Analysis: “Abenomics” and Japan’s credit market meltdown
Japan’s public demand
The below graph reflects the turnaround in real public demand or spending in Japan. As part of the “Abenomics” plan, Japan intends to spend an additional $10.3 trillion yen (2% of GDP) in 2013 to grow the economy. After taking local government and private sector contributions into account, this number could reach 20.2 trillion yen, which is closer to 4% of GDP. This increase in government spending is estimated to push the 2013 budget deficit to around 11.5% of GDP. As Japan goes deeper into debt in order to stimulate economic growth, will this mean further cuts in Japan’s sovereign credit rating from U.S. credit rating agencies?
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Larger budget deficits and aggressive monetary policy
As noted in the first part of a previous series, Japan’s new Prime Minister, Shinzo Abe, in conjunction with Bank of Japan Governor Haruhiko Kuroda, will attempt to end the post-1990 deflationary spiral that has gripped the Japanese economy. These policies, known as “Abenomics,” will attempt to encourage private investment through a more aggressive mix of monetary and fiscal policy. “Abenomics” aims to end deflation by targeting a 2% inflation rate, as well as to increase fiscal spending by 2% of GDP. This level of government spending is expected raise the 2013 deficit to a whopping 11.5% of GDP in 2013—higher than that of the U.S. budget deficit after the 2008 crisis as well as present-day Greece (with approximately 10.0% budget deficits).
Japan’s credit ratings fall and credit spreads grow
In September 1998, Fitch rated Japan’s long-term credit AAA. It then cut the AAA credit rating to AA+ on June 29, 2000, then to AA on November 26, 2001, then to AA- on November 21, 2002. Then almost a decade later, it cut the rating to A+ on May 22, 2012. That represents four notches in the Fitch rating system, moving Japan from “AAA” (the highest credit quality) to AA+, the top of the second category (very high credit quality). (Plus and minus adjustments aren’t assigned to the AAA category for sovereign long-term credit ratings.) Japan’s credit rating still stands four notches above Brazil’s BBB rating
In 2008, the cost to buy insurance against a Japan credit default cost approximately 0.10% per annum. This cost of credit default insurance, known as a credit default swap, or CDS, grew to approximately 1.50% by the time Prime Minister Abe was elected, and has since fallen to around 0.70%. U.S. CDS spreads peaked at approximately 0.65% in 2011, though they now stand at 0.23% (according to Bloomberg).
Credit agencies point to Japan’s ballooning debt levels as cause for concern. The rating agency Moody’s issued a warning on Japan on August 19, noting, “A tipping point for creditworthiness would eventually loom if growth remains elusive and the government’s debt and refinancing needs remain at very high levels.” Essentially, Moody’s, like many investors, fears that the plan could “backfire” as debt levels grow.
Total assets versus total net debt: Japan versus the United States
Much ado has been made about Japan’s debt levels. Headline news tends to point out that the United States has just over 100% debt to GDP levels, versus Japan at over 200%. Total gross debt (government debt plus non-financial corporation debt plus consumer debt) for Japan is approximately 450% of GDP for Japan, and 280% for the United States. Government gross debt is approximately 240% of GDP for Japan, and 107% for the United States. Net debt, which excludes debt held by the government itself for monetary, pension, and other reasons, is approximately 135% of GDP for Japan, and 84% of GDP for the United States. (See The Setting Sun—Japan’s Forgotten Debt Problems by Satyajit Das.)
While having a net deficit of 135% of GDP is a large number compared to other countries, so is Japan’s pool of domestic savings. The United States had a gross national savings rate of approximately 20% of GDP in 1980, falling to around 11% in 2009, and currently standing around 17%. In 1980, Japan had a gross domestic savings rate of roughly 30% of GDP, reaching approximately 34% in 1992, and currently standing at 24%. Despite the large 135% of GDP in net debt, as noted below, Japan also has a significant savings base of roughly $20.7 trillion.
To compare U.S. debt to Japan’s debt, taking into account total savings and net worth:
- In Japan (2012) government net debt and gross debt reached $7.4 trillion and $13.1 trillion, respectively.
- Household net assets ($13.3 trillion) + net assets of domestic non-financial sector ($2.7 trillion) + net foreign assets including foreign reserves ($4.7 trillion) totaled $20.7 trilion (stock basis).
- In the United States (2012), government net debt and gross debt reached $13.8 trillion and $16.7 trillion, respectively.
- Household net assets ($67.3 trillion) + net assets of domestic non-financial sector ($20.3 trillion) + net foreign assets including foreign reserves (-$3.7 trillion) totaled $83.9 trillion.
- Japan has a total-assets-to-net-debt ratio of 2.8, whereas the United States has a ratio of 6.1.
(Source: Household/Non-Financial Sector. Data for Japan: Bank of Japan, Flow of Funds Data, external assets from Ministry of Finance, Balance of Payments Data. For the United States: Household/Non-Financial Sector Data from U.S. Fed, external assets from BEA.)
Though Japan has slightly less than half the U.S. assets-to-net-debt ratio of the United States, Japan still has the asset base it needs to support this large amount of debt for a significant amount of time. “Abenomics” skeptics focus more on the dynamics of this debt. They point out that national debt levels are 24 times national government revenues and that 25% of tax revenue goes to service the debt.
