Beacon Reports recently interviewed leading commentators on Japan’s economy, including Hayman Capital’s Kyle Bass, JP Morgan’s Jesper Koll and The Oriental Economist’s Richard Katz. All are concerned Japan could become a net deficit nation. Some believe it already is. Should capital markets believe Japan cannot repay its public debt, now amounting to almost 240% of GDP, Japan could go the way of Greece. To get another perspective, Beacon Reports spoke to former Bank of Japan insider Tetsuya Inoue.
Tetsuya Inoue worked at the BOJ for 23 years where he rotated in and out of different roles. He was an executive staff member of the BOJ’s Policy Board between 2000 and 2003. Before that he was the assistant to BOJ Deputy Governor Toshihiko Fukui. Inoue left the BOJ in 2008 to join Nomura Research Institute as its General Manager and Chief Researcher. NRI is a publicly listed ‘think tank’ focused on Japan’s economy.
Beacon Reports: Inoue-sensei, Japan suffered its largest trade deficit ever in January 2014 and its current account has slipped into deficit. Is Japan now a chronic deficit nation?
Inoue: No, not yet. I suspect that will take 5 to 10 years.
Many economists are paying close attention to the current account. If Japan fell into structural current account deficit, the country would become more dependent on overseas capital. The Ministry of Finance would then need to attract overseas investors to buy Japanese government bonds (JGBs) to finance the ongoing deficit.
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The current account is important because it reflects imbalances within the domestic economy. It is determined in the long run by the difference between investment and savings. Japan has an aging society that results in a continuous decreasing trend in the savings rate. In addition, managers of Japanese corporations are increasingly reluctant to invest domestically because of Japan’s diminishing economic prospects. In the long run, I believe savings will decline faster than investments. The difference will need to be financed by capital flows into Japan from overseas markets in an amount equal, by definition, to the current account deficit. Therefore, the current account could destabilize in the long run.
The current account is the sum of the trade account (Japan’s exports less its imports) plus the income earned on Japan’s overseas assets. The income account is stable because most income producing foreign assets are the result of previous overseas investments. The trade account however, will continue to be in deficit as part of a continuing cyclic story. Two factors influence the trade account in the short term:
First, Japan needs to import fossil fuels from overseas markets because the country has yet to restart its nuclear power plants following the Fukushima Daiichi nuclear disaster of March 2011. However, if there is slow economic expansion, especially in emerging markets, fossil fuel prices may stabilize or decline. That could help to stabilize the aggregate amount of Japan’s imports.
The second variable is exports. Some people are concerned that Japan’s products are losing competitiveness in export markets. I think differently. After the Lehman shock, the yen appreciated. Many Japanese corporations moved their production overseas. Therefore, the recent yen devaluation had less of a positive impact on Japan exports. Some Japanese firms might transfer production back to Japan if the yen/dollar exchange rate remains between 100 and 105. This may take time, but eventually Japan exports would increase.
Beacon Reports: Some economists believe Japan’s $2.9 trillion of net overseas assets, equal to about 55% of GDP, represent a cushion against capital flight, should Japan’s twin deficits (budget and current account) prove systemic. Which forms do Japan’s net overseas assets take and do you believe they offer true protection?
Inoue: About $1.3 trillion of the $2.9 trillion in net overseas assets are official exchange reserves held by the Ministry of Finance. The rest is owned by the Japanese public, pension funds, insurance companies and so forth. It is comprised mostly of financial assets, especially US Treasuries. Some are held as UK Gilts as well as the sovereign debt of other developed nations.
If there is a financial crisis, stocks and bonds could be easily liquidated to try to contain it. Other assets, such as overseas real estate, would be harder to liquidate. The Japanese government could also, in theory, issue an ordinance to nationalize overseas assets held by private investors to try to contain it, as did certain Latin American countries during the debt crisis of the 1980s.
In the end, I don’t believe the ¥2.9 trillion in net overseas assets will be enough to sustain the market for a sufficient duration of time. That’s because the average daily turnover of yen/dollar in the foreign exchange markets is about ¥600 billion. If you recall, George Soros successfully attacked the pound sterling in 1992. Everyone in the market was astonished to find that major currencies could be attacked. The Bank of England effectively used up all their foreign exchange reserves in only several business days defending the pound. Even if our foreign exchange reserves were much larger, they could easily be used up trying to stabilize the exchange rate. Therefore Japan’s foreign exchange reserves would only ‘buy time’.
Beacon Reports: What’s your assessment of Abenomics? Some people are concerned the Abe administration has bowed to vested interests. They note that Trans-Pacific Partnership (TPP) talks have stalled. They believe the third arrow, meant to drive economic growth through structural reforms, may fail. What’s your opinion?
Inoue: PM Abe’s first arrow under Abenomics – qualitative and quantitative easing – is on track. The BOJ’s Governor Kuroda committed last year to doubling the size of the government’s balance sheet from ¥158 trillion to ¥290 trillion by the end of 2014. The BOJ is doing this mostly by buying JGBs from the market. It has successfully stabilized the JGB market.
The second arrow, a fiscal stimulus package, is larger than 2% of GDP. Part of that includes a ¥5 trillion economic stimulus designed to neutralize the near-term impact of the first-round hike in the consumption tax. Thanks to that, the Japanese economy grew rapidly last year by over 3%. These measures however, only ‘buy time’.
The third arrow of structural reform was outlined in the government’s statement of June 2013. It contained some useful measures to stimulate the domestic economy. Overseas observers were disappointed however, because the statement failed to paint a wider picture of the economic society that the Administration wished to build.
