By Victor Shvets of Macquarie Capital
Japan Debt Mountain: does it matter?
For almost 25 years, Japan’s debt burden has been the poster child of what would happen to others if capital is misallocated, bubbles burst and then clearance and required reforms are either delayed or not implemented. Indeed, at more than 5x GDP, Japan is shouldering a greater debt burden than other key jurisdictions. It is also facing severe demographic challenges, while its labour market remains constrained and the state maintains a sway over the private sector. Since WW II, Japan has always been more statist than most other major economies, with Korea and China subsequently following Japan in developing a similar model. The conventional argument has been that Japan’s debt would ultimately crush its economy and severely crimp public sector spending, while the private sector would be unable to adjust, and hence lose competitiveness. Eventually, the private sector might lose confidence and stop repatriating cash and the country would then suffer from massive capital outflows.
Not only were these dire projections wrong for decades, but as the rest of the world joined Japan in secular stagnation and unorthodox monetary policies, it is no longer perceived as an exception but rather as a pointer to the future. Japan’s success in navigating disruption, deep financialization and permanent overcapacity is now studied and imitated. While there are local nuances, Japan shows the way forward. QEs associated with the Fed were invented in Japan more than a decade earlier. The same applies to fiscal stimuli, collapsing velocity of money and strong disinflation. Whatever are the policies, Japan has already tried them. Japan is far more advanced in fully monetizing its debt by utilizing multiple asset classes, from bonds to equities. It also accepts that normalization is not feasible, and unlike the Fed, it has no illusions that rates could ever rise or that immigration and deep labour market reforms are either possible or desirable. When the US is focusing on returning outdated factories, Japan is building for the future, when labour inputs would no longer be the key.
Although Japan’s cultural and labour market constraints reduce its ability to fully commercialize inventions, it has not prevented the country from maintaining its rating as the most complex economy in the world, while keeping leadership in patents and yielding above-average labour and multi-factor productivity. Japan’s stagnant domestic economy is overshadowed by its competitive externally-facing sectors that are becoming complementary rather than directly competing against China. Even financial repression that Japan practised for decades is becoming a global norm, nowhere more so than in Eurozone. We expect BoJ to quietly abandon its inflation targets while maintaining flexibility in asset acquisitions to keep cost of finance close to zero. This would be a recipe for continuing twilight for years to come, with debt burden neither derailing the economy nor financial markets, even as BoJ assets rise beyond 100% of GDP (~45%+ of JGBs).
Assuming that Abenomics is dead and that there is neither desire nor capacity to lift inflationary outcomes, then it would be positive for ¥. Higher ¥ would erode Topix’s ROEs (corporate governance is unlikely to offset lower returns) but it should also highlight the strength of its globally competitive and thematic plays. In our global portfolios we currently have Yaskawa, Fanuc, Mitsubishi Electric, Nintendo, Nidec, Murata, Keyence, Tokyo Electron and Yamaha. Any further ¥ appreciation should also reduce pressure on Korea and China while extending EM reflationary cycle and its investment ‘goldilocks’.
Why is Debt Mountain not crushing Japan?
“We know that advanced economies with stable governments that borrow in their own currency are capable of running up very high levels of debt without crisis.”
— Paul Krugman
This quote by Paul Krugman neatly encapsulates the main reasons as to why Japan has not been crushed by ever-rising public sector debt. Japan is state with a high degree of credibility and it borrows almost exclusively in its own currency, with debt owned predominantly by its own citizens. Financial crisis is all about perception rather than reality.
However, one issue that Krugman has not emphasized but which is increasingly important is the ability of central banks (CBs) to support and distort the governments’ cost of funds. Given that the CBs are not economic agents, their bids and bond acquisitions are not designed to discover appropriate pricing levels, but rather to support governments’ objectives (usually to simulate economies by lowering cost of capital). In the past, such aggressive interventionist policies were unique and infrequent events (accompanying wars or other major dislocations), but over the last two decades, they have become an increasingly acceptable tool in the governments’ armoury. Japan has been leading from the front for more than two decades, followed by the rest of the world after GFC.
Thus, there are essentially four reasons as to why most bets against Japan failed on a consistent basis:
- Japan is a homogeneous society, with relatively egalitarian income and wealth distribution, and hence, pain has been shared fairly evenly, thus preserving economic and societal coherence.
- Japan maintained credibility by selectively boosting and adjusting national commitments to elderly and medical care while irregularly pushing up consumption tax. Although some of these measures were counter-productive on a longer-term basis, they have placated global markets.
- Japan borrows in its own currency and the bulk of JGB holders are Japanese residents (over 88%). This massively reduces the degree of external vulnerability.
