Tuesday, January 29, 2013

Europe’s Debt Crisis Endgames—Stealth Solutions...

Author: Satyajit Das

In his novella Chronicle of a Death Foretold (Crónica de Una Muerte Anunciada in the original Spanish), Gabriel Garcia Marquez commences at the end of the story gradually revealing the events leading up to a murder. The non-linear telling creates an unusual tension. With the conclusion known, only the precise steps leading to the tragedy remain unclear.
The probable endgame of Europe’s debt crisis is already known – de facto mutualisation of European debt and greater integration. But the precise events leading up to it are unknown. The story is being told backward.
European Problems ….
Europe’s problems are well documented. Many European nations have high and, in some cases, unsustainable levels of debt, compounded by a cluster of maturities and ratings pressures.
Public finances are weak. European bank have either significant exposures to the weak property sector or sovereign debt. Euro-Zone bank claims on the public sector range from 13% to 38%.
Sluggish even before the crisis, Europe’s growth rates are too low to sustain current debt levels. Many European countries have uncompetitive cost structures in global terms.
Following revelations of Greece’s problems in 2009, investor scrutiny of Europe’s position has increased. A number of nations have lost access to commercial sources of finance. Their cost of borrowing has increased to uneconomic levels.
Greece, Ireland and Portugal have required bailouts. Spain is to receive financing to support its banking system. The European Central Bank (“ECB”) has been forced to finance nations and banks, to avoid the risk of defaults.
The crisis has exposed Europe’s social compact based on government spending and welfare services that is unsustainable at current rates of growth and taxes. It has highlighted the inflexibility of single interest rate and common currency which limits policy options. It has revealed the complex inter-relationships which allow the rapid transmission of financial pressures. It has exposed the absence of institutional arrangements to deal with a crisis, because the entire framework assumed that it could not occur.
European Solutions…
The required policy responses have remained largely unchanged since the commencement of the crisis – reduction of debt, temporary financing for entities that have lost market access and recapitalisation of affected banks. Almost two years into the crisis, European policymakers have begun to address each of these areas.
Reduction of debt can be achieved by austerity (directing revenues to the repayment of debt) or debt restructuring (voluntary write offs or default). Austerity measures are enshrined in the Fiscal Stability and Growth Pact which requires Euro-Zone members to reduce budget deficits to less than 3% in any one year and a debt to Gross Domestic Product (“GDP”) ratio no larger than 60%.
The European Union (“EU”) has undertaken a debt restructuring for Greece, euphemistically known as PSI (Private Sector Involvement), writing off Euro 100 billion of debt.
In November 2012, the EU was reluctant to allow further write downs to provide additional debt relief to Greece. With 60-70% of Greek debt now held by official agencies (governments, the ECB, European bailout funds and the International Monetary Fund (“IMF”)), recognition of losses was politically difficult. Instead, a debt buyback (that handed hedge funds a large profit) and lower coupons and longer maturities on existing debt was used to reduce debt.
The fiction of zero coupon perpetual Greek debt allowed Chancellor Angela Merkel to honour her promise that Germans would not suffer any losses from the bailout. There is resistance to similar debt relief for other countries, as Greece is different.
The EU, ECB and IMF have collaborated to provide liquidity support and lower borrowing rates for weaker countries.
Facilities include the bailout funds – the EFSF (European Financial Stability facility) which is to be replaced by the ESM (European Stability Mechanism). The ECB has the ELA (Emergency Liquidity Arrangement), LTRO (Long Term Refinancing Operations), the SMP (Securities Market Program) and its new OMT (Outright Monetary Transactions) facility. The EU has agreed the concept of a banking “union”.
European bureaucrats seem afflicted by acronomania – the belief that a suitable sequence of letters can solve any problem. Unfortunately, the response is inadequate.
Austerity debt is self-defeating. Cuts in spending and increases in taxes lead to contracting economic activity, increasing the budget deficit and debt. Additional austerity merely exacerbates a vicious negative feedback loop as the economy becomes mired in a deep recession with rising unemployment.
Writing off the debt results in large losses to banks and investors. This requires government support to maintain the integrity of the payment and financial system, increasing budget deficits and debt.
Debt relief is complicated by the fact that the claims are cross border. A large proportion of peripheral sovereign debt is held by banks and investors in Germany, France, Netherlands, Finland and Luxembourg. These nations are resisting write-offs, fearing destabilising their financial systems.
