Japan cannot grow its national debt as a percentage of GDP indefinitely. At some point, if government deficit spending remains on its current path, the market will decide the debt cannot be repaid and will stop further buying. When and what might cause that to happen?
Former Goldman Sachs senior economist Takuji Okubo knows the future can never be foretold with absolute certainty. Still, he’s “pretty certain” that Japan will suffer a fiscal crisis – “2016 is a good candidate year,” he told me over lunch. That’s when he thinks Japan’s government will run out of buyers for its debt.
Okubo is the managing director and chief economist of Japan Macro Advisors Inc, a privately held Tokyo based boutique consultancy that provides industry and financial institutions with a source of independent advice on the direction of Japan’s economy. Neither he nor his firm stand to gain, I was personally assured, from a move in the markets caused by publication of this article.
As Okubo sees it, Japan will not be able to follow other advanced nations in the unwinding of asset purchases they have made by following unconventional monetary policies. Central banks of most developed countries have been buying large quantities of their own government securities with newly minted money to stimulate investment and growth. Japan is no exception.
Its unconventional policy, known as quantitative and qualitative easing, keeps interest charges on national debt in a manageable range. If asset purchases were to cease, especially during periods of rising interest rates abroad, a financial crisis might follow.
Okubo predicts the government will run out of buyers for Japanese Government Bonds (JGBs) sometime in 2016. According to Okubo, both the Bank of Japan (BOJ) and Japanese life insurance companies have absorbed 70% of the nation’s increased exposure to both short and long-term Japanese government bonds (Japanese Government Securities or JGSs) – over the past six years. “These two players have almost entirely been responsible for supporting the JGS market,” he says adding, “They are also reaching the end of their capacity to continue doing so.”
The BOJ increased their share of the JGS market from 9.4% in January 2012 to 23.2% in July of this year. Okubo estimates their share will continue to rise if the BOJ keeps to its current policy. While there is no technical limit to how many bonds the BOJ can buy, experts believe the market itself will lose confidence in the ability of the government to repay its debts once a certain red-line is crossed. Okubo believes that threshold is not far away.
Japan’s insurance companies too are reaching the end of their JGS buying spree. Over the past five years, they’ve expanded their JGS portfolio by over one-third while extending the duration – the average age to maturity of their holdings – from 7 to 12 years.
Further, new international regulations in Europe scheduled to come into effect in 2016 under the EU’s Solvency Directive (called Solvency II) may cause Japan’s insurance companies to ‘be prudent’. International consultants Ernst & Young believe that Japan’s insurance regulators will follow many or all Solvency II Directives when adopted (see report). To accommodate the new legislation, insurers will need to match the duration of their assets against their liabilities. Okubo says they will reach those targets before 2016. After that, he forecasts insurance companies will necessarily buy 50% less JGSs than they are at present.
Adding to potential troubles, the Federal Reserve Bank has slowly begun to taper its asset buys, putting upward pressure on U.S. interest rates. Okubo believes U.S. rates will start rising next year and the ECB may start raising rates too. That, he estimates, will further diminish demand for JGBs. “Dismayed by negative real yields in Japan, Japanese households and institutional asset managers will gradually reallocate their portfolios to higher yielding non-yen assets abroad,” says Okubo.
To stem capital flight, nations typically raise domestic interest rates. But that’s not possible here. Japan currently allocates a quarter of central government expenditure to service the nation’s debt. It also borrows half of the total expenditure to make ends meet. Any significant rise in rates would trigger a financial crisis. It’s a catch-22. “If interest rates rise in Japan, the country goes bankrupt,” says Okubo adding, “If the government tries to prevent rates from rising, the yen collapses.” Either way, Okubo believes a crisis in 2016 is likely.
Editor’s closing note: Other experts like Kyle Bass have made similar forecasts in recent years. Those who have shorted JGBs – dubbed the ‘widowmaker’ trade – based on their predictions have lost money. Still, Okubo’s thinking is noteworthy as Japan cannot continue to live above its means indefinitely. Either the nation will learn to live within its means through planned structural reform (much preferred) or markets will force it to do so either through debt default or more likely through inflation.
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