expectations as a result of Japan’s ageing demographics have eroded the incentive to invest and borrow. Money with nowhere to go is therefore being channeled into the JGB market via banks and other domestic financial institutions. Even if investors want to move out of JGBs, the funds are so large that there is no yen financial market of an equivalent size and liquidity. There have been some moves into US Treasuries and Bunds but Japanese investors have a strong ”home bias” and such fund transfers have been limited, at least thus far. Money has therefore stayed in the domestic market, funding the fiscal deficit even when negative factors have arisen. Hence, liquidity has so far not been a problem.
Why are JGB yields so low and stable in the face of major solvency concerns? This has been an enigma for foreign investors. We address this question by breaking down the nominal yield into (1) real interest rates, (2) inflation expectations, and (3) a fiscal premium.
- (1) The real interest rate is generally approximated by the real potential growth rate over the long term. It has fallen sharply in the past two decades due to rapid ageing of the population. In turn, firms have lost some of their capex incentive and thus shifted from cash shortfalls to cash surpluses.
- (2) Inflation expectations have fallen in Japan because nominal wage cuts in the late 1990s have led to widespread deflation expectations.
- (3) So far the JGB market has not factored in a fiscal premium to a significant extent. This is very different from the sovereign Credit Default Swap (CDS) market, where pricing is largely determined by foreign investors. Japan’s sovereign CDS spread, which can be seen as an objective assessment of the government’s solvency, has been rising since the late 2000s. We believe the JGB market’s lack of a fiscal premium is due to the stable domestic uptake of JGBs.
Japan’s fiscal sustainability
To assess Japan’s fiscal sustainability, it is therefore more important to look at it in terms of liquidity rather than solvency. Specifically, we need to assess how long the surplus funds of domestic private agents can absorb fiscal deficits. We project this situation out to FY2020 using a two-pronged approach based on an investment/savings identity. Our first, direct approach is to model the savings behaviour of firms and households. Our second approach is to start from the current account balance, which is equivalent to the overseas sector’s savings that appear as the result of our first approach. This is an indirect method for exploring the domestic potential for fiscal deficit funding. The two approaches complement each other, with reality likely to be somewhere between the two simulations.
The most important underlying factor in our first approach is population ageing.
This is a negative for household savings but positive for corporate savings. To gauge the outlook for domestic uptake of fiscal deficits, we combine our estimates for the cash surpluses of domestic private agents with the government’s forecast for the fiscal deficit.
In a scenario where the deficit is not reduced by more than what the current government plans and the fund outflow of overseas M&A by Japanese firms is taken into account, we find that it would become difficult to fully finance the deficit domestically by FY2018. However, the Japanese government is considering another consumption tax hike beyond the currently-planned 5% increase by FY2015. Thus, for example, if we apply a hypothetical (but realistic, in our view) scenario of a further three percentage point increase in consumption tax rate or an equivalent cut (at least ¥6tn) in permanent fiscal expenditure, we find that the deficit can comfortably be funded domestically through FY2020, the end of our analysis period.
However, we note that measures such as the currently-planned five percentage point increase in consumption tax rate are far from sufficient to solve the solvency problem as they do not address the issue of stabilizing the debt/GDP ratio. We believe they are just stopgap measures to keep the wheels turning even as domestic savings dry up.
Current account outlook
Our second approach is to look at the current account outlook in that it will move into deficit if domestic cash surpluses are unable to finance the fiscal deficit. We simulated the current account up to FY2020 using conservative assumptions: further yen appreciation, offshore production shifts by manufacturers and continued imports of energy alternatives to nuclear power. Our conclusions are as follows:
If overseas production shifts continue at their historical pace (taking the overseas production ratio to 24% in FY2020, from about 18% in FY2010), we would not expect the current account to move into deficit by FY2020.
We would likely see widening trade deficits as (1) offshore production reduces exports and increases imports, and (2) imports are boosted by alternative energy sources. However, large trade deficits are not expected to occur quickly because a fall in exports acts as a curb on imports.
The income account, which has been at the heart of current account surpluses since the mid-2000s, features an increase in earnings from direct investment as a result of offshore production shifts. This mitigates the effect from the widening trade deficits and results in a very gradual deterioration of the current account.
