- Joshua Konstantinos
Japan’s Debt Is Unsustainable – So Why Is Betting Against It The “Widow-Maker” Trade?
Japanese debt has risen to unsustainable levels. Economists writing in “Defying Gravity: Can Japanese Sovereign Debt Continue to Increase Without a Crisis?” warn that:
Almost all recent papers on Japanese government debt reach the same conclusion: the current course of fiscal debt dynamics is not sustainable… all find that without a drastic change in fiscal policy, the Japanese government debt to GDP ratio cannot be stabilized .
And it’s easy to see why. You’ve heard how the U.S. and much of the rest of the world has accumulated a massive amount of debt, with the U.S. now running trillion-dollar deficits. But Japan puts the rest of the world to shame.
By the numbers, if there was one country in the world you would think would have a debt crisis it would be Japan. Money managers have been betting against Japanese debt for decades - and yet as the debt becomes more universally recognized as unpayable, and the major credit bureaus slash their ratings, the yields have only fallen lower and lower.
Betting against Japanese Government Bonds (JGBs) has come to be known as the “widow-maker trade,” as the Financial Times reported:
The most famous “widow-maker” trade in financial markets — one that has frustrated generations of money managers — is betting against Japanese government bonds. Yields have sagged to eye-popping lows for the past three decades, even as government debts have risen, repeatedly tempting traders into “shorting” Japanese debt. Yet time and time again yields have only dipped lower, inflicting painful losses on successive generations of money managers.
To understand why JGB yields have continued to fall despite the odds and to see how long this is likely to continue, we need to understand the history of the modern Japanese economy.
The Japanese Model
By the early 1970’s Japan had pioneered an economic model which would become known as the Japanese Model or the Asian Model, predicated on suppressing domestic consumption and boosting exports to spur economic growth. A major part of this model was manipulating the currency exchanges, devaluing the yen to boost exports. (For more on the mechanics of how this works see: Why Did China Just Devalue the Yuan?). This manipulation of currency exchange was now possible with the end of the Bretton Woods system of fixed currency exchange rates in 1971.
But by 1985, the United States, displeased with the growing trade deficit, negotiated an agreement with West Germany, France, Britain, and Japan to allow their currencies to strengthen against the dollar. When Japan allowed its currency to appreciate, it was immediately thrown into recession. So to offset currency appreciation, Japan’s government massively stimulated the economy and ultimately created a titanic asset bubble in real estate and stocks.
When this bubble popped in 1991, Japanese equity and real estate values crashed, leaving highly leveraged Japanese banks and insurance companies with unserviceable amounts of bad debt. Understandably, Japan bailed out its banks and insurance companies, but this led to decades of stagnant growth known as Ushinawareta Jūnen – the Lost Decades.
(Interesting aside: the Chinese observed what happened to Japan when it strengthened its currency and China is adamant that it will not be forced into strengthening the yuan.)
The reason that bailing out the financial system lead to decades of slow growth is because the economy ended up zombified. Economists writing in “Zombie Lending and Depressed Restructuring in Japan” have proposed that zombie companies are to blame for Japan's Lost Decade(s):
We propose a bank-based explanation for the decade-long Japanese slowdown following the asset price collapse in the early 1990s...Large Japanese banks often engaged in sham loan restructurings that kept credit flowing to otherwise insolvent borrowers (which we call zombies). We examine the implications of suppressing the normal competitive process whereby the zombies would shed workers and lose market share. The congestion created by the zombies reduces the profits for healthy firms, which discourages their entry and investment. We confirm that zombie-dominated industries exhibit more depressed job creation and destruction, and lower productivity.
(For more on the zombification of the economy see: The Zombie Apocalypse Is Here)
Japanese Sovereign Debt
Since the Lost Decades began, Japan has been mired in debt and the prospect of growing the economy out of it has faded. Moreover, there is a demographic issue: Japan’s fertility rate fell below the minimum replacement level before most developed countries and ultimately dropped to a very low level. So Japan not only has the world’s worst debt-to-GDP ratio, but it also has one of the oldest populations as well.
One of the major reasons that Japan’s debt is so unsustainable is because as its working-age population shrinks dramatically in the coming decades, the economy is expected to shrink significantly as well – although costs will soar.
However, Japan has had several advantages in dealing with its debt. Firstly, Japan’s debt expanded in an era when the rest of the world’s population was in its prime earning and saving years. Interest rates continued to fall worldwide as the baby boomers saved more and more for their retirement. Additionally, Japan’s debt is held almost entirely by Japanese citizens and institutions. Compared to other nations, the fraction of Japan’s debt held by foreigners is very low. This reduces the risk that investors will lose confidence in JGBs and try to move their money out of the country.
