The year is 2020, and at the centre of the financial tsunami is Japan. Another decade of very low single digit growth has meant that debt to GDP has steadily climbed from 200% in 2010 to 300%, which is considerably higher than any other country. Another ‘lost decade’ has meant that the Japanese government has been unable to meaningfully cut back on spending or increase taxes, since such behaviour would have risked plunging the economy back into recession and deflation. Nominal tax revenue has been static for twenty years. Worsening demographics have meant that social security costs have skyrocketed – in 2010, 23% of the population was above 65 years old, but this has risen to 30% in 2020.
All the things that kept Japanese government bond yields so low through the 1990s and 2000s have begun to unwind. Demand from the postal savings and postal insurance systems, which held over 30% of all JGBs in 2010, has begun to wane due to the meagre returns on offer in domestic savings. The public pension fund, which held 12% of JGBs in 2009, is steadily redeeming its holdings, since JGBs no longer meet the fund’s required return, and the fund has had to sell assets to meet rising cash outflows. The average individual’s savings rate has steadily fallen, in line with the rapidly aging demographic (the propensity to consume for pensioners is about 120%). Japanese institutional and private investors have traditionally exhibited exceptionally strong home bias, holding over 90% of outstanding JGBs, but domestic demand has rapidly weakened as globalisation of financial markets and the lure of greater returns on overseas assets have resulted in domestic investors diversifying geographically.
Financial markets are getting deeply concerned that Japan will struggle to service its debts. Japanese investors are worried about the Japanese authorities attempting to inflate their way out of the problem and are increasing exposure to overseas markets. A wave of selling has meant that the Yen has weakened and Japanese government bond yields have started to rise sharply. The rise in yields means that the maturing low-coupon JGBs that were issued 10-20 years ago are having to be replaced by higher coupon bonds. Interest payments on sovereign debt are rapidly approaching tax revenues. The Yen is not a global reserve currency, and Japan can’t rely on capital inflows from abroad to fund its deficits. The country is on the brink of getting junked by the rating agencies. Financial markets are wondering what happens when one third of the world’s government bond market defaults in one go.
The year is 2009 again. Thankfully, the nightmare scenario above hasn’t happened, but how realistic is it? Rising sovereign indebtedness has been a very hot topic over the past 12 months (I wrote about it in June here), and having recently read an excellent research note from JP Morgan (which I’ve drawn from heavily above), it’s entirely plausible that Japan could be at the epicentre of a sovereign debt crisis.
A wave of sovereign defaults becomes all the more plausible if you read ‘This Time is Different : Eight Centuries of Financial Folly’, which is the recent publication from Carmen Reinhart and Ken Rogoff (Rogoff almost uncannily foresaw the collapse of Lehman Brothers – see here). The book is based on two highly influential academic papers published last year, (This Time is Different : A Panoramic View of Eight Centuries of Financial Crises and The Aftermath of Financial Crises), and is a ‘must read’ for any bond investor. Looking back over the centuries, they highlight that at the moment we’re in a typical lull in sovereign defaults, one or two decade lulls in defaults are not uncommon, and each lull has invariably been followed by a new wave of defaults. History tells us that there have been numerous periods where a high percentage of all countries are in a long period of default or restructuring.
I suppose that the goodish news is that if the terrible scenario described in the first three paragraphs above does occur, then it’s very unlikely to happen anytime soon. A high sovereign debt to GDP ratio does not mean that paying interest on the debt is necessarily that difficult – again citing JP Morgan, Japan’s debt service cost in 2008 was a very manageable 2.6% of nominal GDP, smaller than the US’s 2.9% and the Eurozone’s 3.0%. Sovereign debt levels are – for the next few years at least – easily sustainable in Japan and the rest of the developed world.
Another piece of good news is that default or restructuring is not inevitable. Canada is a good example of a country that lost its AAA rating in the 1990s, cleaned up its balance sheet, and is now one of the world’s strongest sovereigns (although Canada was arguably in a much stronger position in the mid 1990s than much of the world is in today).
The reaction of the authorities around the world to this crisis over the past year is, in my view, to be greatly admired. There have been mistakes and delays, but errors cannot be helped when such huge decisions need to be made in such a short period of time. The world has experienced much pain, but we can only guess at how many more times worse it could have been. There is no doubt, though, that some of the biggest challenges lie ahead, and as highlighted in the horror scenario above, if politicians fail to take brave and decisive actions over the coming years, then things will get much, much worse. These are issues that politicians are very aware of, but dealing with them is easier said than done (as an example, you can read about how Germany is trying to tackle the issue here).
Finally, we have a copy of Reinhart and Rogoff’s book mentioned above for our readers. The quantitative easing multiple choice question is this – on Thursday this week, how much will the UK’s MPC decide to extend asset purchases by – (a) nothing (b) £25bn, (c) £50bn or (d) other? The first correct answer drawn out of a hat later this week wins. To view the Terms and Conditions of the competition, please click here. Once you have read the T&Cs , please use the ‘get in touch’ function on this blog to enter.