Conclusion: Japanese demographics and pension obligations pose one of the biggest risks to the global economy.
Position: Short Japanese equities (EWJ); Short the Japanese yen (FXY)
At Hedgeye, we try to resist hyperbole as much as humanly possible in today’s manic, never-ending stream of real-time information. But after spending some time researching Japanese demographics and pension obligations, we feel they are one of the most dangerous TAIL risks to global investing over the next 10-20 years.
For background, let us attempt to quantify Japan’s demographic headwinds that are often bandied about (for good reason) without much supporting data. For starters, with 22.7% of its population above the age of 65 as of 2009, Japan has the world’s oldest population. That figure will continue to grow, as Japanese government projections have modeled that ratio to 29.2% by 2020 and 39.6% thirty years after that.
Currently, the ratio of retirees to working-age Japanese is equal to 35.5%. In just ten years time, that ratio will be equal to 48%. In a society notorious for luxurious pension packages, going from a 3-to-1 base in potential contributors to a near 2-to1 base in a matter of just ten years is frightening to say the least. And it doesn’t get any better – by 2050, the ratio of retirees to working-age population will reach 76.4%, according to projections from Japan’s Ministry of Health, Labour and Welfare.
The obvious conclusion here is that more and more people will be in line for pension payouts with less and less people to fund them. To that tune, the funding outlook looks incrementally more bearish when one considers that 56% of Japanese workers rely on financial support from their parents or other sources to cover their living expenses (Japanese Labor Ministry). As it seems, the people who are going to be counted on the most to fund ever-increasing pension liabilities are actually being supported by those very payouts they are needed to cover. This is not good.
This year, we’re already starting to see the ill-effects of funding gaps, with Japan’s public pension fund (the world’s largest at $1.433 trillion) increasing its asset sales by a factor of 5x year-over-year to bridge the gap between insurance premiums and payouts. According to Takahiro Mitani, president of the fund, the now 4 trillion yen ($48 billion) figure can be raised by selling any combination of assets (67.5% JGBs, 12% Japanese equities, 10.8% international equities and 8.3% in foreign bonds, including U.S. Treasuries), according to “market conditions”. We expect the asset sales by Japan’s public pension fund to continue accelerating as the first of Japan’s baby boomers turn 65 in 2012.
Expect the heavy hand of Japanese selling to weigh on global markets in the coming years. Despite this, Mr. Mitani remains convinced that the interest rates on Japanese government bonds will not increase from the potential glut of new supply on the market. We beg to differ. We all know what happens when marginal supply outweighs marginal demand – prices decline.
On the demand front, Japanese government debt (which is north of 200% of GDP) has largely been financed by domestic investors (94%; IMF). Japan’s savers, however, are shifting on the margin to consumers as they age rapidly: Japan’s household savings rate (as a % of disposable personal income) has declined 1,170 bps over the past 20 years to 2.2% (IMF; OECD).
Much has been made about the fact that direct holdings of JGBs by the household sector are only ~5% of the total outstanding amount. When indirect channels are taken into account, however, Japanese households finance 61.5% of JGB issuance through banks and pensions funds, after factoring in an incremental 10% of JGBs held by the basic public pension fund that will be paid out as future liabilities (BoJ Flow of Funds Statistics; IMF).
To compound the decline in domestic demand, a recent report from Mizuho Trust & Banking Co. (Japan’s second largest bank) suggests that demand for 20 and 30-year JGBs will start to wane in the next few years as purchasing from major Japanese life insurers peaks out.
With regards to supply, Japan’s budget deficit as a % of GDP is currently 8.7% (IMF) and more spending initiatives, such as current Prime Minister Naoto Kan’s recently announced 915 billion yen ($11 billion) stimulus plan, don’t suggest that figure will come in meaningfully over the next few years. In fact, baseline IMF projections (taken for whatever they’re worth) have Japan’s budget deficit as a % of GDP at 7.2% in 2015. This means that they will need to continue to issue large sums of government debt to finance deficit spending.
Combined, the outlook for future demand for and supply of Japanese government bonds is one of gross disequilibrium to the supply side, which should, in theory, push down prices substantially and send yields soaring. Currently, about 10.6% of Japan’s federal budget goes to interest payments, which is much higher than the 7.8% we see in America (Japan Ministry of Finance; BEA). Further, all-in National Debt Service, which includes interest payments, bond redemption and administrative costs, stands at roughly 22.4% of Japanese government expenditures.
This figure is one to keep any eye on, as bond redemption costs are arguably a growing canary in the coal mine as it relates to the Japanese fiscal situation. Known as the “60-year Redemption Rule”, Japan’s current debt servicing system requires JGBs to be completely redeemed in cash over a 60-year period irrespective of bond duration – using sources of income other than refinancing. Simply put, Japan can’t just pile more debt upon debt to meet all its refinancing costs. This will continue to be headwind for the Japanese government budget, likely forcing them to meaningfully raise taxes and implement substantial austerity measures over the next decade.
That will be tough, considering that Japan’s dependency ratio (ratio of elderly and children to the working-age population) will grow 1,017 bps to 66.7% in that time span, according to the Japanese Ministry of Health, Labour and Welfare. Plainly stated, the Japanese citizenry will likely need spending to increase over this time period while the government will need to cut its budget meaningfully and raise taxes. We saw what happened in the streets of Greece this summer after the government implemented tough austerity measures. Japan is much, much larger than Greece (population: ~127.5 million vs. ~11 million in Greece).
Circling back to my previous comments regarding the possibility of Japanese interest rates backing up significantly, history tells us that this could happen over a span of decades or, as we saw this summer, in a matter of months once the global investment community (who will be increasingly responsible for funding JGB issuance as Japanese domestic demand wanes) loses confidence in Japan’s fiscal sustainability.
Of course, there’s always the Paul “PRINT LOTS OF MONEY” Krugman factor to consider, whereby Japan could in fact “PRINT LOTS OF MONEY” to buy more of its own government debt. Currently, the Bank of Japan holds about 8% of total JGBs as a result of its monthly purchases designed to stabilize market conditions (IMF). How much more JGB financing could the BoJ undertake without major unintended consequences (i.e. global asset inflation, yen debasement, etc.) is beyond us.
What is not beyond us, however, is where this ship is likely headed over the next 5-10 years. As a result of growing underfunding, Japan’s pension fund may have to invest in riskier assets to meet its long-term payout needs. An entity as large as Japanese pension funds collectively joining the global search for yield will provide a substantial amount of incremental demand for emerging market stocks and bonds over the next decade and beyond. Mr. Mitani, who recently said his mandate is to invest in “safe” assets with a long-term view, may need to step outside his comfort zone pretty soon if the Japanese pension system isn’t to implode upon itself (and the global financial system).
We understand this note sounds alarmist, as it probably should. Similar to Bob Shiller warning everyone about housing in the mid-2000’s, we think the growing liabilities of the Japanese pension system pose a major threat to the global economy. Of course, a crisis isn’t likely to ensue tomorrow or next year, though the probability of a major crisis happening in our lifetime is a lot higher than not, in our opinion. We would be remiss, however, not to send a golf clap in Japan’s direction for at least addressing the problem: the number of Japanese workers in defined-contribution plans (which reduce future pension liabilities on the margin) has grown 40x since 2001 to 3.5 million in 2009 (WSJ). Unfortunately, that’s only 2.7% of the working-age population, so there’s more work to be done to say the least.
God speed, Japan. God speed.