Less than four years ago, Greek and German credit default swaps were priced at roughly similar levels. Back then, investors did not consider a Greek default very likely – and then the market caught up with economic fundamentals.
In many ways, Japan is starting to look a lot like Greece, the PIIGS, France and the US of A....
The Asian nation has been adding debt at an accelerating pace over the past decade. In 2001, Japan’s debt-to-GDP ratio stood at 144 per cent. A decade later, it was 212 per cent – meaning that Japan is now far more indebted than Greece was at the worst point of the recent crisis, when Athens’ debt topped out at 165 per cent.
Japan’s debt burden is still expanding rapidly. We project the country will run a budget deficit of more than 9 per cent of GDP this year. This is a huge gap and will require even more borrowing. The Japanese government says that revenue from bond issues will account for 49 per cent of all government revenue in 2012 – a situation comparable to a family having to borrow half of the money it expects to spend over the next year.
Turning the situation around is difficult. Social security spending and debt repayments are projected to make up 53 per cent of Japan’s 2012 federal budget. Both areas are hard to cut, especially with an aging population.
Government is also tough to trim because Japan’s government spending is only 40 per cent of GDP, lower than in most industrialized nations. Thus, it is unlikely that Japan can, or will, implement austerity to reduce its deficit.
Demographics are the ultimate enemy. Japan’s birth rate is running below its death rate and so the country’s population is both aging and in structural decline. The National Institute of Population and Social Security Research estimated that Japan’s population will be 25 per cent smaller than it is now by 2050. More than 40 per cent of the population will be over 65 years old.
Over the long term, Japan’s economic growth is likely to be impaired because of its large debt and aging population. Anemic growth makes it difficult to grow out of debt. So, the debt cycle becomes reinforcing. More debt leads to slower growth, which leads to sticky deficits. If nothing changes, investors eventually lose confidence in the creditworthiness of a nation and a dramatic re-pricing of sovereign debt occurs, as we’ve seen in Greece, Portugal and Spain.
There are a number of reasons that Japanese sovereign debt may be re-priced sooner rather than later. The first is that Japan will have to refinance 24 per cent of its outstanding debt this year, an enormous amount that will test the limits of the market’s hunger for Japanese bonds. Second, Japan is shifting from a current account surplus to a current account deficit, which naturally reduces the appetite for Japanese bonds.
Finally, with Japan’s decision to shut down its nuclear power program, the country’s dependence on foreign energy is increasing. With a greater need to import larger amounts of high-priced foreign energy comes an increase in inflation expectations, which will make the current yield of 1 per cent on 10-year Japanese bonds unpalatable to investors.
The Japanese economy is wound so tightly from a debt perspective that even a marginal re-pricing of government debt could be the initial domino of a debt crisis.
Japanese philosopher Daisaku Ikeda once said, “A person, who no matter how desperate the situation, gives others hope, is a true leader.”
Given that Japan has had six prime ministers in the last six years, it is not clear that there are any true leaders left to avert this looming crisis.
Daryl G. Jones is director of research at Hedgeye Risk Management in New Haven, Conn.
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