The policies also fail to address growth and improving competitiveness. Without the option of currency devaluation, affected countries must force down costs, which exacerbates the reduction in activity.
Not Enough…
The EU Commission 2012 State Aid Scoreboard calculated that between October 2008 and December 2011, all 27 EU states provided banks alone with Euro 1.6 trillion in assistance (around 13% of EU GDP) for liquidity support, capital and removing impaired assets from balance sheets. Since 2011, further assistance has been provided to banks. There was additional assistance provided by the ECB and IMF to banks and nations. If these are included, then the total amount of assistance to date approaches Euro 3.5 trillion (30% of EU GDP), around Euro 7,000 for every EU citizen.
But the financial resources remaining to deal with the crisis may be insufficient. The amounts available have not changed for almost two years, with little appetite for increasing commitments.
The ESM has total lending capacity of around Euro 500 billion. Financial assistance agreed for Greece, Ireland and Portugal in the form of loans and guarantees is around Euro 294 billion. With around Euro 102 billion coming from the EU budget or bilateral aid to Greece, Euro 192 billion was provided by the EFSF, which will be subsumed into the ESM. Euro 100 billion has been committed to Spain for the recapitalisation of its banking sector. This leaves the ESM with available lending capacity of around Euro 208 billion.
There are increasing constraints on IMF participation, augmenting the ESM.
Greece, Ireland or Portugal may need further assistance, as their economies remain weak and market funding is unavailable or expensive, they may need additional funding to meet maturing debt and also finance budget deficits.
Spain and Italy may need assistance programs. Spain has debt of Euro 800 billion (74% of GDP). Italy has debt of Euro 1.9 trillion (121% of GDP). Both countries have significant debt maturities in the near future. Spain has principal and interest repayment obligations of Euro 160 billion in 2013 and Euro 120 billion in 2014. The Spanish government has announced a financing program of around Euro 260 billion for 2013. Italy has principal and interest repayment obligations of Euro 350 billion in 2013 and Euro 220 billion in 2014.
Capital flight from peripheral European countries is a problem. Banks in peripheral countries have lost between 10% and 20% of their deposits, reflecting concern about solvency and the risk of currency redenomination. Additional resources may be needed to finance a deposit insurance scheme to halt capital flight.
Europe has total bank deposits of around Euro 8 trillion, including around Euro 6 trillion in retail deposits. Around Euro 1.5-2 trillion of these deposits are in banks in peripheral countries. An effective deposit scheme would need to cover around Euro 1-1.5 trillion of deposits, placing a large claim on available funds.
Europe may need bailout facilities of at least Euro 3 trillion to be credible. Potential requirements exceed available resources.
Europe’s Big Bazooka…
The only other potential source of financial support is the ECB. It has already provided over Euro 1 trillion in term financing to banks through the LTRO program alone. These programs mature in late 2014 and early 2015. They may need to be increased or extended to finance the weak banking system.
The ECB has purchased around Euro 210 billion in sovereign bonds under the SMP. In July 2012, the ECB announced the OMT program allowing purchase of unlimited quantities of sovereign bonds. President Mario Draghi announced that: “within our mandate, the ECB is ready to do whatever it takes to preserve the Euro”. Markets and investors have assumed that this is the “big bazooka” -an European version of quantitative easing (“QE”) and debt monetisation precedents of the US, Japan and UK. The ECB’s announcement underpinned relative stability in Europe in the second half of 2012.
But the OMT program is conditional. ECB action is contingent on the relevant government formally requesting assistance and agreeing to comply with the conditions applicable to assistance from the ESM/ EFSF. Instead of avoiding market pressures, the triggering mechanism requires that financing problems of “at-risk” countries get worse before the ECB will act.
ECB purchases will be confined to short or intermediate maturities. This condition is designed to make intervention similar to traditional monetary policy. It is also designed to reduce the cost of bank loans which is driven by shorter-term interest rates.
The ECB can also nominate a cap on yield or the size of its purchases in advance of any intervention. There is uncertainty as to whether the ECB will relinquish its status as a preferred creditor on such purchases in the event of default or restructuring.
The OMT program revealed significant divisions within the ECB. Jens Weidmann, the head of the German Bundesbank and a former advisor to the Chancellor, opposed the measure. Other Euro-Zone members are also known to be uncomfortable.
