"Aja" was the first album for me that offered an optimistic feel about being alive. Not many albums have influenced us as much as "Aja." Fagen and Becker created a most unique flavor of Jazz, beautiful melodies, genius production and perfect performance blend to produce a masterpiece.
"I cried when I wrote this song, sue me if I play too long" This infamous lyric, out of Deacon Blues, typifies the Aja project. Having already achieved everything they wanted to accomplish in the public eye, The Dan started writing the music that was in their hearts. This was the beginning of a new era for Donald Fagan.
Simply one of the best albums ever. I've had the album since I was a kid and I never get tired of the music. Fusion jazz at it's finest. Thanks Donald Fagan. You to Walter B!!
As noted in the first part of this series on Japan’s looming debt crisis, the economic consequences of Japan’s aging population are just beginning to manifest themselves, and dissaving — the act of spending down your life savings — isn’t the only problem that arises. Social and health care spending also accelerate, often placing greater and greater burdens on the government. For example, social security spending in Japan has leapt from 19.7% of the federal budget to more than 31% in the past decade (between 2000 and 2011), according to Japan’s Ministry of Finance. Already, social spending and national debt service costs are causing the federal budget deficit to grow to unwieldy heights and are clearly threatening the cash flow model that has enabled Japan’s rates to stay so low.
All of this raises the question: With a funding deficit virtually exploding in Japan right now, can the event horizon for a debt crisis be that far off?
Should the Japanese government move to curb social security benefits, it will only accelerate the need for households to fund more of their own retirement living and health care expenses, exacerbating the dissavings that has already begun among households. Of course, there are some positive changes which offset the negatives to a degree. A shrinking population also reduces the levels of infrastructure investment and capital formation required, so national savings are enhanced. Nevertheless, the inherent pressures of rising social security costs and rising debt and debt-service costs will require the Japanese workforce to work harder simply to maintain the status quo — in which the fiscal deficit is already 11% of GDP, as noted in Figure 1. If Japan’s current economic model is left unchanged, the fiscal deficit would skyrocket toward 20% of GDP over the next several years. And remember, there are no free lunches. Any cuts in Japan’s federal budget will have consequences elsewhere.
Figure 1: Japanese Government Revenues vs. Expenditures
Sources: Ministry of Finance, CFA Institute.
The crown jewel in Japan’s virtuous cash flow cycle of the past 22 years is its large foreign currency holdings. Due to the many years of trade surpluses, Japan’s corporations maintain vast sums of corporate savings denominated in foreign currencies. These foreign currency holdings generate substantial amounts of investment income each year. However, the control of these vast sums is concentrated in a few hands. Likewise, the bond market (and hence, interest rates) is controlled by many of these same hands. And because bonds are priced in a market, if and when the managers of this capital decide to sell, they can cause a stampede for the exit.
Moreover, what happens to the yen exchange rate if and when this capital is repatriated? Stewards of these foreign currency portfolios sell foreign currencies and buy yen — driving up the value of the yen — and worsening the competitiveness of Japanese exports. Unlike China, which uses its large foreign currency holdings to buy commodities and foreign manufacturers to control strategic assets, Japan is shrinking, so it needs little for growth. While Japan could benefit from the purchase of natural resources and other raw materials which it currently imports, its opportunity set is more limited. The greatest growth industry in Japan right now is perhaps health care, but health care is delivered locally. What strategic value could be gleaned by owning hospitals in say Vietnam or Europe? Consequently, there are limits to the strategic benefits that portfolio allocation could offer Japan.
Already, these corporate investors and banks, in particular, are becoming increasingly concerned about maintaining the status quo. Their ability and willingness are being directly challenged by the escalation of national debt service, the expansion of fiscal deficits, and the ramifications of the Fukushima disaster, as well as the current pressure on the yen exchange rate. Already, Japan’s debt service is 23% of GDP, with interest rates at 1%. What happens if and when rates rise? In short, debt service would explode and crowd out huge portions of the federal budget, as illustrated in Figure 2.
Figure 2: Japanese Debt Service and Rates: What Happens Next?
Sources: Ministry of Finance, Bank of Japan, and CFA Institute.
So, what causes rates to rise? Rates rise when the market senses a paradigm shift. Perhaps first is what corporate asset managers decide to do. Second, the general dissaving that is spawned by aging will reduce aggregate demand at a time when aggregate supply is increasing. Third, a stronger yen means fewer exports and, furthermore, the shift in energy policy after the Fukushima disaster means a downward structural shift in the current account balance. Not only does aging impact federal budgets, but it also puts downward pressure on GDP as described in Part 1. Only now, the funding surplus has become a funding deficit and the required monetization of debt is increasingly likely to lead to some inflation (although it is partly offset by the deflationary impacts of a shrinking population).
