The

Japanese Debt Dilemma

Economic stability relies chiefly on the credibility of governments to honour their debts. Japans gross debt stands at more than twice its GDP, and is fast approaching the one quadrillion yen mark yes, that is 1,000 trillion. Although the numbers are important, it is investors willingness to lend to government that counts after all.

August 2011

estimated 40.9 trillion yen of tax revenues and is 23.3% of the entire 2011 budget.

The Budget Japans Ministry of Finance forecasts the government will be spending 226 for every 100 in tax revenues, and in turn run a budget deficit of about 8.2% of GDP in FY2011. These figures were published prior to the devastating earthquake that has prompted the passage of two supplementary budgets totalling 6 trillion. The government has pledged to cut spending elsewhere instead of issuing new debt and as a result the budget deficit is projected to edge up only slightly to 8.4% of GDP mainly reflecting the weakened prospects for economic growth predicted at 0.4% for 2011.

The percentage of the budget spent on public works, education and defence has dropped consistently over the past decades and is at lower levels than other developed nations. These are areas that governments typically tackle when attempting to restraint budget deficits, but the task is made difficult when done from a low base. Social security has been rising steadily and this trend is set to continue due to Japans ageing population. The debt service has consistently risen, albeit stabilising somewhat over the past two decades as a result of a significant reduction in borrowing rates during the 90s, but this is now being countered by the sheer size of the deficit. The weighted average interest rate on outstanding Japanese debt fell by half from 2.7% in 2000 to 1.36% in 2009, yet debt servicing hardly dropped in nominal terms nor as a percentage of the budget.

Tn
120 100 80 60 40 20 1975 1981 1984 1987 1990 1993

Source: Ministry of Finance

Expenditure

De0icit
Tax Revenues

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Budget Breakdown
17.4 17.6 15.9 36.6 16.6 14.1 21.6 18.8 16 23 10 29.7 51.2 43.2

3.3

5.4 22.1 31.1 18.2

25.2 19.7 17.7

11.1

1999

2002

2005

1978

1996

2008

2011

Debt Management

24 23.3 18.8 20.7 12.7 3.5 1.5 1960 1970 1980 1990 2000 2011 n Public Works n Other (Education & Defense) n Social Security n Local Allocation Tax Grants n Debt Service Source: Ministry of Finance

From a historical standpoint, 2011 tax revenues are projected at two-thirds of their 1990 nominal value, whilst government expenditure is expected to be up one third on the same period. Comparison in nominal terms is made because the price level is practically unchanged since the early 90s.

Perhaps more alarmingly is the fact that Japans debt servicing cost is forecast at 21.5 trillion yen, which is more than half of the

The Japanese debt management office is aware of refunding risks. In recent times it has put more emphasis on issuing longer- term maturities and talks of catering to investors needs by maintaining dialogue. The average maturity for Japanese debt is 6.67 years. This is in line with most major economies other than the UK, which has an exceptionally lengthy average maturity of 13.8 years. The important point here is that

these other major economies have debt-to- GDP ratios that are roughly a third of Japans, meaning they are much less prone to refunding risks. Indeed, yearly debt issuance by the Japanese amounts to over 30% of GDP whereas the figure is lower than 15% in other major economies. This highlights the reliance of Japan on continued low interest rates.

% 8 7 6 5 4 3 2 1

10 Year JGB Yield

S&P Downgrades

Source: Ministry of Finance

The debt management office boasts about its CostatRisk analysis, which calculates the median interest payment cost and range of its distribution by simulating future interest rate fluctuations using the stochastic interest rate model. In its report it goes on to say, In a normal yield curve, yields rise as maturity lengthens. Therefore, based on this assumption, shortening the average maturity of issued JGBs will reduce interest payment costs. However, the probability to be exposed to interest rate risks increases since the frequency of refunding increases. In this way, the trade-off between cost and risk can be quantified by using the CaR analysis. The Japanese have clearly identified the risks but it is questionable if they are doing enough to counter them. It seems to me that they have opted for sophisticated mathematics and disregarded the notion of self-fulfilling prophecies that engulf our modern global markets.

1986 1991 1996 2001 2006 2011

Deflation

The ratings mean nothing On August 5th Standard & Poors, the rating agency, downgraded US sovereign debt from its coveted triple AAA rating. Beyond the scope of what the downgrade means for America, it certainly sends a clear signal to other developed nations that no one is immune from loosing their AAA. Japan on the other hand needs not worry since it has already lost its triple AAA more than a decade ago. In fact, Japans rating now stands three steps below the top rating. One has to wonder what implications such downgrades have on the wider economy, and on the governments ability to finance itself? Well, Japans debt carries the lowest yield in the world and is practically unchanged since the first downgrade. After all, it is investor perception that matters so much so that it could bring credible governments down or allow unsustainable ones to continue borrowing at attractive rates.