Consensus of Unsustainablity
However, the fact that the debt is held domestically does not mean that the situation is sustainable.
Japan’s own cabinet office when asking the question “Is the Japanese Fiscal Situation Sustainable?” concluded that:
Formal tests report that sustainability has been lost since late 1990s and that Medium-term simulations show that without policy action debt to GDP ratio continues to rise. Researchers concerned with sustainability unanimously agree that the Japanese government will have to generate sufficient fiscal surplus for achieving sustainability. Moreover, when the share of foreign investors increases, as indicated by Tokuoka (2010) and Hoshi and Ito (2012), the surge in JGB bond yields is apprehended, and it may induce the crowding-out of private capital formation or reduce non-interest spending owing to the increase in interest rate payment. In addition, following the results of Onji et al. (2012), the JGB market may become volatile once government financial institutions quit their role of primary purchasers of JGBs. This could also prove detrimental to the macro economy as well as the government budget.
In a 2011 National Bureau of Economic Research paper “Japanese Government Debt and Sustainability of Fiscal Policy” Takero Dio, Takeo Hoshi, and Tatsuyosho Okimoto analyze Japan’s debt and conclude that:
…All the results point to the same conclusion: the Japanese government debt poses serious challenges. To stabilize the debt to GDP ratio, Japan needs to implement a tax rate hike with an extraordinary magnitude. Such tax increase to make the fiscal policy sustainable would represent a drastic departure from the Japanese fiscal policy in the last 30 years. The fiscal policy in Japan is found to be unsustainable even when we allow the possibility of regime changes. If the government fails to reduce the primary deficit by increasing the taxes and reducing the expenditures and transfer payments, Japan would be forced to reduce the value of government debt through either inflation or outright default .
In fact, even the rating agencies have been forced to downgrade Japanese government debt in recent years, with the rating agency Fitch downgrading it from the highest AAA rating in 1998 down to its current A rating. In 2016, Japan’s outlook was dropped to negative – a warning of future downgrades to come.
According to Japanese economists, projections show that, unless there is significant fiscal adjustment, the supply of JGBs will outstrip domestic demand for them by the mid-2020s. The limit in domestic demand due to demographics is also noted by a 2011 IMF working paper “Assessing the Risks to the Japanese Government Bond (JGB) Market”, which notes that:
Japan’s large pool of domestic savings, stable investor base, and high share of domestic ownership of JGBs have helped maintain stability in the JGB market. But these favorable factors are likely to diminish over time as population aging reduces household saving and risk appetite recovers. Without a significant policy adjustment, the stock of gross public debt could exceed household financial assets in around 10 years, at which point domestic financing may become more difficult.
Why Betting Against Japanese Debt Has Failed For Decades
Despite Japan’s enormous debt burden and their truly bleak demographic future, not only have interest rates not risen on Japan’s debt but it is now yielding negative interest. How is this possible? We have seen that JGBs have a large percentage of domestic ownership, and while that is an advantage in pricing, it does not truly explain the phenomenon.
Because of the massive amount of debt that the Japanese government took on to bail out their economy in the 1990s, the Bank of Japan (BOJ) was forced to begin ryōteki kin’yū kanwa (quantitative easing) in 2001. This quantitative easing policy (QE) was adopted by the rest of the G7 nations following the 2008 financial crisis when they too were forced to take on massive debts to bail out their financial systems.
QE by major central banks has worked to push down long-term interest rates to unprecedented lows. As economists at the BIS have noted, much of the fall in interest rates over the decades can be explained by demographic factors – i.e. the baby boomer generation saving for retirement. However, demographic factors alone do not explain today’s ultra-low and even negative interest rates, which are a product of quantitative easing.
There is a great deal of misunderstanding about quantitative easing. Some prominent investors characterized it as “printing money” and expected it to cause massive inflation. Others have used the lack of inflation as an argument about why sovereign debt doesn’t matter. Neither of these characterizations are accurate. Ultimately, QE is neutral to the monetary base and does not remove government liabilities, although it does lower debt-servicing costs. Former Federal Reserve chair Ben Bernanke has attempted to refute the idea that QE is printing money, explaining that:
…sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed.
Essentially, the mechanism of QE is that the Federal Reserve and other central banks are buying government bonds – but not directly from the Treasury Department. The Fed is buying government bonds from banks and paying for them with central bank reserves.
Crucially, these cash reserves are held by the central bank and pay an interest rate just as the Treasury bonds did. In a sense, the Federal Reserve swapped 10-year Treasury bonds with hypothetical Federal Reserve Bonds. Very little has fundamentally changed. No new currency has entered the economy and the banks gained the reserves but lost the bonds, so their balance sheets are essentially unchanged.