The concern is that the reflationary policies of “Abenomics” could lead to higher nominal and possibly real interest rates. This could take an even larger bite out of the Japanese government’s budget on a both nominal and real basis. With a weakening yen, Japan is expected to become a larger importer in the near term, as discussed in the related series Japanese exports: Are we seeing an “Abenomics”-led recovery in Japan? Japan’s historical trade surplus is showing signs of turning into a trade deficit over the past few years, with trade deficits starting to grow.
Should Japan’s trade deficit maintain a similar trajectory over the next five years, the annual trade deficit could grow form around $120 billion per year to $360 billion per year, or from 2% of GDP to 6% of GDP—similar to the highest levels seen in the United States in 2007. Simply drawing such a trajectory would suggest that Japan would start to eat into its $20.7 trillion in assets at a fairly significant rate. However, such simplistic assumptions would ignore other factors, such as Japan’s weakening yen, which would likely lead to export growth as well, though perhaps on a lagged basis.
“Abenomics” skeptics like Heyman Capital’s Kyle Bass think that Japan’s interest rates will rise significantly, and potentially cause some form of economic collapse. With total assets to net debt at nearly three times, it would seem that Japan has a significant store of assets to finance its debt for the foreseeable future. But Kyle Bass points to higher interest rates as a ticking time bomb for Japan. With 25% of government spending going to service government debt in an ultra-low rate environment, an increasing amount of government spending could go to servicing debt as interest rates rise under “Abenomics.” The big question is, should interest rates rise under “Abenomics,” will increases in nominal private sector savings and nominal increases in government revenues be enough to offset the nominal increase in debt service?
Economist Jesper Koll of JP Morgan Securities Japan thinks that higher interest rates could help both the Japanese banking system via charging higher interest rates and the private sector by providing higher income on savings, as the net stock of private savings remains larger than the net stock of private sector debt. Plus, foreign holdings of Japan’s public debt have increased from 5% to 9% over the past two years—despite the record-low rates and growth in debt. In other words, despite the outlook of higher rates and high debt, foreigners, on net, continue to buy Japanese bonds, not sell them.
Looking forward, the growth in public demand in Japan, driven by large fiscal spending packages under “Abenomics,” is likely to continue. Significant corporate and private savings rates in Japan have been able to offset and finance these large deficits. In fact, Nomura Securities Holdings’ Richard Koo reminds us that domestic savings are largely the mirror image of government borrowings (debt). Koo estimates that, in total, Japanese domestic savings offsets approximately 84.6% of the changes in government debt. Perhaps the keystone of the rising rate hypothesis is the expectation that savings rates (domestic, corporate, and financial sector) will decline in the future, from the 20%-to-30% historical level to more in line with U.S. levels (2% to 10%). Should the drop in savings be predominantly due to consumption gains and not investment gains, perhaps future growth rates in Japan would remain stagnant.
However, with a weakening currency relative to its Asian export competitors, Japan could see a growth in exports, on a real and nominal basis, requiring significant investment in Japan. Should the weakening yen lead to an export and investment boom in the longer run, perhaps Japan will mitigate the near-term scare of the growing trade deficit and a slowing savings rate. Therein lies the rub. Should the yen weaken far enough, the “hollowing out” of the Japanese manufacturing base vis-à-vis China could show signs of reversal. Future production capacity in key sectors, such as autos, could see production return to Japan.
Regarding “Abenomics”-induced runaway inflation and currency collapse, most economists would seem to agree that high levels of inflation of over 2% per annum are unlikely to arrive anytime soon, and that the real yield on government bonds won’t go into a period of significant negative real rates. As a result, the fiscal stimulus of “Abenomics” should support consumption growth in Japan—in both the public sector, as noted in the above graph, as well as in the private sector, as noted earlier in this series. Whether or not consumption overwhelms investment in Japan in the future is hard to estimate. Though if history is any guide, perhaps consumption growth will remain modest at best.
As a result, a sudden collapse in Japanese government bonds is probably not that likely, unless future data delivers surprises, reflecting that Japan has gone on a reckless consumption binge, has virtually stopped saving, and invests its wealth in wasteful government programs (essentially, become the United States). History and culture suggest that this won’t happen anytime soon.
As 2013 progresses, investors could see a continued outperformance of Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan ETF (EWJ) versus China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further clarification as to why DXJ could outperform both EWJ and other Asian equity indices, please see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.” Plus, as Japan pursues unprecedented monetary expansion, and the U.S. Fed ponders monetary tightening, Japanese equities could also outperform broad U.S. equity indices, as reflected in the State Street Global Advisors S&P 500 SPDR (SPY), State Street Global Advisors Dow Jones Index SPDR (DIA), and Blackrock iShares S&P 500 Index (IVV).
For further analysis of how China is being affected by Japan and “Abenomics,” please see China’s exports: Is the Golden Age of Cheap Labor Coming to an End? For further analysis of how United States–related consumption trends could impact Japan’s “Abenomics”-led recovery, please see U.S. consumer spending: Sustaining the unsustainable? For further analysis of how exports in Japan are being affected by “Abenomics,” please see Japanese exports: Are we seeing an “Abenomics”-led recovery in Japan?”