The legal basis of the OMT program remains uncertain. Article 123 of the Lisbon Treaty prohibits the ECB from directly buying national governments’ debt. Future legal challenges cannot be ruled out. Overcoming legal issues would require time consuming treaty changes, support for which is not assured.
The OMT has not been activated to date. In 2008, US Treasury Secretary Hank Paulson’s argued that if everyone knows that you have a bazooka in your pocket it may not be unnecessary to use it. The ECB has gambled that the announcement that it is prepared to intervene will restore market access of peripheral borrowers and reduce the interest rate demanded by the market. The borrowing cost of weaker countries remains above sustainable levels. The true access to market remains unclear because of the activity of banks purchasing sovereign debt which can be financed with the ECB at a profit.
The ECB President’s statements have been dominated by two words: “may” and “adequate”. Market analyst Carl Weinberg neatly summarised this as: “A promise to do something unspecified at some yet-to-be-determined time involving yet-to-be-invented programs and institutions, in a yet-to-be-decided way”.
Dr. Draghi, anointed as the Financial Times’ 2013 Person of the Year, operatically stated that the OMT program would: “And believe me, it will be enough”. Markets will undoubtedly test the ECB’s resolve. As Yogi Berra knew: “In theory there is no difference between theory and practice. In practice there is.”
Stealth Integration…
The scale of the problems, the inadequacy of financial resources available and political difficulties means that decisive actions to resolve the European debt crisis are unlikely. A slide into a deeper economic malaise, both for at risk countries but also stronger Euro-Zone members, is the most likely course of events.
The real economy, already in recession, is likely to remain weak, with low growth and high and rising unemployment. The key influences will be austerity programs and weak global environment, including slowdowns in emerging economies. Other factors will be the continued restriction of credit as European banks restructure and shed assets.
The low levels of economic activity will be particularly pronounced in the peripheral economies. The weakness will be transmitted to stronger economies, through weaker exports. Given that their largest markets are within Europe and in recession, Germany and France will also experience slowdowns. Increased financial strains from the need to support the weaker countries will also contribute to the contraction.
Governments in the at-risk economies will not meet budget deficit or debt level targets. Banks will face rising bad debt losses and require capital infusions. For both sovereigns and banks, access to financial markets will remain restricted. Cost of commercial funding will remain above affordable levels. Further funding assistance may be required.
Euro-Zone members remain committed to avoiding the unknown risks of a default and departure of countries from the Euro. This means that assistance will be forthcoming, although the exact form and attached conditions remains uncertain.
Peripheral countries will be forced to rely on the ESM and ECB to provide funding. Unless the size of the ESM is increased, the ECB will be forced to provide financing directly and indirectly. In the indirect case, the ECB will provide cheap funds to banks to purchase government bonds which will be used as collateral for the central bank financing.
The TARGET2 (“Trans-European Automated Real-time Gross Settlement Express Transfer System”) is a payment system to settle cross border funds flows between Euro-Zone countries. Before 2008, deficits of individual nations were financed by banks and investors. Since the commencement of the crisis, the absence of commercial financing has meant that central banks in stronger countries have used the TARGET2 to finance peripheral countries without access to money markets to fund trade deficits and capital flight. This process will continue.
Over time, financing will become concentrated in official Euro-Zone agencies, the ECB and the TARGET2 system. Risk will shift from the peripheral countries to the core of the Euro-Zone, especially Germany and France. This reflects the reality that the stronger countries stand behind each of the support mechanisms.
The ESM relies primarily on the support of four countries: Germany (27.1%), France (20.4%), Italy (17.9%) and Spain (11.9%). Market analyst Grant Williams prosaically described the other countries backing the ESM as Greece, irrelevant, doesn’t matter, don’t bother, makes no difference, who cares, somewhere near Poland, pointless, up the top, former something-or-the-other, tax shelter, pretty much a non-country and somewhere with mountains. If Spain or Italy needs assistance, then the contingent commitment of the remaining countries, especially France and Germany, would increase. A similar process operates in respect of the ECB.
Germany is by far the largest creditor in TARGET2. The Netherlands, Finland and Luxembourg are the other creditors with all other Euro-Zone countries being net debtors within the system. The Bundesbank has current exposure of over Euro 750 billion to other central banks in the Euro-Zone.
