J. Kyle Bass thinks the government of Japan has mismanaged its finances to breaking point. He says the country will be the first developed nation to experience financial meltdown. In an exclusive interview with Beacon Reports, Kyle explains why Japan has moved into a position of ‘checkmate’.
Kyle Bass is Managing Partner at Hayman Capital Management, LP. He is credited with having correctly predicted the subprime mortgage crash of 2007, and in doing so earning $500 million for his firm. The Financial Times recently reported that Kyle’s $1.5bn hedge fund has averaged after-fee returns of 25% a year since 2006.
Beacon Reports: Kyle, what’s your latest thinking?
Kyle: I believe that 20 years of pro-cyclicality has manifested itself in a low volatility Japanese Government Bond (JGB) environment. In human psychology, beliefs become axiomatic through repetition. Investors are now conditioned to move their assets to the safety of JGBs when things go wrong. That’s now changing because of the size of Abe’s and Kuroda’s aggressive monetary easing plan.
That plan, one of the three arrows in Abe’s growth strategy (called ‘Abenomics’), has the BOJ buying just over ¥60 trillion of new bonds each year for the next two years. It effectively doubles Japan’s monetary base. Considering the likely fiscal deficit for this year and next is running about ¥50 trillion each year, or close to 11% of GDP, I think the BOJ can only buy another 10 or ¥12 trillion of JGBs. I don’t think that cushion is going to be enough to monetize the entire fiscal deficit if they are going to be the buyer of last resort.
The key question is, will the BOJ be able to hang on to rates? I think they can in the near-term and I think they can’t in the medium to long-term. If investors holding JGBs actually believe that ‘Abenomics’ will work, then it creates a problem – the ‘Rational Investor Paradox’ – where investors rationally sell some of their JGBs because they are being told to expect negative real rates of return if the administration achieves its 2% CPI target.
Whether that means they sell some or all of them is up to the individual sellers. One bank sold more than 20% of its JGB ownership in the first quarter. If 5% of owners sell, that’s another ¥50 trillion. The reason you’re seeing so much bond market volatility, even though the BOJ is actively trying to keep a lid on rates, is that the BOJ is being overwhelmed by selling despite its large purchase program.
We’re seeing the problem because average duration of JGBs held by the three biggest city banks in Japan is only about 1.2 years. I think the banks are going to let their portfolios expire on maturity. The BOJ must try to hold the yield curve down. It has responded by saying that they’re going to try to implement a Japanese style Long-Term Refinancing Operation (LTRO) in which they would buy all JGBs with a duration of up to two years at a yield of 1/10 of 1%. In essence this equals a policy of unlimited monetary easing.
The point I’m trying to make is that the BOJ is trying to have their cake and eat it too. They’re saying, “Oh… this won’t be fully allotted and this will be open-ended.” But you can’t say that you are going hold down rates and buy everything within two years – and then in the next breath say it won’t involve open-ended purchases – because it’s going to have to.
I believe rates are going to go a lot higher if those owning JGBs believe in ‘Abenomics’. The key question is: Will the BOJ lose control over rates if yields are pushed up much higher? Will selling beget more selling? Will the people who own JGBs realize the government can’t finance itself should rates move up as much as they did in 2003?
Beacon Reports: Some people believe Japanese pension funds, banks and insurance companies are stable, captive investors in JGBs. Even if some investors did sell, their holdings would be bought by the BOJ, so yields at the short to medium end of the yield curve should remain stable. Why would investors panic and sell en masse, should rates move higher?
Kyle: That’s a good question.
You need to think about the different constituencies of ownership of JGBs. The largest buyers of JGBs over last 10 years have been (1) the Government Pension Investment Fund (GPIF), which is the largest pension fund in the world by assets; (2) the Japan Post Bank, which is the largest bank in the world by deposits; (3) the entire banking sector; and (4) the life and other insurance companies.
As for pension funds, whose liabilities are almost exclusive denominated in yen, you need to think about how pension funding works. What did the Madoff scheme teach you? Both pension funding and the Madoff scheme work as long as more people enter rather than exit their schemes.
The balance is now turning because of Japan’s fast aging and declining population, together with the country’s unwillingness to accept immigrants. Pension funds used to be one of the largest buyers and holders of JGBs. They are now net sellers, paying out more than they are bringing in. That’s a mechanistic reason for why they are selling. Also the banks in Japan went to a mark-to-market accounting regime as yields on JGBs headed lower. All the profitability generated by bond prices moving up has been recorded by the banks as operating profit. Now those bonds will reset at low levels. Any move in rates has become problematic for the banks.
Remember, Japanese banks in general have 900% of their tangible assets invested in JGBs that are the most negatively convex instrument you can put into a portfolio. Assume for instance that a bank holds a 10 year bond yielding 80 basis points. A 100 basis point move will cost the JGB investor about 10 years of expected interest payments.
Think about the psychology of all the players and financial implications if rates do move 100 basis points. Think about the solvency of a nation which currently spends 50% of its central government tax revenues on debt service, half of which earns the lowest yields of any country in the world.
You can’t look at this as a simple question. You need to think about this as a multivariate equation. You have to think about the incentives and the fears of all the participants. And you need to think about the fiscal sustainability of the government.
