Beacon Reports

Last month on CNBC, Kyle Bass, founder of Hayman Capital Management, predicted Japan would face financial meltdown within the next 18 to 24 months. He was responding to Prime Minister Abe’s attempt to end the country’s two-decade old slump by targeting a 2% inflation rate. Bass is credited with having correctly predicted the subprime mortgage debacle that led to the financial crises in the late-2000s. Uttering an attention grabbing sound bite that caused many eyebrows to raise, Bass said, “People buying Japanese stocks are picking up a dime in front of a bulldozer.”

Does Bass have it right?

Beacon Reports spoke to Jesper Koll, Managing Director and Head of Japanese Equity Research at JPMorgan Securities Japan, to get an informed opinion.

Kyle Bass

First, a recap of the Bass argument: Bass points to Japan’s decade of deflation as being the main reason why the private sector continues to hold Japanese Government Bonds (JGBs). With nominal yields of less than 1%, it is only defacto domestic deflation that has made investment in JGBs attractive in real terms. A reversal from deflation to inflation, according to Bass, will cause a massive sell-off of JGBs by institutions in search of higher yields abroad.

Any capital flight out of JGBs would cause bond yields to rise. That would typically not be a problem, but the Japanese government is highly leveraged. National debt levels are 24 times central government tax revenues. 25% of national tax revenue is currently used to service the nation’s debt. Every 1% increase in bond yield costs the Japanese government another 25% in tax revenues to service the debt. A 2% increase in yield, according to Bass, would cause Japan’s financial system to implode.

Bass thinks the Abe government is shooting itself in the foot by setting a 2% inflation target.

The 2% inflation target, incidentally, is part of Abe’s three-pronged approach to reflate Japan’s economy through monetary, fiscal and structural measures, otherwise referred to as Abenomics.

Without further ado….

Beacon Reports: Jesper, what do you make of Bass’s prediction? Does he have it right?

Jesper: Does Bass have it right in terms of the investment recommendation? Absolutely not. Does he have it right in terms of some of the numbers? Again, absolutely not. Does he have it right in terms of some of the fiscal issues that need to be addressed? The answer on that is yes.

If Japan were to get higher interest rates, then debt service costs should go up. That is absolutely correct. But it’s not just a capital loss for the financial system. It is also a business gain because the banks, for example, are going to be able to charge higher lending rates. Also the general public, Mr. and Mrs. Watanabe, are going to earn higher interest rates. And the government also owns assets. The overall effect on the economy will be still positive when you net it all out.

I’m confident of that because the net stock of private sector savings is higher than the net stock of public sector liabilities. Therefore, net-net, an increase in interest rates is a positive for the Japanese economy and not a negative.

Beacon Reports: If institutions started to dump JGBs, could not Japan sell-off some of its $ 3.3 trillion in net overseas assets to cover the shortfall? Do not these provide a cushion?

Jesper: No they would not. The bulk of these assets, such as Toyota factories in the United States, are held by the private sector. The Japanese government can’t force Toyota to sell their overseas factories. That assumes Japan is controlled by a dictator who could nationalize Toyota. That is nonsense, these are private companies.

In reality, it makes no sense for Japanese banks and insurance companies to sell their bonds. When you buy a bond, you hold it on your books until maturity. You don’t have to mark to market all but a small portion that is your trading portfolio. The notion that when interest rates rise (i.e. the price of bonds falls), then therefore Japanese institutions are going to become forced sellers, is false. Institutions have no incentive to sell those bonds.

Beacon Reports: What about Japan’s foreign exchange reserves?

Jesper: Foreign-exchange holdings are about 8% of GDP, which is not a significant amount, but you are assuming there is going to be a crisis. It’s absurd to consider these disaster scenarios. Japan is a rich country. Japan has enough of a free market and adjustment mechanism to make right such imbalances.

For example, and let’s be specific − Japan is becoming a net debtor country with a current account deficit on a flow basis. Yet ownership of public debt by foreigners has increased from 5% two years ago to over 9% on the latest statistics. Now, why would the rest of the world be buying JGBs? The answer is simple. They see it as a worthwhile investment.

Let’s take another example. Abe wants to get us out of modest deflation towards a positive 2% inflation − a good thing. To accomplish that, he’s employing an aggressive, sizable fiscal expansion plan which is being funded by issuance of JGBs. Since those plans were announced, interest rates have actually fallen. Yields are below where they were before Mr. Abe became prime minister.

