Earlier today, Japan’s lower house of parliament (a.k.a. the Diet) passed a bill authorizing the sale of ¥38.3 trillion of JGBs to cover ~40% of already-approved FY12 expenditures, which began on APR 1st. While no set limit exists, this motion is akin to the US’s own statutory debt ceiling and, like our own debt ceiling, Japan’s deficit financing legislation allows for minority parties to have a say in the accumulation of sovereign debt.
Enter the LDP, Japan’s primary minority party in the more relevant lower house (House of Representatives – 120 of 480 seats) and a slight minority in the upper house (House of Councillors – 87 of 242 seats) where no party has formed an outright majority. They have signaled as recently as last week that they will not approve the bill unless Prime Minster Yoshihiko Noda calls new elections, which would be roughly one year early, as they are officially due by AUG ’13. As it stands, neither party looks to dominate in the event of a snap election; both the DPJ and LDP have a paltry 13% approval rating per an Asahi poll released earlier this month.
This marks the latest political ploy for the LDP to regain political power in Japan, having recently backed off using the now-ratified VAT hike bill as collateral for Noda’s head. Members of the LDP remain broadly bitter about their party’s AUG ’09 defeat to the DPJ – which was architected by the now-defected Ichiro Ozawa – and they continue to look aggressively for opportunities to restore their long-time position atop Japan’s political hierarchy. Needless to say, we’d be remiss to dismiss these threats as mere political wrangling. Per Finance Minister Jun Azumi’s latest projections, the Japanese government will run out of cash sometime in October if this bill isn’t ratified in time.
The ramifications of a potential/actual Japanese government shutdown are three-fold:
- A potential sovereign default;
- A potential sovereign credit rating downgrade(s); and
- An associated $75-80 billion capital call across the Japanese banking system in the event JGBs are downgraded to single-A level by Moody’s and/or Standard and Poor’s, where the outlook is already “negative”.
To point #1, we do not see material risk of a JGB default over the intermediate term, despite debt service compromising roughly one-fourth of FY12 federal expenditures. Rather, we anticipate that Japanese lawmakers will either find a clause(s) within Japanese statue to completely circumvent a near-term default or they’ll cobble together some political compromise under the increasing scrutiny of global financial markets and ratings agencies. Either way, we don’t view a JGB default as a probable risk over the next couple of months, as indicated by Japan’s sovereign CDS:
Unlike point #1, we do view point #2 as a heightened and increasingly-probable risk over the intermediate term. Per Takahira Ogawa, S&P’s director of sovereign ratings in Singapore, “political risk is the biggest negative for Japan’s rating”. In and of themselves, neither political risk nor an incremental downgrade of Japanese sovereign debt should do much to the historically-bulletproof JGB marketplace, which continues to have demand buoyed by surplus liquidity in the banking system that gets parked largely in JGBs for lack of better alternatives (second chart below). To this point, deposits at Japanese banks exceeded the aggregate size of their loan book by ¥173.2 trillion as of JUL; this spread, also known as the “Yotai Gap” is equivalent to 17.4% of the total amount of JGBs outstanding, creating a substantial amount of excess demand.
For additional drivers of JGB market strength in the face of an overwhelmingly-consensus bearish thesis, refer to our MAR 2 presentation titled, “JAPAN’S DEBT, DEFICIT AND DEMOGRAPHIC RECKONING” as well as in our MAR 30 note titled, “DIGGING DEEPER INTO JAPANESE SOVEREIGN DEBT” and our JUL 27 note titled, “ARE JAPANESE GOVERNMENT BONDS POISED TO MAKE SOME NOISE”. Staying on top of which levers are at the most risk of becoming unsupportive on the margin are the key to staying ahead of a JGB market crisis, should one materialize over the long-term TAIL.
Jumping back to ramifications of Japan’s looming government shutdown, we view point #3 as laid out above as among the key catalysts for a JGB market crisis over the intermediate term. Per our calculations according to Basel II standards, Japanese banks would be on the hook for a $79.1 billion capital call in the event JGBs become a single-A entity (at the current exchange rate), after previously having to hold no capital against these assets. It remains to be seen how Japanese banks plan to react to this event; they could merely slow demand for other assets or they could materially slow their rate of JGB accumulation. Time will certainly be more telling here than we ever could; at any rate, we maintain that this is not a risk that should be glossed over by investors.
In addition to a changing risk profile of Japanese bank exposures, we also view a structural shift in long-term inflation expectations as a key catalyst for a JGB crisis; our latest thoughts here were previously outlined in the latter of the aforementioned research notes. To this point, the amount of JGBs held on the BOJ balance sheet now exceeds the total supply of banknotes in the country (¥80.96 trillion vs. ¥80.78 trillion), raising concern that investors will lose confidence amid fears of runaway inflation perpetuated by sovereign debt monetization – an event which has already happened twice in Japan: during the Great Depression and during WWII.
The BOJ counters that it does not include JGBs bought as part of its “transitory” asset purchase program in its calculus, allowing it to exceed the self-imposed “banknotes rule”. The obvious risk here is that BOJ Governor Masaaki Shirakawa loses credibility with the market; we suspect he knows this and that this has been a contributing factor to the BOJ’s unwillingness to acquiesce to incessant political demands for incremental monetary easing. At the current pace of accumulation (¥3.9 trillion per month in 2012; ¥2.8 trillion per month in 2013), the BOJ will have increased its ownership of JGBS by ¥44 trillion in the current fiscal year – more than the ¥40 trillion to be issued per the aforementioned FY12 deficit financing bill!
All told, we see three ramifications of a potential/actual Japanese government shutdown over the near term: a potential sovereign default, a potential sovereign credit rating downgrade(s) and an associated $75-80 billion capital call across the Japanese banking system in the event JGBs are downgraded to single-A level by Moody’s and/or Standard and Poor’s. Moreover, the confluence of these risks has the potential to perpetuate a meaningful back-up in JGB yields over the intermediate term – though, admittedly, this remains an improbable risk for the time being.