Although Japan is able to borrow at attractive nominal rates, the story is quite different in real terms. Ten year US treasuries are yielding just under 2.5% which is equivalent to roughly 0% in real terms (after accounting for inflation). In contrast Japan has lower nominal yields of 1.1% on its 10 year JGB, but as a result of the stubbornly low inflation (and sometimes deflation) the real rate is around 1%. A further drawback of deflation is that it keeps tax revenues subdued, reduces consumer spending and thus inflates the debt burden. Indeed some scholars argue the post WWII era debt was never really paid off but rather maintained at low rates coupled with inflation that eventually made its value trivial, and that really demonstrates why it is extremely undesirable to have deflation coupled with large debt burdens.

Politics & demographics

Following the mishandling of the Great East Japan earthquake and the nuclear crisis that ensued, Naoto Kan, Japans sixth prime minister in as many years pledged to step down in return for securing enough votes to defeat a motion of no confidence aimed at toppling his government. Most commentators agree that Japans politics is in paralysis with no clear vision or leadership on how to tackle the countrys key problems, namely the deficit. Japans population is set to decline in the coming decades and this is significant because it means debt-per-capita will naturally rise, making it more challenging to pay off the debt

 there is only so much tax you can extract from an individual. Life expectancy in Japan is one of the highest in the world at 83 years; this puts further strain on the government to support people long after they retire, and hence the consistent increases in social security costs. The Japanese are renowned for their savings, but could the ageing be accompanied by a shift towards more consumption and less saving as some predict? If this materialises the government might find less demand for its ever-growing debt load as pensions are consumed and households reduce their bank deposits and JGB holdings.

Breakdown of JGB holders

3.3 5.1 5.2

Banks BoJ Pension Funds

20

43.1

Public Pension Insurers

11.6 4.4 7.4

Households Other Foreigners

The ministry of finance relies much less on foreign investors compared with other nations as 95% of Japanese debt is held domestically. The Japanese people have a strong sense of collective purpose, something clearly demonstrated by the resilient reaction to the recent earthquake. This social cohesion could well play a role if the government finds itself in financial trouble.

December 2009

Source: Ministry of Finance

prevented stagnation turning into prolonged contraction. Taxation in Japan is at significantly lower levels relative to GDP than in other developed nations, meaning they have room to raise taxes. Sales tax for instance is at 5%, only matched by Canada in the OECD countries. Tackling this tax would be particularly appropriate, as it would broadly share the burden instead of penalising the working population. Japan is an export reliant nation, and the consistent current account surpluses have certainly played a role in enabling the country to sustain the massive debt burden so far. It allows Japan to fund itself internally. Investors are aware of this and pile into the yen when there is global uncertainty, but the very strength of the yen could be crippling the Japanese economy and promoting deflation. The current account balance as a percentage of GDP has eased in recent years, and this could be further exacerbated if the shift from saving to consumption materialises. Japan sits on over one trillion US dollars of foreign currency reserves only second to China. This can act as a potent weapon in defending the currency in case of a full-blown sovereign debt crisis, but the government is unlikely to resort to it unless there is a very substantial weakness in the yen. The very existence of the large reserves is causing investors to perceive japan as a safe refuge.

Conclusion

The economy

Unemployment in Japan stands at 4.6% - exactly half the US rate. This is impressive given the current global climate, but the fact that Japan is running large deficits with such low unemployment indicates that the problems are more structural rather than cyclical. Japans infamous lost decade is in reality two decades of economic stagnation but the government is wary of this and is reluctant to increase taxes as to not subdue economic growth. So far this strategy has only increased the debt without a marked impact on economic growth, but perhaps it has

Soft tax revenues and low borrowing rates usually accompany economic stagnation, whereas elevated tax revenues and high borrowing rates are characteristic of economic growth - the dilemma is obvious with regards to a nations solvency. There is point at which the debt load of a sovereign becomes so large that it will only keep growing regardless of the economic situation, eventually leading to default. Some will argue Japan has reached that point, whilst others will argue the contrary. Time will tell. Disclosure: The views expressed are personal and do not constitute investment advice. Amr El Sherif aeelsherif@hotmail.com +447748917523