Monday, January 31, 2011

Why Japan's Debt Is A Non-Issue

On January 27, 2011, S&P lowered Japan's long-term sovereign debt rating for the first time in nine years to AA- from AA. According to S&P, the government "lacks a coherent strategy" to tackle Japan's debt load, which could lead government debt ratios to peak only in the mid-2020s. Japan's gross-public-debt-to-GDP ratio, which was 189.3% in 2009, is the highest among developed economies.

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Though a sovereign debt crisis like that of Greece is not imminent, without increasing the national tax burden—which is relatively low compared to other major economies—Japan will not be able to sustain public spending without incurring more debt. Japan's aging population and underfunded pensions exacerbate this burden. Issuing more debt to finance public expenditures is easier for Japan compared to other European countries with high debt because Japan benefits from low debt-servicing costs in part due to chronic deflation. Unlike Greece, Japan maintains a current account surplus and a net foreign asset position. Locals hold around 95% of Japan's debt, whereas foreigners hold more than three-quarters of Greece's debt.

Unless proposed expenditures are minimized, Prime Minister Naoto Kan’s administration will struggle to fund its 2011 budget without reneging on its JPY44-trillion cap on new bond issuance. Tax revenue will fall alongside corporate profits and personal income. Since Kan’s aggressive advocacy of a consumption tax hike cost his party the Upper House, plans for the hike are likely to be shelved. A corporate tax cut remains under consideration, but budget deficits will be hard to shake off without a corresponding increase in revenue elsewhere.


S&P estimated (according to its January 27, 2011, note "Ratings On Japan Lowered To 'AA-'; Outlook Stable") that Japan's government fiscal deficits will decline from an estimated 9.1% of GDP in FY2011 (ending March 31, 2011) to 8.0% in FY2013. Unless the government undertakes a fiscal consolidation program, S&P does not foresee Japan achieving a primary external balance before 2020.


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Japan's Cabinet Office estimated that the primary fiscal deficit, which excludes debt-servicing costs, will total JPY21.7 trillion in FY2015, 4.2% of GDP. In FY2020, Japan is estimated to post a primary budget deficit of JPY23.2 trillion, or 4.2% of nominal GDP. If real GDP grows more than 2% each year, Japan's primary balance deficit would be 3.2% of nominal GDP in FY2015 and 2.5% in FY2020.

The OECD forecasts that Japan's gross public debt will exceed 200% of GDP in 2011. In order to halve the primary budget deficit by 2015, the OECD maintains that additional tax revenue need to be generated and that the BoJ should "should implement more ambitious quantitative easing measures to relax monetary conditions in the face of entrenched deflation and maintain such policies until underlying inflation is significantly positive."

Japan’s long-term public debt has risen to JPY862 trillion (US$9.26 trillion), nearly 200% of the nation’s 2009 gross domestic product. Japan’s debt was 189.3% of GDP in 2009 and is projected to grow to 204.3 % in 2011.On January 18, 2011, credit-default swaps (CDS) used to protect payment of Japanese government debt, hit a six-month high and climbed to 86.49 bps. This means that it costs $86,490 to insure $10 million in Japanese debt. CDS for U.S. debt were 49.85 bp.




Why The Debt Is "Manageable"

The financing of Japan’s public sector debt is currently enjoying an extremely virtuous confluence of events—the strong home bias of domestic investors, ample domestic savings, and modest deflation. As long as these persist, financing the public sector debt should not be problematic...In the near term, it seems likely that the three conditions that have eased the financing of Japan’s public debt will persist.

While JGB market participants believe Japan occupies the worst fiscal position in the world, the nation's fiscal problems can still be rectified with tax hikes. The basis for this optimism appears to lie in Japan's low social contribution rate, one of the lowest in the world at 39%. A social contribution rate of 52.3%, a rate on par with European nations, would be sufficient to cover recent fiscal deficits.

In addition, the JGB market seems to have concluded that the Japanese government can fiscally consolidate because the there is room to raise the consumption tax rate, currently the lowest in the world at 5%.

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Despite the high level of government indebtedness, the budgetary burden of servicing debt interest is not especially high as a share of GDP and revenue, especially once account is taken of the relatively low tax/GDP ratio. This reflects the fact that interest rates on government borrowing remain low in nominal and real terms.

Currency and deposits make up over 55% of assets for Japanese households. Compared to just 14.3% in America. This represents about US$8.9 trillion in savings that could potentially be mobilized to support the Japanese government debt. Americans by contrast, hold a far greater amount of their wealth in the stock market. U.S. households have over 30% of their assets in shares and equities. As opposed to just 6.6% in Japan. Japanese household savings are over 100% of outstanding government debt. With the American government now sitting $12.7 trillion in the red, household savings are only at 50% of debt.


Japan is better placed than either the U.S. or the UK. This is partly because the debt problem is frequently overstated, as net debt is only about half the gross level, but also because the switch from investment, financed by untaxed depreciation, into incomes and spending which are taxed twice, will mean that tax revenue should rise rapidly with recovery.

The Japanese private sector remains in a position of net creditor, offsetting the government's position as a borrower, not to mention that more than 95% of Japanese debt is still held by Japanese investors.
Unless the private Japanese investors switches out of the deposits, or dumps the yen in favour of other currencies, or start selling bonds in droves - I do not see this being a grave issue. Its not good but its not catastrophic.

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Thats the sad part, Japan sorely needs a huge whack on the head for them to reform their economy and finances, but that is not likely to happen. So the Japanese economy will meander like a an old man but not showing any signs of dying anytime soon.


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