Beacon Reports: Jesper Koll, Managing Director and Head of Japanese Equity Research at JPMorgan Securities Japan, earlier this year told Beacon Reports, “If Japan were to get higher interest rates, then debt service costs should go up… but it’s not just a capital loss for the financial system. It is also a business gain because the banks… 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.” Does Jesper have it right?
Kyle: I think the person saying this is looking at the situation with Panglossian spectacles. That statement would ring true absent the debt stock the country is carrying. What I mean by that is, if your debts are more than 24 times the central government tax revenues and interests rates move higher, your expenses will move exponentially while your revenues will move in a linear fashion.
A move up in interest rates is so complex that it’s impossible to make a blanket statement that things are going to be better − that the banks will be able to charge higher rates of interest. A move up in rates is going to decimate the banks given that the debt stock is so large and now represents such a large percentage of the bank’s tangible assets.
As for net private sector savings, should domestic rates move higher quickly, it is going to be problematic for both banks and brokerage companies. You have to think about the psyche of the people − they must determine whether the debt can ever be repaid, should the BOJ continue their purchases.
I ran a survey of 1,009 Japanese investors where we asked: “If rates were to move up 100 basis points, would that engender more confidence and make you want to buy more JGBs?” or, “Would you take your money elsewhere, even if it were hamstringing your government’s ability to operate?” 8 – 9% of respondents that said that they would buy more bonds and almost 80% said they would run, not walk the other way.
Beacon Reports: Is there a place for such a huge amount of Japanese money to flee to?”
Kyle: Is that really a question?
Beacon Reports: That is really a question.
Kyle: Do you believe that bond holders would just stay in JGBs? Here’s what you need to think about: Abe is encouraging the GPIF to buy fewer bonds and to allocate more of their assets into equities globally because it is underweight equities compared to pension funds elsewhere…..
Beacon Reports: Are you suggesting bond holders will move their money overseas?
Kyle: Yes. There are more solvent governments overseas. They have higher yields. The Abe administration is saying they’re going to weaken the yen. It may not be their primary policy because, as a central bank, weakening your currency can’t ever be your primary policy. But it can be a second or third derivative of one of your policies – which clearly it is.
If your government’s bonds offer the lowest yields in the world and policymakers are going to materially devalue your currency, then you are going to seek higher nominal yields elsewhere. The government will face a paradox. What I’m telling you is − I don’t think there’s any way out.
Beacon Reports: Japan is not Greece. It is a rich developed nation. The Japanese are educated, organized and hard working. The country’s infrastructure – roads, buildings, bridges, factories, trains – are in better shape than most other developed nations. A shinkansen departs every ten minutes and they run on time. The country enjoys reserve currency status. Why should Japan be the first developed nation to mark the beginning of the end of the 70-year debt supercycle?
Kyle: You need to divorce yourself from preconceived ideas. I’ve never met a more gentle, considerate, welcoming, thoughtful, or spiritual population in any other country in my lifetime. Japan is a beautiful country and its people are great. That’s beside the point. The point is the government has mismanaged its finances to an extent where they have moved the country into a checkmate.
The reason why Japan is going to be first is that they spend 50% of their central government tax revenue on debt service alone. They are near the point where they just can’t borrow anymore. Further, the Japanese would rather not admit wrongdoing: They never restructured their banks during the post late 80s – early 90s collapse. They’ve taken rates to zero. Their economy has continued to move along for the past 10 – 15 years because it was export based. That’s changed − there is nowhere to go.
Japan’s trade surplus is negative. The balance of trade is negative. The current account is moving into a negative position. The demography of the country is unstoppably rolling over. It’s a multivariate equation in which everything is working against the government at the same time. Kuroda and Abe have only one way to go – and that’s to go all in – which is what they did.
Beacon Reports: Do not your predictions discount the possibility that the 3rd arrow of Abe’s growth strategy – structural reform – will succeed? Do you believe that arrow, which will not be fully defined until after the July 21 Upper House elections, is going to be toothless?
To put that question into context, Japan is a consensus seeking society. Change takes longer than in other developed nations. Unquoted politicians and members of the Industrial Competitiveness Council (ICC) are now saying: “This is Japan’s last chance.” Perhaps they have heard your predictions. They’ve seen the spike in 10 year yields and will now drive through needed structural reforms – although 24 years late. Does not the global investment world see Japan’s productivity gap as an opportunity? Does not the 3rd arrow count?
Kyle: Yes, the third arrow counts. Structural reform is going to be important. Getting women and the elderly back into the workforce, for instance, is going to be important to Japan’s long-term health. Those and others are great reforms. I just think the incremental manner in which they are being implemented is consensus driven. Japan is not going to be able to do enough to overcome the enormity of the debt problem in such a short period of time. There is a duration mismatch in the way reforms are thought about and implemented vis-à-vis the enormity of the problem that is staring them in the face right now.
Beacon Reports: What will trigger the panic?
Kyle: Global developed country monetary instability would be a trigger. Cost-push inflation fears is another. I think that will evidence itself in the forward swaps market. I would pay close attention to the forward curve and the expectations of the forward curve. We use them regularly at our firm.
Where does Kyle Bass think Beacon Report’s readers should be investing their own capital? Read Kyle Bass’s Investment Advice For Residents (and Non-Residents) of Japan by clicking here.
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