Yesterday’s Japanese Downgrade Illustrates Our Proclamation Of The Paths To Contagion

I spent the majority of 2010 and a decent portion of 2009 warning that massive debt simply does not just “go away”, particularly after significant asset devaluation. The result of these two actions (once combined) is the evaporation of equity, the waning of value, and the ultimate destruction of capital. Sovereign nations and global financial institutions alike have been dodging, ducking, weaving, fibbing, lying, closing their eyes, sticking their collective heads in the sand and kicking the can down the road for 3 years now. This is not the end of the world, but it is the end of the massive amount of economic capital that so many swear is still abound. The longer we take to acquiesce and accept this foregone conclusion, the harder the pill will be to swallow – “can kicking” be damned.

And on that note, Bloomberg reports: Japan’s Credit Rating Cut to AA- by S&P on Mounting Debt Burden

Japan’s credit rating was cut for the first time in nine years by Standard & Poor’s as persistent deflation and political gridlock undermine efforts to reduce a 943 trillion yen ($11 trillion) debt burden. The world’s most indebted nation is now ranked at AA-, the fourth-highest level, putting the country on a par with China, which likely passed Japan last year to become the second-largest economy. The government lacks a “coherent strategy” to address the nation’s debt, the rating company said in a statement. The outlook for the rating is stable, S&P said.

The yen and bond futures fell on concern the downgrade will push up the cost of borrowing for Japan, where public debt is about twice the size of gross domestic product. Vice Finance Minister Fumihiko Igarashi this week said the government must fix its finances to avoid a debt crisis that could trigger a “global depression.

“I hope this serves as a warning for the government, they have absolutely no sense of crisis,” said Azusa Kato, an economist at BNP Paribas in Tokyo. “Once bond yields spike and the fire is lit, the amount needed to finance Japan’s borrowing needs is going to jump and it’s going to be too late.”

The yen fell after the announcement, later paring declines and trading at 82.77 per dollar as of 7:23 p.m. in Tokyo. Ten- year bond futures for March delivery declined to 139.55 at the Singapore Exchange.

I have a trending currency model to be distributed to professional/institutional subscribers, but encountered a last minute technical glitch. It will be be available by next week, and can be used to see the medium and long term trends quite clearly for those in interested in the macro perspective.

… Thirteen Japanese companies included in the benchmark Topix stock index are more highly rated than AA- by S&P, including Toyota Motor Co. An S&P spokeswoman declined to say whether company-rating downgrades will follow. Shiori Hashimoto, a spokeswoman for Toyota City, Japan-based Toyota, declined to comment.

It is possible for companies to have higher ratings than the local or foreign currency ratings of their home country, S&P said in a May 2009 report. The best candidates have a robust export base, little reliance on the public sector and sell products with “relatively inelastic” demand. The S&P report said businesses with sales mainly in local currency, subject to regulation and heavily dependent on imports probably won’t pass stress tests without “heavy overcollateralization or reserves.”

Downgrades in Europe

Japan joins developed economies including Portugal and Spain in being downgraded as emerging nations bounce back more strongly from the global recession. The previous change to Japan’s rating by S&P was an upgrade in 2007, before the financial crisis. The nation lost its AAA rating, the highest grade, in 2001 after holding it since 1975.

With domestic investors holding more than 90 percent of Japanese government bonds, the downgrade “probably won’t prompt them to move money out of Japanese bonds into foreign assets because the problem of sovereign debt is worsening worldwide,” said Naomi Hasegawa, a senior debt strategist in Tokyo at Mitsubishi UFJ Morgan Stanley Securities Co., a unit of Japan’s largest lender by assets.

The Potential for Spillover Effects Simply Cannot Be Ignored If You Look At This From An Empirical Perspective

A key risk in sovereign default is the spillover effect due to interlinkages in the financial system, reference”Financial Contagion vs. Economic Contagion: Does the Market Underestimate the Effects of the Latter?” Sovereign defaults transmit risks ACROSS asset classes, and a crisis in one country can easily engulf others due to cross border exposures. Empirical data points out that sovereign default are usually clustered. The Asian financial crisis of 1997–98, when sovereign debt problems hopscotched from economy to economy, is a testimony to what could happen to Europe this time around. In addition, the spillover effect also affects corporate bond yields as company’s ability to borrow money not only depends upon its own creditworthiness, but also on the financial health of its home-country. When investors lose confidence in the government’s ability to use public finances they demand a premium to access capital to corporates, raising the financing costs. A downgrade in sovereign ratings/default also has negative affect on the stock markets.

The charts below show bond volatility and equity volatility across major markets – US, UK, Germany and Japan. Both equity markets and bond markets across geographies are strongly correlated thus demonstrating cross border intervention. In addition, we have also shown interlinks between equity and bond market demonstrating cross-asset correlation.

Last year, we introducing the “BoomBustBlog Sovereign Contagion Model“, wherein we spent many analyst man/months to create a realistic model to capture the potential for social unrest, financial and economic contagion as they could skip across sovereign borders, continents, asset classes and hemispheres. We are in the final stages of a significant update to this model, which still stands as what we consider a tour de force in realistic risk modeling. Nearly every MSM analyst roundup attempts to speculate on who may be next in the contagion. Most analysis looks at gross claims between countries, which of course can be very illuminating, but also tends to leave out many salient points and important risks/exposures.

foreign claims of PIIGS

In order to derive more meaningful conclusions about the risk emanating from the cross border exposures, it is essential to closely scrutinize the geographical break down of the total exposure as well as the level of risk surrounding each component. We have therefore developed a Sovereign Contagion model which aims to quantify the amount of risk weighted foreign claims and contingent exposure for major developed countries including major European countries, the US, Japan and Asia major.

I.          Summary of the methodology

  • We have followed a bottom-up approach wherein we have first identified the countries/regions with high financial risk either owing to rising sovereign risk (ballooning government debt and fiscal deficit) or structural issues including remnants from the asset bubble collapse, declining GDP, rising unemployment, current account deficits, etc. For the purpose of our analysis, we have selected PIIGS, CEE, Middle East (UAE and Kuwait), China and closely related countries (Korea and Malaysia), the US and UK as the trigger points of the financial risk dissemination across the analysed developed countries.
  • In order to quantify the financial risk emanating in the selected regions (trigger points), we looked into the probability of the risk event happening due to three factors – a) government default b) private sector default c) social unrest. The probabilities for each factor were arrived on the basis of a number of variables determining the relative weakness of the country. The aggregate risk event probability for each country (trigger point) is the average of the risk event probability due to the three factors.
  • Foreign claims of the developed countries against the trigger point countries were taken as the relevant exposure. The exposures of each developed country were expressed as % of its respective GDP in order to build a relative scale for inter-country comparison.
  • The risk event probability of the trigger point countries was multiplied by the respective exposure of the developed countries to arrive at the total risk weighted exposure of each developed country.

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