The TARGET2 net claims are not a true measure of the risk of the Bundesbank. The net balance would only be lost in the case of a breakup of the Euro-Zone and if sovereign central banks refuse to honour their debts. This risk is difficult to quantify. But there is a clear transfer of financing risk to the stronger core countries. This ultimately weakens their financial position materially.
Germany provides an indication of the magnitude of the task. German guarantees supporting the EFSF are Euro 211 billion. The ESM will require a capital contribution from Germany. If the ESM lends its full commitment of Euro 500 billion and the recipients default, Germany’s liability could be as high as Euro 280 billion. There is also the indirect exposure via the ECB and the TARGET2 claims.
The size of these exposures is large, both in relation to Germany’s GDP of around Euro 2.5 trillion and German private household assets which are estimated at Euro 4.7 trillion. Germany also has substantial levels of its own debt (around 81% of GDP). The increase in commitments or debt levels will absorb German savings, crippling the economy. Germany demographics, with an aging population, compound its problems.
Over time, the transfer of risk will mean de facto debt mutualisation and financial transfers by stealth. This is precisely the outcome that Germany and its allies have sought to avoid.
World of Pain…
De facto integration may help make European debt problems more manageable.
As a single unit, the Euro-Zone’s current account is nearly balanced, its trade account has a small surplus, the overall fiscal deficit is modest and the aggregate level of public debt while high is more manageable. Around 75% of its trade is within member nations, aided by removal of trade barriers and the common currency. Germany, the EU’s largest economy and one of the world’s largest exporters, sells over 60% of its products within the common market, much of it to other Euro-Zone members.
But significant disparities between individual Euro-Zone members of income levels, public finances, external balances and debt levels will necessitate a net wealth transfer from richer nations to weaker members. Stronger more creditworthy members will also have to underwrite the borrowings of weaker nations. Despite opposition to such joint and several liabilities from net lenders such as Germany, Finland and Netherlands, this process is now the most likely outcome.
Stealth integration will have substantial costs. For the peripheral nations, financing assistance will be available, albeit in doses which will keep the recipient barely alive and prolong its suffering. It will require adherence to strict austerity policies, which may mire the economies in recession.
Living standards will be reduced by internal devaluation. In the period since the introduction of the Euro, German unit-labour costs rose by 7-8%, compared to 30% in Italy, 35% in Spain and 42% in Greece. These rises have to be reversed to increase competitiveness. Employment conditions, pension benefits and social benefits provided by the state will become less generous. Taxes will rise, reducing after tax income.
In the stronger nations, savers will see the value of their savings fall. They too will suffer losses of social amenities as income and savings are directed to support weaker Euro-Zone members. As integration becomes a reality, ordinary Germans will discover the reality of an old proverb: “if you stay the beast will eat you, if you run the beast will catch you”.
Europe will find itself locked in a period of subdued economic activity and high unemployment. The core Euro-Zone countries, especially Germany and France, are increasingly affected by the problems of the rest of Europe. In early 2013, Joerg Asmussen, a German ECB board member, was quoted as predicting Germany could become the “Sick Man of Europe” if the problems continued.
The dry economic language masks a world of human pain as life will turn into a grim struggle for survival. Unemployment rates, which in some countries approach 30% and 50% for people under 25 years, will feed increasing instability. Social unrest and conflict is likely. Militant opposition to austerity and declines in living standards will increase.
Major political parties in many countries now poll less than 50% of the total vote, requiring unstable coalitions which make decision making difficult. As Jean-Claude Juncker, the Luxembourg Prime Minister noted: “We all know what to do, we just don’t know how to get re-elected after we have done it.”
The political environment favours political parties which favour more radical actions, such as abandonment of the Euro or default on outstanding debts. Opposition to immigration and cultural minorities, often taking the form of violent action, is growing. It is these realities rather than the economics that may determine the future of Europe.
European political leaders are increasingly optimistic in their language- the Euro-Zone crisis is “behind us”; the problems are “resolved”. Only German Chancellor Angela Merkel has sounded cautious, arguing that the crisis is likely to continue for many years. It may be tactic acknowledgement of the cost of the crisis to Germany. It may also a strategy to prepare Germans for the harsh reality of the likely endgame.
While de facto integration is the likely outcome, a smooth transition is not guaranteed. Outflows of actual cash to beleaguered nations, the first claims on the German budget, significant rating downgrades for core Euro-Zone members or a rise in inflation and consumer prices may alter the dynamic quickly. If voters in Germany and other stronger states become aware of the reality of debt pooling and institutionalised structural wealth transfers, then the outcome might be different. Continued deterioration in economic activity requiring further bailouts as well as unsustainable unemployment and social breakdown may still trigger repudiation of debts, defaults or a breakdown of the Euro and the Euro-Zone.

Tuesday, January 22, 2013

The Setting Sun – Japan’s Forgotten Debt Problems...

Author: Satyajit Das

In 1979, the publication of Harvard sociologist Ezra Vogel’s international best-selling book Japan as Number 1signalled the nation’s arrival as an economic power. Today, Japan’s industrial and economic decline is palpable.
But in 2012, Japan’s Nikkei 225 stock average rose by around 23%. Much of the increase reflects faith in the reflation strategy of second time Prime Minster Shinzo Abe to increase growth through an additional US$120 billion of public spending, create inflation to reduce the debt to GDP ratio and devalue the Yen. The strategies, which have all been tried before with limited success, may not restore the health of the Japanese economy.
Dark Statistics…
In the post war period, Japan enjoyed decades of strong economic growth – around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between1971 and 1990. Since the collapse of the Japanese debt bubble in 1989/ 1990, Japanese growth has been sluggish, averaging around 0.8% per annum. Nominal gross domestic product (“GDP”) has been largely stagnant since 1992. Japan’s economy operates far below capacity, with the output gap (the difference between actual and potential GDP) being around 5- 7%.
The Japanese stock market is around 70-80% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It now trades around 8,000-12,000. Japanese real estate prices are at the same levels as 1981. Short term interest rates are around zero, under the Bank of Japan’s (“BoJ”) Zero Interest Rate (“ZIRP”) policy which has been in place for over a decade. 10 year Japanese government bonds yield around 1.00% per annum.
Since 1990, public finances have deteriorated significantly. Government spending to stimulate economic activity has outstripped tax revenues, resulting in a sharp increase in Japanese government gross debt to around 240% of GDP. Net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 135%. The US government has gross and net debt of 107% and 84%. Total gross debt (government, non-financial corporation and consumer) is over 450% of GDP, compared to around 280% for the US.
Japan’s demographics parallel its economic decline. Japan’s population is forecast to decline from its current level of 128 million to around 90 million by 2050 and 47 million by 2100. A frequently repeated joke states that in 600 hundred years based on the present rate of decline there will be 480 Japanese left.
The proportion of Japan’s population above 65 years will rise from 12% of the total population to around 23%. Japan’s work force is expected to fall from 70% currently by around 15% over the next 20 years. For every two retirees there will be around three working people, down from six in 1990.
According to one forecast by 2050, Japan will have a median age of 52, the oldest society ever known. Currently sales of adult diapers now exceed those intended for babies.
Japan’s problems have been compounded by two major natural disasters – the 1994 Kobe earthquake and the 2011 Tohoku earthquake and tsunami.
In the face of the nation’s long term decline, Japanese politics has become increasingly fractious. Frequent changes of leadership, often driven by arcane internal factional politics, have created an unstable environment and a lack of policy continuity. Japan has had seven prime ministers in six years and six finance ministers in three years. Former Brazilian President Luiz Inácio Lula da Silva once joked that in Japan you say good morning to one prime minister and good afternoon to another.
Origins of the Crisis…
Japan’s post war economic success, like that in Germany, was based on an export driven economic model, using low costs and manufacturing competence. An under-valued Yen provided Japanese exporters with a competitive advantage.
The Plaza Accord signed on 22 September 1985 called for France, West Germany, Japan, the United States, and the United Kingdom to devalue the dollar in relation to the Japanese Yen and German Deutsche Mark by intervening in currency markets. Between 1985 and 1987, the Yen increased in value by 51% against the dollar.
Japan moved from an era of En’yasu, an inexpensive Yen, to a period of Endaka or Endaka Fukyo, an expensive Yen. The higher Yen adversely affected Japanese exporters. Japanese economic growth fell sharply, from 4.4% in 1985 to 2.9% in 1986.
Desperate to restore growth and offset the stronger Yen, the Japanese authorities eased monetary policy with the BoJ cutting interest rates from 5% to 2.5% between January 1986 and February 1987. The lower rates led to a rapid increase in debt funded investment, driving real estate and stock prices higher. At the peak of the “bubble” economy, the 3.41 square kilometre (1.32 square miles) area of the Tokyo Imperial Palace had a theoretical value greater than all the real estate in the state of California.
Seeking to reverse the unsustainable asset price inflation, the authorities increased interest rates to 6% between 1989 and 1990 triggering the collapse of the boom. As Japan’s economic problems worsened rapidly, the government responded with large fiscal stimulus programs. The BoJ cut interest rates to zero. But the policy measures failed to revive the economy, which slid into deflation.
There was a parallel deterioration in public finances. At the time of collapse of the bubble economy, Japan’s budget was in surplus and government gross debt was around 20% of GDP. As the Japanese economy stagnated, weak tax revenues and higher government spending to resuscitate growth created substantial budget deficits.
Japan’s total tax revenue is currently at a 24 year low. Corporate tax receipts have fallen to 50 year lows. Japan now spends more than 200 Yen for every 100 Yen of tax revenue received.
The period of Japanese economic decline was known as the Lost Decade or Ushinawareta Jūnen. As the economy failed to recovery and the problems extended beyond 2000, it has come to be referred to as the Lost Two Decades or the Lost 20 Years (Ushinawareta Nijūnen).
Japanese Airbags…
Japan’s large pool of savings, low interest rates and a large current account surplus has allowed the build-up of government debt.
Japan has a large pool of savings, estimated at around US$19 trillion, built up through legendary frugality and thrift during the nation’s rise to prosperity after World War II. High savings rates also reflected the country’s young age structure especially until the 1980s, the low level of public pension benefits, the growth of income levels through to the late 1980s, the bonus system of compensation, the lack of availability of consumer credit and incentives for saving.
In recent years, household savings were complemented by strong corporate savings, around 8% of GDP. This reflects slow growth, excess capacity, lack of investment opportunities and caution driven by economic uncertainty.
Much of these savings are invested domestically. A significant amount of the savings is held as bank deposits, including large amounts with the Japanese Postal System. In the absence of demand for credit from borrowers, the banks hold large quantities of government bonds to match the deposits, helping finance the government. Japanese banks hold around 65-75% of all Japanese government bonds (“JGBs”) with the Japanese Postal System being the largest holder. Around 90% of all JGBs are held domestically.
The high levels of debt are sustainable because of low interest rates, driven by the BoJ’s ZIRP and successive rounds of JGB bond purchases as part of quantitative easing (“QE”) programs since 2001. The BoJ balance sheet is now around US$2 trillion an increase from around 10% of Japan’s GDP to 30% since the mid-1990s. BoJ holdings of JGBs are around US$1.2 trillion, around 11% of the total outstanding.
Low interest rates perversely have not discouraged investment in bank deposits or government bonds. This reflects the poor performance of other investments, such as equity and property, during this period. The strong Yen has increased the risk of foreign investments.
Although nominal returns are low, Japanese investors have received high real rates of return, because of falling prices or deflation.
Over the last 50 years, Japan has also run large current account surpluses, other than in 1973–1975 and 1979–1980 when high oil prices led to large falls in the trade balances. The current account surplus has resulted in Japan accumulating foreign assets of around US$4 trillion or a net foreign investment position of approximately 50 % of GDP. This helped Japan avoid the need to finance its budget deficit overseas and also boosted domestic resources, increasing demand for JGBs.
Since the global financial crisis and more recent European debt crisis, Japan has been viewed as a “safe haven”. Investors have purchased Yen and JGBs, pushing rates to their lowest levels in almost a decade and increasing foreign ownership of JGBs to around 9%, the highest level since 1979, the first year for which comparable data is available. These factors have assisted Japan to finance its budget deficit.
Airbags designed to protect occupants of a car from injury in a crash only work once. Similarly, the factors which allowed Japan to increase its government debt levels are unlikely to continue.
Change in the Weather…
Following the collapse of the bubble, policymakers implemented a variety of economic stimulus programs.
Japan’s budget surplus of 2.4% in 1991 has become a chronic budget deficit, increasing from 2.5% in 1993 to about 8% by the end of the 1990s. It has remained high during the 2000s. The BoJ has tried unsuccessfully to increase inflation to reduce debt. Japanese inflation has averaged minus 0.2% in the 2000s, a decline from levels of 2.5% in the 1980s and 1.2% in the 1990s. The policies have failed to restore economic growth, trapping Japan in a period of economic stagnation.
