[Viewpoint] Japan’s debt time bombOnly in a world that’s truly out of whack is Japanese debt a haven.
Ten-year bonds issued by the industrialized nation with the biggest burden yield just 1.07 percent, a seven-year low. Never mind that rapidly aging Japan is home to some of the ugliest demographic trends anywhere. Money is zooming into yen-denominated assets to avoid global turbulence.
It’s not 100 percent irrational. Prime Minister Naoto Kan pledges to trim debt that’s almost twice the size of Japan’s $4.9 trillion economy. Deepening deflation also means a rally in stocks is about as likely as the Bank of Japan raising interest rates this year.
Seeking shelter in Japanese debt is a bit nutty, though, when you consider what tends to happen when yields get to today’s levels. It rarely goes well for Japan bond bulls.
Just as traders find great psychological importance in the 10,000 level for the Dow Jones industrial average, $1,150 for an ounce of gold or 100 yen to the dollar, investors in Japanese government bonds are obsessing over 1.2 percent.
Six times in the past decade, traders tried to drive bond rates decisively below that level. The most recent attempt was late last month, when 10-year yields reached 1.125 percent. And that begs a question: Do fiscal trends in Japan really warrant debt yields lower than 1.2 percent? No - not even in a world as upside down as ours.
Take Kan’s own comments about sovereign risk in Asia’s biggest economy. It’s breathtaking for a prime minister to fret aloud about his nation going the way of Greece. Last month, Kan tantalized the bond market by admitting that “our finances can go bankrupt if we don’t address our rising public debt.”
Japan has few options. A solid bounce back in U.S. growth that boosts Japanese exports seems a long way off. Kan, meanwhile, will further undermine Japan’s outlook if he goes ahead with a poorly timed consumption-tax increase. It would only hurt Japan’s efforts to get households to spend more.
With official interest rates near zero, government spending is critical. Unless Kan can do what no predecessor has for 10 years - increase growth without massive stimulus packages - Japan’s debt will increase. Kan plans to balance the national budget in 10 years. That seems unrealistic without rapid growth.
Part of the faith that investors have in Japanese bonds is the Finance Ministry’s almost magical ability to avoid market meltdowns. While it helps that more than 90 percent of Japan’s debt is held domestically, the nation’s bureaucrats have humbled many a hedge-fund manager.
Yet things get shaky when yields stray below 1.2 percent. In June 2003, yields on 10-year bonds slid to a record 0.43 percent. The move came as the BOJ stepped up bond purchases in so-called quantitative easing to defeat deflation. Investors grew antsy about Japan’s finances in the months that followed, driving yields to 1.6 percent by September. It was a powerful sell-off that investors won’t forget.
A similar plunge in prices can’t be ruled out. Not only has Japan’s fiscal trajectory darkened since then, but so have its population challenges. And the euro area’s woes show investors are losing patience with the view that rich economies can borrow indefinitely to finance growth.
That’s the short run. The longer-term risks are the really scary ones. About 23 percent of Japan’s 126 million people are older than 65, while less than 13 percent are younger than 15. The real trouble starts in the fiscal year beginning in 2012 as many of the baby boomers retire.
The national savings rate will fall as a mass of retiring workers stop working and hoarding money. Pension-benefit payouts will increase, too. That means less money available to go into government bonds. Japan’s reliance on domestic demand for bonds keeps the country from being grouped with Greece, Ireland, Italy, Portugal and Spain. It’s now becoming untenable.
Japan’s debt quandary arguably dwarfs those in Europe, says Carl Weinberg, chief economist of High Frequency Economics in Valhalla, New York. He sees no plausible scenario where Japan’s debt-to-gross-domestic-product ratio - almost 200 percent - declines.
It’s this kind of scenario that concerns credit-rating companies. Officials at Standard & Poor’s and Fitch Ratings, for example, are awaiting the outcome of the July 11 upper-house election to gauge Kan’s ability to rein in debt. A sizeable mandate would give him more latitude to do just that.
The wild card here is the global economy. Europe’s debt troubles will get worse before they improve and a vague promise by Group of 20 leaders last weekend to reduce deficits once economies recover won’t calm investors.
In a world awash with sovereign risks, cash-rich nations with a history of placid debt-market trading, like Japan, are winning fans. For how long, though?
If confidence in markets unravels anew, Japan’s debt vulnerabilities will become too great to ignore and yields will rise markedly. Some haven.
*The writer is a Bloomberg News columnist.
By William Pesek
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