Now the bond market in Japan is well aware of how the game is played. Of course, the Bank of Japan plays a key role in all of this – in part by buying JGB’s when demand is weak, and in part by cajoling these same financial institutions to purchase JGB’s. With the tools of regulation at their backs, the BOJ does indeed wield much power. What the bond market is perhaps missing are the ongoing incremental changes that have accumulated over 22 years. Such a consistent message to the market establishes a strong belief among market participants. It’s when this belief begins to change that rates will change. So, are beliefs changing? On the margin, banks are showing more reluctance to increasing their exposure to JGB’s. And on balance, the funding deficit is becoming a large problem, changing the very economic model that has enabled Japan for so long. These changes will place increasing pressure on the BOJ to keep the status quo alive and somehow prevent the market from realizing the game has changed. Bank of Japan Governor Masaaki Shirakawa truly has the challenge of a lifetime to keep it all together.
Some have argued that Japan can ameliorate its budget shortfall by raising tax rates. In economics, there are no grand solutions, only trade-offs. So, it is a fallacy to think that increasing tax rates necessarily increases tax revenues to the government. Many governments and countries have tried raising tax rates and failed to increase tax revenues either due to tax avoidance or damage to economic growth (or both). Japan is currently considering a number of measures to increase taxes (including a proposal to double the national sales tax, from 5% to 10%), but it is not at all clear that these measures will grow the overall tax revenues to the federal government because of various trade-offs across the global economy. And Japan’s funding model is vulnerable to changes in behavior that emanate from changes in tax policy. For instance, what if the rise in tax rates causes capital flight from Japan and the delicate funding deficit accelerates?
Other analysts have compared Japan’s relatively low tax revenue/GDP ratio with that of other countries, claiming that there is ample room to raise taxes. However, this belies the welfare society construct that Japan has developed in the past 75 years. In contrast to the welfare state, the welfare society provides social benefits through private employers. Japan’s welfare society attempts to maintain near-total employment via liberal government loans to private companies, often circumventing the need for unemployment benefits. Also, retirement pensions come largely from personal savings and company compensation rather than as benefits from the state. So, the state has intentionally shifted the cost of its social programs to companies. Should it raise taxes on the private sector, additional pressure would be placed on corporate budgets, thereby weakening the economy.
Compounding matters, Japan’s manufacturing prowess is weakening while the country as a whole is becoming less competitive. They have lost leadership positions in a number of key industries and the rise of the yen is making their exports less competitive as well. Moreover, pressured budgets make it more difficult to engage in the long-range R&D spending that had helped the country become a global leader in manufacturing. As an example, once a stalwart in consumer technology, Sony recently announced the layoff of 10,000 workers.
Since the epic global financial meltdown in 2008, the U.S. Federal Reserve has maintained an aggressive policy of depreciating the U.S. dollar. As noted in Figure 3, the yen has appreciated some 30% against its post-bubble average, as well as against the dollar, since the collapse in 2008.
Figure 3: Yen vs. US$
Sources: St. Louis Federal Reserve Bank, CFA Institute.
This recent appreciation of the yen is exacerbating all of Japan’s problems — its export products are now 30% more expensive on global markets. Its profile is similar against other major currencies. For the first time since the Japanese bubble collapsed, Japan will now need substantial alternate forms of funding to keep the government afloat. Consider Table 1, which illustrates how the funding sources of the federal government are changing and the pressures these changes will place on the Japanese bond market over the next 10 years.
Table 1: Japan Funding Surplus/Deficit Decade by Decade
The funding deficit over the 2000–10 time frame has been modestly negative and made up for with accommodative policy by the Bank of Japan. This accommodative policy has been offset by deflationary forces in Japan, so the net effect has been mild deflation. Looking forward, if this funding deficit of, say, –5% of GDP were made up for with accommodative monetary policy, then the inflationary force of this accommodative monetary policy would very likely exceed the mild deflation (say, –1% or so) that has been occurring in Japan for some time. The net result would be some mild inflation of, perhaps, 2–4% (depending on how much monetization and how much debt issuance occurs), but it would likely be enough to recalibrate the bond market’s expectations. And if JGB yields rise from 1% to just 2%, Japan’s debt service will explode. Thus, a vicious cycle of higher yields, greater fiscal deficits, greater monetization, and greater inflation will occur.
However, the status quo in Japan — if left unchanged — will see to it that the funding deficit widens materially. As debt continues climbing and GDP continues falling, the growth in the debt-to-GDP ratio accelerates. The combination of a rising yen and stagnating corporations will result in the structural trade surplus deteriorating over time (which is why the BOJ will try to get the yen to decline somewhat). Additionally, debt service and social security spending will continue growing as percentages of the federal budget — all without any increase in interest rates. So there is a widening funding deficit that must be made up for with some combination of debt issuance and/or monetization. The combination of large fiscal deficits, funding shortfalls, and private sector dissaving will ensure that Japan must seek investors on the international markets. Consequently, the (natural) domestic demand base for JGBs is falling, while the government’s need for foreign investors is rising. Although some have suggested that the Bank of Japan could devalue the yen, what would happen to the cost of imports if it did? (Remember that Japan imports virtually all of its raw materials, such as energy and hard commodities.) If it chopped the yen in half and many of its input costs doubled, could its export companies be competitive? What would happen to the balance of trade (all else being equal)?