- BoJ has been exceptionally aggressive in driving money supply up and cost of capital down. This aggressiveness coincided with the growing global disinflationary trend, which eroded bond yields and significantly reduced the proportion of the government spending that is spent financing interest commitments.
As can be seen below, despite massive rise in the governments’ gross and net debt burden, the proportion of state spending that is dedicated to servicing interest has declined significantly over the last decade and is now below 5% of total expenditure.
The extent to which BoJ has become the key to Japan’s perceived longer-term sustainability can be seen from the explosion of its balance sheet and how its asset base increased at a pace much faster than state requirements. BoJ has by now accumulated almost 45% of the entire JGB’s market (vs 10% only five years ago), and its balance sheet is rapidly closing on 100% of the country’s GDP (vs 37% G4 average). Also, BoJ is not just buying state paper but it has become actively involved in the corporate and ETF (equities) markets. BoJ already controls 75% of all of Japanese ETFs (although only 4% of overall equities) and as much as 15% of the Japanese corporate bonds.
The public sector over the last two decades did not really have an option but to become far more aggressive in transferring excess debt from private sector and onto government books. While this private sector de-leveraging was largely complete by 2005, the combination of GFC as well as subsequent earthquake (2011), continued to suppress private sector desire for more aggressive spending. Private sector sectoral savings even today remain at ~6% of GDP, whilst velocity of money is at best only stabilizing.
If public sector did not step in, the country would have undergone a massive and uncontrolled deflationary bust. Instead, Japan had simply kept its nominal demand intact, despite the private sector sustaining losses (real estate and equities) of equivalent to 100% of Japan’s GDP in ‘90/91 (or ~US$5 trillion). For perspective, consider that the GFC caused initial contraction of only around 1/3 of the US GDP. In other words, bursting of an asset bubble in the ‘90s Japan was at least three times more powerful than the GFC’s impact.
The net outcome of aggressive public sector policies offsetting sluggish and deleveraging private sectors was a ‘tranquil autumn’ of a civilized relative decline.
The Japanese economy is today a fraction of its importance several decades ago. Whereas in the late ‘80s, Japan was responsible for ~10% of global merchandise exports, its share is now below 3.8%. In the same period, Germany’s share eased from 10%-11% in ‘80s to around 8%, while the US’s share is down from 12% to ~9% and France’s share is down from 5% in the ‘80s to ~3%. The same occurred to Japan’s share of global GDP (whether on a nominal or PPP basis). The growth rates have compressed massively, but the country managed to maintain its overall aggregate demand and per capita income intact.
Japan emerged from this traumatic experience, as land of no inflation (indeed mild deflation for most of the time) and steady demand funded by the fiscal stimulus and resilient private sector productivity.
It has become a land where the central bank has been effectively cancelling national debt by acquiring more securities than the government needed to fund its deficits. While this poses many questions (such as ability of life and insurance companies to price their products, in the absence of a viable JGB market), it also implies that Japan is shifting closer to embracing far more extreme (but necessary) policies, such as minimum income guarantees and abandoning any further consumption taxes.
In the world where labour inputs are becoming increasingly less relevant and where robotics, automation, AI and social capital are likely to play an increasingly important role, even the traditional argument of a negative impact of demographics no longer dooms Japan to oblivion and collapse. It also implies that the conventional arguments in favour of large-scale increase in immigration is not only irrelevant but is likely to be faulty on both theoretical and practical grounds. It is likely that the current age of ‘declining return on humans and conventional capital’ will become far more pronounced over the next decade. It so happens that Japan is in the forefront of this evolution.
It is highly unlikely that Japan would ever accept large-scale immigration (whether it applies to high or low skill labour). It is equally unlikely that the Japanese themselves would ever prefer to work and live in foreign jurisdictions. At the same time, the pace of human replacement (whether it is waiters in the restaurants or nurses in hospitals) is accelerating in Japan at a far more robust pace than elsewhere. The unique nature of Japan is also translating into sustainably high levels of private sector productivity while containing income and wealth inequalities. Although Japan is today more unequal than it was in late 1980s-early 1990s, it still remains one of the most egalitarian societies in the world.
While Japan is yet reluctant to accept the most radical of policies, it is far more advanced in fully monetizing its debt burden and unlike most other countries it no longer requires an ever accelerating pace of financialization (or addition of new debt-driven generations). The objective in Japan is to maintain per capita income rather than generating growth to accommodate a rising population and keeping society intact. The extent to which Japan would be able to achieve this objective would depend critically on Japanese corporates and its overall economy maintaining productivity gains.
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In part 2 tomorrow: "Global lessons from Japan - the future is Red"