The delay in TPP talks was also disappointing. I expected that TPP would trigger meaningful discussions of domestic reform on issues ranging from immigration to agriculture. It is hard to know what the bureaucrats are currently discussing in private. Hopefully, the government will introduce more reforms and fill in the wider picture this coming June when the Administration releases their next statement.
Beacon Reports: Capital markets are watching for signs of real wage inflation in the Japanese economy. They argue that when wages are rising people will spend more, which is good for growth and financial stability. Is Japan on the road to real wage inflation?
Inoue: That’s a tough question. From the short-term perspective, wage inflation is necessary to achieve the BOJ’s 2% inflation target. Some inflation is helpful to the Ministry of Finance as it reduces the large nominal fiscal deficits it has suffered. But we need to travel a delicate and narrow path. Raising wages too quickly could increase the operating costs of Japanese companies. It could further destabilize their competitiveness in global markets.
Beacon Reports: Are we nearing a Kyle Bass moment?
Inoue: There is no immediate concern of financial instability. Despite expanding outstanding public debt, coupon rates on new JGB issuances have stabilized. Currently, about 22% of government tax revenue is spent on servicing the national debt. The weighted average coupon rate on the total outstanding debt is around 1.2%. 10-year JGB yields are around .7%.
However, the projected growth rate of Japan’s economy is too low. The private sector institutions, economists and policymakers agree the country could grow at the rate of about 1 1/2 to 2% in the coming years. That is not enough to reduce public debt to acceptable levels. So we have a tricky situation.
Longer term, we need to reduce the budget deficit and maintain stability of the JGB market. This will be crucial for the future of the Japanese economy. It will not be an easy task and it will take some time. As we have seen in the US, the UK and some other European countries, recording a current account deficit does not trigger a crisis as long as investors have confidence in their nation’s economic policies.
If Japan becomes a chronic deficit nation, the Japanese government could still do something to persuade overseas investors to keep their investments in JGBs. For instance, they could more strongly push through structural reforms to accelerate economic growth and/or employ strategies for fiscal consolidation. That would be absolutely necessary to prevent capital flight by overseas investors.
It is important to note that 93% of the JGB market is still dominated by domestic investors. This has mixed implications. On the one hand it works to stabilize the JGB market. On the other hand domestic institutional investors, banks and so forth, privately collaborate to ensure the stability of the market. So there is no one person or voice to send an early warning message of impending crisis.
That could negatively impact Japan’s financial system as happened to Southern European countries during the period 2010 – 2011. We could proceed to the edge… and fall off. We can’t let that happen.
Publisher’s note: Those who believe a financial crisis is imminent might wish to review the protective measures proposed by Kyle Bass which appeared in the June 14th, 2013 edition of Beacon Reports. You can read Kyle’s advice here. In future editions of Beacon Reports we intend to provide expanded commentary on Japan’s economy by offering a wider selection of views from thought leaders in the field. Stay tuned….
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It’s remarkable how little Tetsuya Inoue disagrees with Kyle Bass. The big difference is that Inoue thinks preparation for structural reform (“nemawashi”) is going on behind the scenes, and he hopes / believes the major institutions can hold things together long enough for these reforms to make a difference.
But even Inoue acknowledges Japan must walk a “delicate and narrow path”. And there’s one serious problem he only mentions indirectly.
Inoue acknowledges the problem of major economic institutions colluding to muffle the warning signs. (Which would be a remarkable admission in the West!) But he doesn’t state why that’s such a problem. Without a sense of impending economic crisis, nobody’s going to move against vested interests, and the structural reforms won’t happen.
A “Kyle Bass moment”?!? Are you serious? I thought the “widowmaker” trade died a while ago (for good reason). Has anything Kyle predicted about Japan over the many years ever come true?
I’d ask Kyle: How can Japan collapse or default from its fiscal debt when its obligations are basically all in yen….and Japan is the one who issues all that yen!
Quick response to Geoff Botting:
50% of taxes are now spent on servicing debt, and that figure continues to grow as the government continues to run a huge deficit. If you think that’s sustainable, I’ll leave you to your dream world.
As you say, the government can always print more yen, but in real terms, those newly printed yen will be worth a fraction of what creditors are expecting to receive. In other words, Mrs. Watanabe is going to be very unhappy when prices go up, and she sees just how little her pension can buy her.
Simple math and demographics tell us that a lot of people are going to be a lot poorer than they expect.
Kyle Bass is just sketching out a few of the details.
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Sorry, that should have been 25% of taxes, not 50%. And apologies for any offence I caused with my “dream world” remark.
Many thanks to Richard Solomon for pointing out the error before allowing the comment to be published.
As for the payments to service the debt, who gets the money? When the moneys goes into the private sector, it’s recorded as income, when it goes to the public sector, it becomes revenue. Among the biggest holders of JGBs are the pension fund and bank and post office savings, so a lot of the payments end up…back in the hands of Japanese citizens, many of them retirees who will spend it in Japan. The money doesn’t really exit the system.
As for the yen becoming devalued….well, it hasn’t, even after 14 years of QE and ballooning debt. Compare the merchandise sold in a “100 yen shop” 15 years ago to now. Your 100 yen actually buys a lot more now than ever. In fact, the yen remains the one of the hardest, most stable currencies in the world.
I agree people are going to be poorer, but that’s true of all the developed countries. The era of high growth is over for us. But that’s due to globalization, not BOJ policy.