Who is buying those bonds? The Bank of Japan (the central bank) is aggressively purchasing them. They are committed to purchasing the entire debt out to a maturity of up to three years. Today, the risk of short-term interest rates on JGBs with maturities up to three years increasing is de facto nil, because the Bank of Japan is the buyer of last resort.

In my personal opinion there is a high probability that, with the new central bank governor coming in, this maturity will be extended from three to five years. The Bank of Japan would then remain the buyer of last resort for JGBs for maturities out to five years. The implication is that yields on JGBs will not be going up.

Beacon Reports: Won’t debt monetization in the long-run lead to inflation? Jesper: The key driver on whether there will be or not be inflation is productivity. If there are real increases in productivity, the risk of inflation spiraling out of control (that is, hyperinflation) gets completely mitigated because there will be overall productivity increases. The Abe administration must implement real deregulation, so that private investors put their savings and capital to work, by building new factories, new hospitals, and so forth.

For instance, agricultural land reform is key to the future prosperity of Japan. Why are the young fleeing the country side? Obviously, because Tokyo is such a sexy and exciting place, right? It’s also because the work in the countryside yields nothing. If you look at the money making opportunities for somebody to exploit the land that has become vacant, there aren’t any because of the distorted agricultural policy. It simply is uneconomic for any entrepreneur in the countryside to start a business. This is happening at a time when demand for Japanese food products is increasing on the world markets. With a deregulation push, Japanese agriculture could turn agriculture into a high-growth, high profit sector.

On the other hand, if Japan prints money to build bridges to nowhere, that would be negative because that won’t create wealth or sustained economic growth.

Beacon Reports: Where does the falling yen figure into the equation?

Jesper: Corporate Japan has a budgeted exchange rate of 79 dollar/yen and about 100 euro/yen. Today the dollar/yen is trading around 85 to 90 and euro/yen is trading between 115 and 120. Japanese corporations are smiling at these rates; They’re perfectly happy. The overall impact on the economy is positive because it gives some price power to Japanese corporations to pass on higher import costs during a period when demand for goods and services is rising. For that to happen, you need rising wages.

Now, if you had a continuing depreciation of the currency, eventually you would start to experience an income shock. Import prices would increase to the point where, net-net, it cuts the purchasing power of people. That would be inflationary. If that were to happen without a drop in unemployment and without wages increasing, then, of course, that would be negative.

Beacon Reports: In your recent article published in the ACCJ Journal entitled, “Welcome Back Optimists“, you point to a positive turn in Japan’s credit cycle. Can you elaborate on the upturn?

Jesper: Japan’s private sector stands out in having deleveraged over the past 20 years. One of its symptoms is that real estate prices, whether residential or commercial, de facto have been falling for the last 30 years. Over the last year we have experienced a modest pickup in bank credit creation, driven partly by the rebuilding (fukkatsu) of the disaster struck areas and partly by an increase in residential borrowing.

There is a younger generation of Japanese (the eco-boomers) borrowing money to buy and build homes located within 30 minutes of their workplace, rather than an hour and a half or two hours away. That’s a positive development.

The effect on Mr. and Mrs. Watanabe from this increased leveraging should be positive, assuming they don’t gear too highly. The result would be, for the first time in a generation, stable or increasing residential property prices that would lead to a feel-good factor. That would allow for a more confident outlook on the overall Japanese economy.

Beacon Reports: Will Abenomics succeed?

Jesper: At the end of the day, Abenomics is about creating an asset bubble economy.

To create a positive effect on the economy the dollar/yen foreign exchange rate must be between 85 – 95, net-net.

The Abe government must be able to push through structural reform through deregulation. Can the government take on the Agricultural or the Medical Association lobby? It gets interesting and we shall see whether Mr. Abe and his team will be able to deliver on that.

One question that remains is, will we or will we not get positive wealth effects through asset inflation, for instance, from a pickup in the residential property market? The residential property market is very important for the well-being of the average Japanese person. It is much more important than the Japanese stock market because home ownership in Japan is high and, unlike in the United States, there is no culture of owning stocks.

We need to watch for the real asset effect (shisan-koka) that will create an aggregate feel-good factor and an aggregate increase in wealth. The pickup in bank lending and particularly the pickup in mortgage demand makes me hopeful that that is indeed what’s going to become a supportive factor.

Jesper Koll is Managing Director and Head of Japanese Equity Research, JPMorgan Securities Japan Co., Ltd.