While the underlying economics will change gradually over time, the crisis will erupt when the bond market breaks from the past. When the market realizes that the status quo has changed, rates will rise and force the government’s fiscal budget to explode, creating a sequence of cascading events. Watch closely to see what the major Japanese banks do with their JGB holdings. In addition, watch pension fund managers. The stewards of capital changing their policy allocations will determine when the status quo shifts.
So, when does Japan breach the event horizon? No one can say for certain, but after 22 years of operating in limbo, the event horizon now appears to coincide with the investment horizon of investors. Perhaps the BOJ will find a devaluation of the yen too irresistible to pass up, a move that will reset Japan’s current course in one fell swoop. Or perhaps the bond market will decide for them. At any rate, one thing is clear: change is coming to Japan.
Some of the best-known research on financial crises asserts that countries get into trouble when debt-to-GDP ratios surpass 80%. With a national debt that now checks in at roughly 220% of gross domestic product, Japan, at least by rule of thumb, should have collapsed a long time ago. Yet Japan has — thus far — somehow avoided a debt crisis.
In fact, many investors have bet against Japan over the years . . . and lost. A common mistake over the past two decades has been shorting Japanese government bonds — trades which have mostly ended in a trail of tears. In a country where interest rates have moved slowly but consistently lower over the past two decades, investors who have gambled on the thesis that Japan’s financial structure is unsustainable have been forced to learn one of the harshest lessons of investing: There is little difference between being early and being wrong.
So, how exactly have interest rates in Japan remained so stubbornly low in the face of a persistently stagnant economy and high and growing debt? Why aren’t investors demanding higher rates of return? Can this economic anomaly continue? If so, for how long? If not, when does Japan cross the event horizon for a major shift in fortunes?
The answers to these questions have proven so elusive over the years that I figure it’s time to try to get to the heart of the matter. After all, it’s not just about Japan: A better understanding of Japan’s fragile economic imbalances sheds light on current events in Europe and the United States, which, in the aftermath of the 2008 financial crisis, have implemented policies similar to those that have been pursued by Japan.
The story begins with Japan’s post-war economic miracle. In order to rebuild its economy after the devastation of World War II, the Japanese government adopted an export model to boost export growth and import know-how. Japan invested heavily in education, research and manufacturing. A key element of the export model is, of course, accommodative monetary policy whereby a country uses credit creation, infrastructure development, and lower-than-market interest rates (known in monetary parlance as “financial repression”) to focus the country on exports. As the original “Asian Tiger,” Japan employed this strategy to great effect over the years, growing GDP sharply on the back of strong exports. As long as GDP and exports are growing, this model works. But when GDP stops growing and exports slow, the model fails. The point of failure for Japan was when its easy monetary policy stimulated a real estate and stock market bubble instead of fueling exports.
In 1985, the major economies of the world (United States, Japan, West Germany, France, and the United Kingdom) coordinated the Plaza Accord to reduce the value of the dollar relative to other major currencies (including the yen) with the specific intent of reducing trade imbalances. In the 24 months after signing the accord, the yen appreciated by 50%. By mid-1986, the rising yen had forced Japan into a recession (because the stronger yen harmed the country’s exports).
As illustrated by the dotted line in Figure 1, the Bank of Japan (BOJ) responded by reducing the official discount rate five times between January 1986 and February 1987, leaving it finally at 2.5% — which remained in effect until May 1989. The BOJ was ferociously trying to stimulate the economy with aggressive easing. In addition to low rates, the BOJ maintained high levels of money supply and credit growth, which drove the creation of the bubble as illustrated in Figure 2.
The bubble manifested itself in both real estate and the stock market. It finally popped as the BOJ raised interest rates in 1989–1990, with historic collapses from which — even now, some 22 years later — the country has not recovered.
Nevertheless, Japan has been able to finance itself at extremely low rates during those 22 years. How? The financing of federal governments is much more complicated than the simple taxation of citizens. Governments finance themselves through some combination of direct taxation of citizens, taxation of businesses, tariffs on imports from other countries, build-up and usage of foreign currency reserves from international trade, issuance of debt, and money printing (if possible). Therefore, Japan’s ability to finance its federal government will be determined by the health of its GDP growth (which grows tax revenues, all else equal), its ability to grow federal tax revenues, its ability to control its budget, its ability and willingness to use its substantial foreign exchange reserves, and perhaps most importantly, its ability to continue selling bonds to the public. The secret of Japan’s ability to finance itself over the past 22 years is that it has used its current account surplus to create a closed loop — more money flows into Japan than flows out, and that net inflow is largely invested in JGBs (Japanese government bonds).
