The Jubilee

  • A Krainer
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  • March 2010
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Japan: a harbinger of (bad) things to come?

Posted by Alex Krainer on March 18, 2010

Large and gathering imbalances brewing in the Japanese economy threaten to generate a tsunami-like fallout that could soak most of the global economy. This might give rise to the next crisis of unforeseeable proportions.

False sense of security

The Japanese experience has provided comfort to western policy-makers, supposedly proving that governments can spend and borrow for as long as they like. Japan has run deficits for years and has seen its debt burden explode, yet it has also seen its long-term borrowing costs decline. But these benign conditions are likely to come to a head.

In the past, the Japanese government could rely on a captive domestic market in which to place its debt. A large pool of savers, made cautious by prior painful experience with risky assets has been happy to own as much risk free government debt as possible.

Japan’s demographic and government funding shortfall

But Japan’s savers are now retiring. Retirees run down their assets. After nearly a decade of rising demand for Japanese Government Bonds (JGBs), eroding household wealth in Japan has stalled demand for JGBs. This has contributed to a sharp rise in the ratio of government revenues generated from bond issuance to that generated by tax collection, from about 50% in 2007 to 90% in 2009. The Japanese Ministry of Finance projects that this ratio will rise to above 100% in 2011. In other words, tax revenue will be less important than borrowing as a source of funding.

With the government deficit running at over 40% of expenditure and Japan’s savers buying less government debt, who will finance Japan’s deficit in the future? The JGB yield of 1.5% would need to triple before it could attract international bond investors.

The risk of global fallout

Japan’s policymakers could be forced to sell assets, including US Treasuries currently worth $750 billion. As the world’s second largest holder of US sovereign debt, Japan’s actions could precipitate heavy consequences for the global economy, particularly in the US. Incidentally, I wonder if these conditions are behind last summer’s bizarre incident of US T-Bond smuggling at the Italian/Swiss border crossing at Chiasso, Italy.
Global economy is already in a precarious state; the ratio of total net liabilities to GDP for developed countries is at 400%. Greece is at 875%. Such levels of insolvency can only end in one way: hyperinflation.

No time for complacency

Japan’s experience has fueled the complacency of western nations regarding current deficit spending. The hope is that this can go on indefinitely. However, the history of financial crises suggests otherwise. Another crisis is imminent, and the ensuing fallout could have staggering proportions.

Fittingly, Grice and Edwards point out that human conduct is shaped by perception of risk, not any quantitative assessment of it, citing an academic study of the perception of lava-risk among Hawaiians. Appreciation of lava flow hazards was found to be “proportional to the time lapsed since the most recent eruption,” rather than on any objective estimate of risk.

Lack of concern about inflation today could cost investors dearly: historical evidence analyzed by Stanley Fischer indicates that episodes of high inflation (25% or more) in market oriented economies since 1960 have on average more than halved investors’ wealth.

The opportunity

Conditions brewing in Japan (or in Greece, Italy, Spain, Portugal, Britain, or the USA…) are likely to lead to events and trends of considerable proportions. As Sun Tzu’s timeless wisdom suggests, conditions, events and trends represent the three large avenues of opportunity. It will be crucial for investors to be on the right side of the coming changes. These are times for focused attention and bold action.


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