That’s why you can see a graph of the money supply that shows a massive increase, and yet inflation has not spiked. The money never entered the economy; it is being held in a vault at the central bank (or more realistically is just a number in a spreadsheet). In practical terms it was an asset swap and not a true increase in the money supply. The graphic below illustrates how QE affects the balance sheets of the banking system, the central bank, and the Treasury in a hypothetical QE process.
QE is essentially an asset swap where the amount of money in circulation remains unchanged. It does not increase or decrease the money supply directly. And nor does it reduce the fundamental debt burden and obligations of governments as part of the QE process. The central bank pays the banks interest on excess reserves (IOER) they hold with the central bank at a rate which is typically close to the yield on the bonds themselves.
But with the understanding that QE is an asset swap that essentially leaves balances sheets unchanged, how does QE work to lower long-term interest rates? Economists for the Peterson Institute for International Economics and the Federal Reserve Bank of New York explain how this asset swap impacts rates. In the 2010 paper “The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases,” they describe how:
The primary channel through which LSAPs [Large Scale Asset Purchases - i.e. QE] appear to work is by affecting the risk premium on the asset being purchased. By purchasing a particular asset, a central bank reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others, while simultaneously increasing the amount of short-term, risk-free bank reserves held by the private sector. In order for investors to be willing to make those adjustments, the expected return on the purchased security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. This pattern was described by Tobin (1958, 1969) and is commonly known as the “portfolio balance” effect. 69 [emphasis added]
Put more simply, by lowering the total amount of Treasury bonds available in the private sector, the central bank has reduced the amount of safe assets available to investors. With supply reduced and demand unchanged, investors will bid the interest rates on government bonds lower. This “portfolio balancing” effect also impacts other securities. Investors searching for yield and relative security will also bid interest rates lower on alternative investments such as highly-rated corporate debt, etc.
The Inherent Limitation of QE
Importantly though, QE is only possible as long as there are bonds being held by banks. Pension funds or other investors are not eligible to keep reserves at the central bank, and of course banks hold a finite amount of government bonds. Therefore QE cannot be continued indefinitely.
Already the BOJ has begun to run out of eligible bonds to buy – or swap, really – for reserves at the central bank. As Ben Bernanke noted in late 2016, “…constraints on the availability of JGBs were seen in many quarters as limiting the BOJ’s ability to maintain its easy policies beyond the next year or two.” Japan is very close to purchasing all of the outstanding JGBs, at which point it will not be able to continue its QE program.
(Interesting tangent: In Europe, the European Central Bank (ECB) is also approaching a limit to its bond purchases. In September 2016, the Financial Times raised the question “When will the ECB run out of bonds to buy? Warning that the “QE programme could hit a wall as early as this year because of lack of eligible debt.” Although in Europe's case, they are merely running into the rather arbitrary limit of 30% of outstanding bonds that Europe has set for itself.)
Japan has built up a tremendous amount of debt over the last fifty years. And with their declining population it is unlikely that the debt can be paid back in real terms. This has become increasingly apparent, and yet yields have not risen to force the nation into a sovereign debt crisis. On the contrary, they have fallen to the point of negative rates. The reason this has happened, and the reason that everyone who has bet against JGBs has failed miserably, is because QE has allowed the Bank of Japan (BOJ) to to force long term interest rates lower and lower. This has come at the cost of further zombifining their economy, but the more pressing issue is that the BOJ is coming close to buying up all of the existing government bonds.Although the central bank can purchase corporate debt as well (and have already begun to do so), this will not keep yields low on JGBs if it is unable to continue the QE process.
Japan is facing a steep decline in its working-age population and a dramatic increase in its elderly just as it is reaching the limits of domestic appetite for government debt. QE is inherently a limited tool. Once Japan runs out of eligible bonds to purchase, the country may yet see the sovereign debt crisis that hedge fund managers have been looking for for decades – one more reason that The Next Recession (Whenever It Comes) Will Be About Sovereign Debt.
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Sleeping on a Volcano: The Worldwide Demographic Upheaval and the Economic and Geopolitical Implications Makes the case the sovereign debt is unsustainable in an aging world. The book takes into account not only the rapidly changing and uncharted waters of the global economy under unconventional monetary policy, but also the longer demographic and geopolitical trends which have already begun to shift.
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About the Author Joshua Konstantinos Founder and Global Macro Strategist at Cassandra Capital LLC and author of Sleeping on A Volcano: The Worldwide Demographic Upheaval and the Economic and Geopolitical Implications, Joshua has been obsessively following global trends and collecting data for over a decade. His analysis takes into account not only the larger view of the rapidly changing global economy but also the longer demographic and geopolitical trends.