Here’s how it works: on the trade side, Japan exports more than it imports bringing more capital into Japan than leaving. Japan has maintained a trade surplus for about 30 years. And because of this persistent trade surplus, Japan has built up a large portfolio of foreign currencies. These foreign currencies are then invested in foreign assets (e.g., U.S. Treasuries) earning Japan a steady stream of income. Because this portfolio is large, Japan — as a country — regularly earns more income on its foreign currency holdings than they pay out to foreign investors. In combination, the trade surplus and the income surplus brings new money into corporate Japan. Corporate Japan places that money into the banking system, which then gets levered up and dramatically expands its purchasing power. Then the banks, life insurance companies, and pension funds turn around and buy lots of JGBs (accompanied with much pressure/regulation by the Bank of Japan).
In fact, the major banks, such as Bank of Tokyo-Mitsubishi UFJ, Sumitomo Mitsui, and Mizuho, regularly buy JGBs — even viewing it as a “public mission” to support Japan. In addition, the Bank of Japan buys lots of JGBs on the open market, trying to drive up prices and drive down yields, thereby manufacturing low rates. While this monetization of debt creates inflationary pressures, it has thus far been offset by the deflationary pressures of a declining workforce and declining population. There are short-term fluctuations from year to year, but it is clear when looking at averages decade by decade that funding pressures in Japan have been growing over time.
Table 1: Breakdown of Funding Surpluses/Deficits as a % of GDP
As you can see in Table 1, this is the answer to the original question. This cash flow cycle is how Japan has funded itself over the past 22+ years. Only now, the profile is changing. The Japanese debt crisis is being spawned by a burgeoning fiscal deficit. As the fiscal deficit has expanded, it has placed greater pressure on the Japanese government to sell debt and on the Bank of Japan to purchase it. Of course, the BOJ has been stepping in and buying JGBs when corporate demand has not been strong enough to keep rates low, as illustrated in Figure 3.
Figure 3: JGBs Owned by the Bank of Japan (in ¥100 mm)
Although Japan probably still is often thought of as a high-saving society, this is no longer true, at least for households. Japan’s household savings rate is now around 2% (down from a peak of 44% in 1990). So, in combination with chronic, large fiscal deficits, Japan’s low bond yields appear to present an oxymoron. However, Japan has also maintained a high corporate savings rate and low levels of fixed investment (both residential and nonresidential), making Japan a net exporter of capital. However, its fiscal profligacy is catching up with it: Its fiscal deficit has risen to more than 11% of GDP, where it remains today.
Up to now, Japan has been able to finance this funding deficit, as illustrated in Figure 4, primarily by issuing bonds. Historically, these bonds have been purchased by the public through various channels, ranging from household purchases to corporations to domestic banks to the post office. However, the aging of Japan’s population is altering the fundamental demand structure for bonds.
Figure 4: Japan: Bonds Issued as a Percent of GDP
Sources: Ministry of Finance, CFA Institute.
Although the aging of Japan’s population has been much discussed over the years, it is just now beginning to manifest itself — and as people become old, they tend to spend their savings rather than accumulate more savings — a process known as dissaving. Ominously, Japan’s population declined for the first time in 2009 (and has been declining ever since). Already about 30% of Japan’s population is elderly; that figure is expected to grow to about 40% over the next 30 years or so. And given Japan’s welfare society system, their (shrinking) working-age population will save less and less as their burdens in supporting the dependent-age population (both young and old) grow more and more. According to a McKinsey study, savings rates in Japan decline markedly after people turn 50 years old. Given its demographic profile, Japan’s combination of aging and life cycle effects will continue unabated.
At present, Japan has just over 127 mm people. According to the National Institute of Population and Social Security Research, Japan’s population — 20 years from today — will shrink to about 118 mm by the year 2032 (with an even greater deceleration in the working age population). Today, Japan’s GDP per capita stands at about ¥3.7 mm per person. Assuming they can maintain this level over time and keeping inflation neutral, Japan’s GDP would shrink from ¥476 trillion today to about ¥442 trillion in 2032. Given the ongoing massive fiscal deficits which Japan finances through similar levels of debt issuance, their national debt levels will rise to ¥2.4 quadrillion (rising from ¥980 trillion today). Another big question mark is of course interest rate levels. Even assuming their average interest cost on debt remains unchanged from today’s levels, Japan’s debt service will consume over 50% of the federal budget by 2032 (up from 23% today). With a populace that does not favor immigration, it seems that the die is cast. Japan will inevitably age and shrink — but not its debt.