However, in an extreme case where the shifts far exceed their historical pace, taking the overseas production ratio to 33% in FY2020 from around 18% in FY2010, trade deficits would widen much more quickly and the current account would likely move into deficit in FY2019.
The foreign incentive to invest in JGBs
The foreign ownership ratio for JGBs has risen to 8.3% (as of end-March 2012) from its most recent low of 5.7% (end-March 2010), prompting two questions among foreign investors in particular: (1) Why has the JGB yield not risen along with foreign ownership ratio (why are foreign investors not demanding a fiscal premium)? and (2) Will the foreign presence escalate to, say, well above 10% in the near future?
A key point in respect to question (1) is that the increase in the foreign investor presence has been concentrated at the short end.
Although deeply concerned about Japan’s fiscal situation, we believe foreign investors have noted the stable JGB uptake by domestic investors and they do not expect Japan to see a full-blown crisis within the next 12 months or so. They therefore do not require a fiscal premium on short-term JGBs. Forex swap market distortions caused by the European crisis has been another reason for them to invest in short-term JGBs, in our view.
In respect to question (2), we think it depends crucially on how long the European crisis will continue. As long as Europe is in a crisis mode, foreign investors are likely to seek temporary and liquid sovereign safe havens, such as JGBs, as alternatives to European bonds. Thus, we think it is possible that the foreign ownership ratio can increase further from the current 8.3%. That said, we do not expect the ratio to accelerate to far above 10% any time soon. This is because (1) foreign investment has been skewed to the short end and (2) once concerns over the European situation ease, we would likely see foreign investors shift back to European bonds.
We believe it is very difficult for the Japanese government to stabilize the debt/GDP ratio. Our analysis suggests that unless the government makes more aggressive budget cuts than the current plan, domestic funding may become difficult in 6-7 years’ time, meaning that Japan would need more financing from foreign investors. Higher JGB yields would be required to attract foreign investors, possibly triggering a negative spiral in which debt service costs rise and the fiscal situation becomes even more severe.
This is why we think measures such as consumption tax hikes are important. In isolation, they will not stabilize the debt/GDP ratio, but larger annual tax revenues are needed to fund fiscal expenditures, even if this merely keeps the wheels turning. The government will also need to address Japan’s narrow tax base and inefficiencies in tax collection, in our view.
To tackle the solvency issue effectively, we believe the government will need to accompany tax increases with decisive spending cuts, including severe cutbacks in social security spending, although we think deep cuts in social security spending are unlikely in Japan’s current political climate. One important lesson learned from previous fiscal consolidation cases is that the expenditure-cut approach has resulted in substantial debt reduction on average. By contrast, the tax-driven approach tended to have the reverse effect.
For the next several years, we do not expect a sharp rise in JGB yields triggered by a sell-off by foreign investors. This is very different compared to the situation in European countries such as Greece and Italy. Although the foreign ownership ratio has increased recently, investment has been skewed towards the short end. Even if we were to see heavy net selling of short-dated JGBs by foreign investors, we would not expect major market jitters given that the Bank of Japan (BoJ) can resort to a variety of operations to increase the supply of funds and thus calm markets.
This leads to the question of whether domestic investors would sell off JGBs on their own initiative. We think the ultimate anchor for domestic JGB investors is the belief that there is scope to cut spending/raise taxes in the future. If this belief is shaken, we would expect them to consider moving out of JGBs. That said, we would still not expect an immediate surge in JGB yields1. Our reasoning is that (1) there is no ready alternative for funds equivalent to twice the GDP of the world’s third-largest economy, and (2) the BoJ is expected to make JGB purchases to support yields.
Another catalyst for a sell-off by domestic investors is if Japanese manufacturers make greater-than-expected overseas production shifts (overseas M&A). Overseas M&A activity has accelerated, driven by shrinking domestic demand and a strong yen, among others. According to our analysis, this trend will bring forward domestic financing difficulties, because such long-term capital outflows cannot be considered as a ready domestic funding source for fiscal deficits. Overseas production shifts also mean a loss of employment opportunities in Japan, which would lead to slower nominal GDP growth, which is closely related to tax revenues in Japan.
Lastly, if Japan’s finances collapse and JGB yields do spiral, we would not expect contagion to the US or Germany given that Japanese investors would likely seek refuge in US and German bonds—in the same way that investors have fled the European crisis—and foreign investors would increasingly resort to ”safer” assets for the time being.
Full report below: