Last week, Daryl Jones and I took our team’s 100-page slide deck regarding the risks associated with Japanese sovereign debt on the road to meet with clients in Boston and New York. Per usual, the discussions were both lively and educational for both parties. Specifically, there were a number of thoughtful follow-up questions that we’ve researched further:
- Is there a historical tipping point for a sovereign interest expense burden as it relates to default and/or financial crises?
- How large of a risk to Japanese banks are their holdings of JGBs?
- What are the assumptions the government is making regarding Japan’s fiscal outlook? How do Japan’s fiscal metrics look under various economic scenarios?
- What’s the composition of Japan’s current account? Can the income balance sustain the current account surplus even in the absence of a reflating trade balance?
- What’s the risk that the ~95% never sells and how much damage could the ~5% do if they become a heavy seller?
- What sorts of labor market reforms could Japan undertake to boost economic output and lower the financial burden?
- What are the best ways to play your thesis?
- What’s the timing of the VAT hike discussions, given its importance as a catalyst for a ratings downgrade(s)?
Q: Is there a historical tipping point for a sovereign interest expense burden as it relates to default and/or financial crises?
In our search, we found a surprising lack of focus on interest payments in the academic study of sovereign debt crises. In fact, most studies focused primarily on the aggregate debt burden as well as inflation/deflation of consumer and asset prices amid dramatic currency fluctuations.
That said, however, we were able to find a keen study out of Global Financial Data that uses two centuries of data across twelve countries to determine which groups ultimately bear the cost of sovereign debt. Specifically regarding interest expense, the paper read:
“The interest coverage cost is more important to sparking a financial crisis than the debt/GDP ratio… if the interest coverage [i.e. interest expense/GDP] rises above 5%, this can spark a financial crisis if it appears the level will remain above that level and will continue to rise.”
Adopting this framework, we’ve used a combination of OECD and IMF data to plot sovereign interest coverage cost (per GFD’s definition) across time for a handful of key economies. On this metric, Japan is at a safe “2.6%” (data through 2009):
That said, however, Japan’s interest coverage cost appears to have bottomed out in this range – meaning that despite bombed-out nominal yields, Japan’s interest burden is poised to grow alongside the stock of sovereign debt for the foreseeable future. The following scenario analysis from the Peterson Institute agrees with our conclusion:
Q: How large of a risk to Japanese banks are their holdings of JGBs?
Japanese banks, which hold roughly 25% of their assets in JGBs and are the largest owners of Japanese sovereign debt, are very much at risk should Japan succumb to our Sovereign Debt Dichotomy thesis. In the slide deck, we’ve focused slides 59-61 on the risk of further sovereign downgrades as it relates to JGBs going from a 0% risk-weighted asset (RWA) to a 20% RWA at the single-A level; a roughly $70-80B capital hole would need to be filled across the banking system.
Looking at their vulnerability from an interest rate risk perspective, a recent BOJ statement claimed that if interest rates backed up +100bps across all maturities, Japanese banks would experience a ¥3.5 trillion (~$43B) loss on their balance sheets. Taking that a step further, a DEC ’11 IMF working paper suggested that the total value of interest rate risk on Japanese bank balance sheets in the aforementioned +100bps scenario corresponds to ~10% of major banks’ tier 1 capital and over 30% of regional banks’ tier one capital:
Lastly, from a duration perspective, the average maturity of major banks’ JGB holdings has declined from over 3yrs in the early-00’s to roughly 2.5yrs. Regional banks have seen the average maturity of their JGB holdings increase to nearly 4yrs from a trough of ~2.75yrs in FY07. As the chart below highlights, Japanese banks have sought to become increasingly exposed to duration risk amid ever-falling nominal interest rates; the central banker’s dare to chase yield is alive and well in Japan:
Q: What are the assumptions the government is making regarding Japan’s fiscal outlook? How do Japan’s fiscal metrics look under various economic scenarios?
Per the latest Economic and Fiscal Projections for Medium to Long Term Analysis report out of Japan’s Cabinet Office (AUG ’11), Japan targets mid-to-upper +1% nominal GDP growth on average from FY11 to FY20 in their baseline (“Prudent”) scenario. In their aggressive (“Growth Strategy”) scenario, nominal GDP is expected to average roughly +3% over that same duration.
Both of their growth scenarios appear aggressive to us, given Japan’s trailing 10yr average nominal GDP growth rate of -0.7%, which we use in one of our scenario analyses (along with the 10yr trends in real GDP growth and Japan’s GDP deflator). In the other, we “split-the-difference” between Japan’s trend-line economic statistics and those of the ultra-aggressive Cabinet Office’s “Growth Strategy” scenario. Lastly, in both our scenarios, we generously hold spending flat (relative to their projections), only subtracting out the lost revenues that would accompany lower nominal GDP.
Before we compare our scenario analyses with the Japan’s official outlook(s), below is a list of key assumptions the Cabinet Office makes regarding the long-term outlook for Japanese fiscal and regulatory policy:
- Assumes a steady state with regards to Japan’s energy situation (no restarting of the nuclear plants from an energy supply perspective; no new energy investment from a demand perspective);
- Assumes a similar expenditure pattern to the post-quake response to the Great Hanshin-Awaji Earthquake, extending temporary fiscal research measures for 5yrs in one scenario and 10yrs in the other (to be generous, we run our scenario analyses off their 5yr scenario); and
- Assumes the consumption tax rate (central and local) will be raised in stages to 10% by FY15 and assumes that +20bps of new expenditure will be added with every +100bps increase in the consumption tax rate.
The tables and charts below highlight the divergence between our view of where Japan’s fiscal metrics are headed over the next four years vs. Japan’s official baseline and aggressive outlooks. Even giving Japan the benefit of the doubt on growth (i.e. looking to our “Split-the-Difference” scenario), Japan’s debt/GDP and deficit/GDP metrics will be +930bps and +130bps higher, respectively, than the Cabinet Office’s “Prudent” growth scenario. Obviously, this spread widens when taking into account Japan’s historic economic performance and contrasting that scenario with the pollyannaish assumptions embedded in their “Growth Strategy” scenario.
Q: What’s the composition of Japan’s current account? Can the income balance sustain the current account surplus even in the absence of a reflating trade balance?
Over the years, as Japan’s persistent current account surpluses have relentlessly buoyed the country’s net foreign assets position. From a capital account perspective, the Japanese private sector has increasingly acquired offshore assets to supplement investment income, as well as to take advantage of cost savings by increasing production abroad. The latter phenomenon has been a boon to Japan’s income balance, as those earnings get repatriated over time.
In theory, as long as Japan maintains a current account surplus and net foreign assets continue to increase, the country’s income balance will remain in surplus. In light of this, you’d have to see a fairly dramatic trade deficit to north of ¥14-16 trillion to swing Japan’s current account into deficit territory (holding flat recent trends in the income balance). While a rising energy import bill that is predicated on a lower domestic production of nuclear energy going forward (currently, almost all reactors are idle) acts as a governor on Japan’s net exports, it is unlikely that Japan will experience a dramatic-enough loss of productivity and/or a measured-enough increase in consumption to post consistent, elevated trade deficits.
From a longer-term perspective, however, we borrow the following table from Japan’s Ministry of Finance Fiscal 1984 White Paper on Trade (courtesy of NLI Research) to highlight where Japan is in terms of its balance of payment cycle with respect to its stage of economic development. If Japan’s 2011 BOP data was any indication (could be an aberration given the Great East Japan Earthquake & Tsunami and generational levels of flooding in Thailand), the country is entering the 2nd stage of being a net creditor nation. If that is the case, we could be a generation or two away from Japan becoming a net debtor nation again, of course, following persistent current account deficits.
While 30 to 60 years is a long time horizon to make a call on sovereign debt risk, we turn our attention to risks associated with Japan’s current account over the next 3-5yrs. Japan, which has experienced a secular decline in domestic investment during its post-bubble era, may be unable to meaningfully kick-start economic growth that is commensurate with its ageing population absent a pickup in investment (investment leads future consumption growth).
That is a dangerous request, and puts Japan in a catch-22: increase investments relative to savings and erode the current account or maintain the current account surplus and idly watch as infrastructure and capital equipment deteriorate. To the latter point, Japanese corporations have dramatically neglected fixed investment over the past ten years, which suggests to us that such a cycle might be closer than one would tend to expect – especially if Japan is going to even sniff its Cabinet Office’s aggressive growth assumptions (see above).
All told, Japan’s current account surplus, while likely be structurally lower going forward amid structural headwinds to the trade deficit due to declining productivity and higher energy imports, is not really at risk of shifting into consistent deficits anytime soon. That said, however, the days of persistent 3-4% (of GDP) surpluses may indeed be over and a structural downshift to the 1-2% (of GDP) does seem likely.
Q: What’s the risk that the ~95% never sells and how much damage could the ~5% do if they become a heavy seller?
On paper, there is little incentive for the Japanese sovereign to ever pursue a default given that the vast majority of its debt burden is financed with domestic capital (93.7% to be exact). The is largely due to the secular deleveraging we’ve seen out of the Japanese private sector, given that their persistent financial surpluses have been more-or-less circulated throughout the banking system and ultimately parked in JGBs.
A chart of this relationship between Japan’s total private sector net financial position vs. the central government’s net financial position highlights this inverse relationship perfectly. To the extent that Japanese households and private nonfinancial corporates continue to build cash on the margin, faster or in-line with the pace of sovereign debt growth, it can be reasonably argued that there won’t be internal pressure on JGB prices from a supply/demand perspective (absent specific catalysts like a credit downgrade, etc.).
Turning to the ~5%, an interesting analysis out of the IMF in conjunction with the Japan Securities Dealers Association and Japanese Ministry of Finance shows that foreign investors in JGBs perhaps pose slightly more risk than meets the naked eye.
As the chart below highlights, while foreign investors’ share of transactions in the JGB secondary cash market is commensurate with their share of ownership, their share of transactions in the JGB futures market is substantially higher, controlling roughly one-third of all outstanding contracts. Moreover, while down from its 2007 peak, turnover in the JGB futures market is roughly three-quarters that of the JGB cash market, meaning that one-sided selling by foreigners does indeed pose a fair amount of risk to Japanese brokerages. It’s no surprise to us to see Nomura 5yr CDS just above the Lehman Line of 300bps wide (currently at 301bps).
Q: What sorts of labor market reforms could Japan undertake to boost economic output and lower the financial burden?
Shifting gears, we focused a fair amount of one of our discussions on what Japan could do from a regulatory perspective to increase its growth potential and lower its debt burden. Specifically, labor market reform(s) dominated the general flow of that discourse.
It’s certainly true that Japan has one of the world’s most rigid and inefficient labor markets known to man, largely stemming from a focus on lifetime employment contracts. This has resulted in unabated growth in non-benefited, non-regular employees. There are, however, other areas of concern as well, including a relatively low level of female participation in the Japanese labor force – despite Japanese women being more educated than their domestic male and OECD female counterparts with 14.3 years of schooling by their mid-20s.
Potential avenues for reform include:
- Adopting a more flexible system of employment in order to mitigate barriers to labor force re-entry from a full-time job seeker perspective;
- A government led shift to encourage female participation in the labor force, partially by upping social expenditures on child support;
- Broadly encouraging immigration by providing favorable tax treatment and making it easier for foreigners to obtain work visas and permanent residency (Japan’s working-age population is on course to drop by roughly -40% by 2050); and
- Expanding government assistance programs designed to re-train and re-locate job seekers.
All told, while there is, in fact, much Japan can do from a reform perspective to improve its long-term economic outlook, we must be cognizant of the fact that even if such reforms were implemented today, we are unlikely to see any material results for perhaps at least a decade or more! Dramatically altering long-held social dynamics is a long-term process that requires a great deal of patience.
Q: What are the best ways to play your thesis?
From a longer-term perspective, we continue to see asymmetric risk in the Japanese yen vs. peer currencies – particularly against the USD. That said, however, we don’t want to be short the yen at every price, as short-term interest rate spreadscontinue to be the driving force behind short-to-intermediate term fluctuations in various JPY exchange rates. In fact, even us long-term yen bears would not be surprised to see yen strength over the intermediate term, given our outlook for global growth over that duration.
Other potential ways to play the thesis that were discussed in our meetings included:
- Hedging for volatility in the JPY and JGB markets;
- Shorting the equity of internally-facing Japanese consumer names vs. being long the equity of outward facing exporters; and
- Going long of Japanese sovereign and bank CDS – particularly on those banks that are not as strongly capitalized.
These are just a few ideas that we thought had the highest probability of working over the intermediate-to-long term. As always, not all positions will work and certainly not from every price!
Looking at the yen’s monetary policy fundamentals from a long-term TAIL perspective, we expect the mounting political pressure emanating from the Diet upon the BOJ to dovetail into a reasonably-aggressive expansion of the central bank’s balance sheet as it seeks to achieve its recently-adopted +1% inflation target. Moreover, this is likely to come during a time when both the Fed and the ECB are exhibiting slowing growth of their balance sheets – widening a critical spread to the detriment of JPY exchange rates.
Looking at the latest developments, it appears BNP Paribas SA economist Ryutaro Kono – a known hawk – will be rejected for appointment to the BOJ’s nine member monetary policy board. Two spots open up on APR 5 and the replacements for Seiji Nakamura and Hidetoshi Kamezaki are still unknown, leaving the bank to potentially head into its APR 9-10 meeting understaffed. While it is not yet confirmed who will replace the departed board members, it is increasingly likely in our opinion that they will be quite dovish and openly committed to implementing measures designed to combat deflation. We hold this belief due to the widespread, multi-partisan rejection of Kono by members of the Diet due to his hawkish lean (central bank board members need to be approved by both houses).
Looking ahead to next year, when the marginally hawkish Masaaki Shirakawa’s term as BOJ Governor ends in APR ’13, we would anticipate his replacement to also be a fairly dramatic step in the dovish direction. Coupled with Japan’s structurally-impaired growth outlook, waning productivity, eroding current account dynamics, and bloated fiscal position, we see asymmetric downside risk in the Japanese yen vs. peer currencies over the long-term TAIL.
Q: What’s the timing of the VAT hike discussions, given its importance as a catalyst for a ratings downgrade(s)?
The latest news out of the Diet shows that the DPJ has recently agreed upon a watered-down version of the VAT hike bill, which now only calls for implementation if economic conditions are favorable at the time of execution. The bill has yet to be submitted to the broader parliament for deliberation, so there remains no clear date to hang on the calendar from a catalyst perspective.
Looking ahead, the LDP, led by Sadakazu Tanigaki continues to oppose ratifying this piece of legislation at the current juncture, demanding a dissolution of the Diet prior to any cooperation on the bill in an attempt to regain political power. He was on NHK television as recently as MAR 2 highlighting this view.
It remains the case that both parties support raising the consumption tax; that really isn’t the issue from a credit rating perspective. What’s at stake here is Japan exhibiting further political ineptitude that is becoming an increasing factor in the sovereign rating calculus. Japan moving on to its 7thprime minister in 5-6 years amid chronic infighting that puts individual political desires ahead of the long-term health of the economy would very likely be a credit-negative event.
Still unable to pass the FY12 budget law, which begins APR 1, the Diet has resorted to drafting a stopgap budget of ¥3.6 trillion (~$43B) to cover the minimum costs of operation for the first six days of APR (the budget automatically becomes law then because it was approved by the DPJ-controlled lower house 30 days ago). If their progress (or lack thereof) on the FY12 budget is any indication, we might be in for some fireworks regarding the consumption tax debate.
Stay tuned; there’s nothing like a little political drama to keep things interesting!