Nomura economist Richard Koo argues that Japan is experiencing a “balance sheet recession”, triggered by the collapse of financial asset prices. Financially insolvent firms are reducing debt – deleveraging- despite low interest rates. This is evidenced by a sharp fall in investment (currently around 22% of GDP, down from 32% in 1990) and corporations becoming net savers from net borrowers.
Private consumption is weak, falling to about 57% of GDP, further reducing domestic demand. This reflects weak employment, lack of growth in income and the aging population. Strong exports and a current account surplus have partially offset the lack of domestic demand, as firms focused on overseas markets.
With investment and consumption weak, large budget deficits have supported economic activity, avoiding an even larger downturn in economic activity.
In a balance sheet recession, monetary policy is ineffective with limited demand for credit. GDP tends to decline by the amount of debt repayment and un-borrowed individual savings. Government stimulus spending is the primary driver of growth.
Given the strategies have been tried unsuccessfully before, the Prime Minster Shinzo’s policies have a desperate quality. Although the measures will provide a short term lift in economic activity, it is unlikely to create a sustainable recovery. They will increase the budget deficit and government debt levels.
Continued economic weakness, a decline in savings rates and a reversal of the current account surplus make the Japanese government debt burden increasingly unsustainable.
Getting Poorer at Home…
The Japanese government’s ability to finance spending is increasingly constrained by falling Japanese household savings rates, which have declined from between 15% and 25% in the 1980s and 1990s to under 3%, a level below the US until recently. This decline reflects decreasing income and the aging population.
At around 5%, Japan’s unemployment rates are low relative to international peers but higher than the 2-3% levels that existed prior to 1991. The official rate understates real unemployment because of government employment adjustment subsidies and structural change in the Japanese labour to lower costs to offset the impact of a higher Yen and global competition.
Wage have fallen with average annual salaries including bonuses falling every year since 1999 and decreasing by around 12% in total. Between 1994 and 2007, labour costs as a percentage of manufacturing output declined from73% to 49%. Japanese worker’s share of GDP fell to 65% in 2007, from a peak of 73% in 1999.
In a change from the tradition of lifetime employment, 34% of the labour force (around) 20 million workers are employed in part-time or contract roles, an increase from 20% in 1990. These workers do not have job security, training or benefits associated with full time work.
In 2009, previously unreleased government statistics revealed that 15.7% of Japanese, including 14% of children and 21% of the elderly, live below the poverty line.
The aging population further reduces the savings rate. Household surveys indicate that around a quarter of households with two people or more have no employment. In aggregate, the amount of money being paid to retirees from savings exceeds the amount of new money that is going into savings funds. This is compounded by low returns on investments which accelerates the rundown of savings.
Getting Poorer Abroad…
Japan’s current account surplus has also allowed the government to run large budget deficits which can be funded domestically. Since 2007, the Japanese trade account surplus has fallen sharply, turning into a deficit in 2012.
The secular factors driving the fall include an appreciating Yen and slower global growth, which has reduced demand for Japanese products, such as cars and consumer electronics. In late 2012, territorial disputes with China exacerbated the decline in exports. It also reflects the impact of the Tohoku earthquake and tsunami as well as the subsequent decision to shut down Japanese nuclear power generators, which increased energy imports, especially Liquid Natural Gas.
Deep seated structural factors also underlie changes in the trade account. Since the 1980s, rising costs and the higher Yen have driven Japanese firms to relocate some production facilities overseas, taking advantage of lower labour costs and circumventing trade barriers. More advanced, technologically complex and high value manufacturing was kept in Japan. But post 2007 Japanese firms have increasingly been forced to close these domestic production facilities as they have become uncompetitive.
The combination of falling exports, lower saving rates, declining corporate earnings and cash surpluses is likely to move the Japanese current account into deficit. In turn, this will force Japan to become a net importer of capital to finance government spending, altering the dynamics of its finances.
The Way It Ends…
If Japan continues to run large budget deficits, as is likely, then the falling saving rate and reversal in its current account will make it more difficult for the government to borrow, at least at current low rates.
Ignoring foreign borrowing and debt monetisation by the central bank, the stock of private sector savings limits the amount of government debt. In the case of Japan, this equates to around 250-300% of GDP. Japan’s gross government debt will reach this level around 2015, although net government debt will not reach this limit until after 2020.
