Sunday, July 27, 2014

The land of the rising sun has become a fading star

Japan's economic prospects are dismal.

Since being surpassed as the second largest economy in the world (a position it held for over two decades) in 2010, it has fallen far behind China in nominal GDP, and will likely fall far further in the years to come.

There are two overriding factors determining this grim conclusion: debt and demographics.

Japan's national debt is over one quadrillion yen (ten trillion USD) - more than twice its GDP.

Debt servicing costs are projected to be over 23 trillion yen in 2014, while total tax revenues (after a major tax hike in the latest budget) will be 50 trillion yen. Thus nearly half of government revenues go straight to paying off interest on the debt. And this is with rock-bottom interest rates: as of July 25, 2014, Japan pays just 0.53% on ten year bonds (0.15% for five years and a stunning 0.06% for two).

On its face, Japan's financial situation is precarious.

Japan has been able to meet all debt payments and fund its deficits at such low rates of interest because its populace saves a significant portion of its income, and funnels a large percentage of those savings into Japanese bonds. Of large economies, Japan is an outlier in that the vast majority (over 90%) of its national debt is held domestically.

Which is why Japanese demographics matters.

Japan is aging, perhaps faster than any other nation. According to the Japanese Statistics Bureau, the number of Japanese 65 years and older [Excel] will steadily increase for the next twenty years, while the number of those aged between 15 and 64 declines, year after year. Using these numbers as an (imperfect) proxy for retirees and workforce, the stage is set for an inevitable crunch. (The following scenario may happen tomorrow or in ten years, but there is no way to avoid this impending crisis.)

With fewer workers, barring a miraculous increase in productivity, GDP will flatten or fall. Aggregate wages in Japan will also decline (likely at a greater rate, as younger workers are paid less than older ones) which will lead to lower overall savings. Since Japanese savings are the source of almost all purchases of Japanese bonds, the Japanese government will no longer be able to fund its ongoing deficits (41 trillion yen in 2012, with no significant decrease on the horizon), never mind its maturing debt, while paying virtually no interest. 

Drastic spending cuts and/or dramatic tax increases sufficient to eliminate the deficit (7.6% of GDP last year) in the near term would almost certainly plummet the country into a severe recession. The economic downturn would lower tax revenues and raise government social program expenditures - thus returning Japan to a deficit position. 

With an enormous and increasing debt, coupled with a flat or declining GDP, Japan will one day (soon) reach a crisis point. As I see it, Japan will have three options:
  1. Default in part or in full on outstanding debt.
  2. Raise the interest rates paid on government bonds.
  3. Have the central bank print money to buy bonds at a (much) lower interest rate than the market demands.
I view an explicit default as very unlikely. Doing so would destroy the wealth of the Japanese populace, who hold almost all national debt. It would be both contrary to the national interest and political suicide. 

Japan could raise interest rates, but this too is unlikely. Consider the effect of an increase of just half a percent on the interest rate Japan pays on its 10 year bonds. Even in the unlikely scenario that Japan runs balanced budgets for the next decade, this small rate rise doubles what the country must pay in interest every year, resulting in a situation where over 80% of taxes collected will go solely to paying interest on the national debt as bonds mature. This is clearly a recipe for national bankruptcy, leading to scenario 1 (default), which Japan will go to great lengths to avoid. 

This leaves printing yen - having the central bank buy bonds, in massive quantities, both to make up for the shrinking numbers of people buying bonds and to keep interest rates near zero. Rapidly increasing the money supply will lead to a rapidly depreciating currency. Since Japan has been a net importer since 2011, in the short run a lower yen will further deteriorate the country's financial position, as they must pay more yen for its imports (primarily energy products). Last year, Japan's trade deficit was 13.8 trillion yen (US$137B) - with a rapidly depreciating currency, the number of yen leaving the country will sharply increase. This is not good for Japan.

There is one silver lining in this scenario, which unfortunately comes with its own cloud. As the yen falls in value, Japan's mighty manufacturing capabilities become more cost competitive globally. This will improve Japan's balance of trade, and reduce one major source of capital flight. But if Japan takes full advantage of a weak yen to increase its exports, it will do so largely at the expense of its neighbours, including Indonesia, Vietnam, Korea, and - especially - China. Sino-Japanese relations are already deteriorating on multiple levels, including territorial claims, historical grievances, increasing militarization, and political rhetoric favouring nationalistic fervour over regional and international cooperation. Currency devaluation would exacerbate these tensions. In addition, the yen is one of the most widely traded currencies globally, and markets around the world would be rocked by a sudden drop in the value of the yen. Given the current context, deliberately depreciating Japan's currency could lead to a much broader regional economic or political conflict.

But let's set aside geopolitical and global currency market considerations and remain focused on Japanese economics. Devaluation of the yen will be considered a beggar thy neighbour tactic by other Pacific countries. Some will likely take steps to devalue their own currencies in response, seeking to maintain their share of global imports. Thus Japan would suffer all the negative effects of a weak currency (now shared with several regional nations) with few of the desired benefits. Any increase in Japanese exports is likely to be limited and short lived due to the reactions of other nations.

Thus Japan is trapped in a vise, largely of its own making. Both its demographics and debt profile were foreseeable for decades, but no effective remedial action was taken to counteract these trends. It saddens me, because I lived in Japan (nearly twenty years ago now) and have great admiration for its history, culture, and people. But with its shrinking workforce, aging populace, enormous debt, and continuing deficits, all roads lead economic disaster for Japan.

As Ernest Hemingway wrote in The Sun Also Rises:
"How did you go bankrupt?" Bill asked.
"Two ways," Mike said. "Gradually and then suddenly."
Twenty five years ago, Japan was a seemingly invincible economic colossus that struck fear in the hearts of businesses and industry worldwide. Now, I believe its days of going bankrupt gradually are nearing their end.

I hope I'm wrong.


My argument is based on the following assumptions:
  1. The average savings rate of the Japanese worker will remain roughly the same. (This is a conservative assumption, as historically it has been quite high compared to other wealthy nations; if the savings rate changes, it is far more likely to decrease than increase.)
  2. The investment mix for Japanese savings will not change substantially in the coming years. (Also a conservative view, as Japanese savers historically (and presently) significantly overweight their portfolios with domestic bonds, which fund the national deficit and maturing debt.)
  3. Japan will not accept large scale immigration to offset its declining workforce over the next two decades.
  4. Japanese real wages and productivity, already high by global standards, will not increase dramatically over the next 20 years. They will do so, at best, gradually - a few percentage points per annum.
  5. As people retire, they will become net spenders, not savers.
  6. International investors will not significantly increase their purchases of Japanese bonds at current interest rates.