Even before Japan’s government debt exceed household’s financial assets, the declining savings rate and increasing drawing on savings by aging households will reduce inflows into JGBs making domestic funding of the deficit more difficult.
Insurance companies and pension funds are increasingly selling their holdings or reducing purchases to fund the increase in payouts to people eligible for retirement benefits. Institutional investors and to a lesser extent retail investors are also increasingly investing in other assets, including foreign securities, in an effort to increase returns and diversify their portfolios.
Forecast current account deficits will complicate the government’s financing task. Japan’s large merchandise trade surplus has shrunk and will remain under pressure reflecting weak export demand and high imported energy costs.
Japan’s large portfolio of foreign assets will cushion the effects for a time. Japan has accumulated large foreign assets totalling around US$4 trillion, making it the world’s biggest net international creditor. The BoJ is the largest investor in US Treasury bonds, with holdings of around US$1 trillion. But even if net income from foreign assets (interest payments, profits and dividends) stays constant, Japan’s overall current account may move into deficit as soon as 2015.
As the drawdown on financial assets to finance retirement accelerates, Japan will initially run down its overseas investments, losing its net foreign asset position. Unless public finances improve, Japan ultimately will be forced to finance its budget deficit by borrowing overseas.
Where the marginal buyers of JGBs are foreign investors rather than domestic Japanese investors, interest rates may increase, perhaps significantly. Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan’s interest payments will be an unsustainable proportion of tax receipts.
Higher interest rates will also trigger problems for Japanese banks, Japanese pension funds and insurance companies, which also have large holdings of JGBs.
JGBs total around 24% of all bank assets, which is expected to rise to 30% by 2017. An increase in JGB yields would result in immediate mark-to-market large losses on existing holdings, although higher returns would boost income longer term. BoJ estimates that a 1% rise in rates would cause losses of US$43 billion for major banks, equivalent to 10% of Tier 1 Capital for major banks or 20% for regional banks.
To avoid the identified chain of events, Japan must address the core problems. But reductions in the budget deficit are difficult. Spending on social security accounts and interest expense now totals a major part of government spending. Increasing health and aged care costs are expected by 2025 to be around 10-12% of GDP. An aging population and shrinking workforce will continue to drive slower growth and lower tax revenues. Tax increases are politically unpopular. Reductions in the budget deficit are likely to reduce already weak economic activity, compounding the problems.
Japanese policy makers have other options. Financial repression forcing investment in low interest JGBs is one alternative. The BoJ can maintain its zero rate policy and monetise debt to finance the government. Japan can try to inflate away their debt. But ultimately, Japan may have no option other than a domestic default to reduce its debt levels.
Older Japanese, especially retirees who are major holders of JGBs, would suffer large losses. Younger Japanese would benefit from the reduction in debt and reduced claims on future tax revenues. Such a drastic alternative, with its massive economic and social costs, is difficult to conceive other than as the last option.
Cassandra in Japan…
Investors and traders have repeatedly bet on a Japanese crisis, usually by short selling JGBs to benefit from higher rates. With low Japanese interest rates, the risk of the trade has always seemed limited while the potential profit large. But the bet has failed each time, giving the strategy its name – the widow maker.
Given its large domestic savings and also the ability of the BoJ to further monetise its debt, the status quo can be maintained for a little longer. But eventually Japan’s deteriorating public finances and declining ability to finance itself domestically will coincide with weakening ratings and large refinancing needs.
Japan’s deteriorating public finances and declining ability to finance itself domestically will coincide with weakening ratings and large refinancing needs.
Although no longer AAA since May 2009, Japan currently has a strong debt rating – AA3 (Moody’s Investor Services) from or AA minus (Standard & Poor’s). In 2012, Fitch downgraded the country’s credit rating to A plus from AA. Its rapidly deteriorating financial position will place continuing pressure on its rating, making fund raising more difficult and expensive especially outside Japan.
Japan has an average debt maturity of 6 years, shorter than Spain, Italy and France. Around 60% of its debt must be refinanced in the next 5 years. This will expose Japan to the discipline of market investors at a vulnerable moment.
Once the problems emerge, they will be difficult to contain. As Economist Rudiger Dornbush once observed: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought”.
This piece is cross-posted from Naked Capitalism with permission.