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2017-12-14Macro `n Cheese

Big in Japan

In Hemingway’s “The Sun Also Rises” the purposeless scion Mike tells the protagonist Jake of the two ways he went bankrupt: “Gradually and then suddenly." We would not be surprised if this dialogue inspired Roger to write this week’s piece on public debt in the land of the rising sun.

I have to admit, I have some mild contact phobia when it comes to Japan’s economic situation. Mainly because a few years ago, I saw a concurrence of rising rates and a weakening Yen, which I believed, and still believe, could be a trigger for the big Japanese blowout. Hence, I am one of all those who have fomented the infamous “widow maker trade”. For that I am sorry. I am not proud of it. The worst part is, I cannot promise not to repeat it.

To explain why, I want to take you through my line of reasoning, which is not as far from the more benign view of mainstream economists as you might think. In all honesty, I think the difference is a matter of linear versus non-linear expectations formation.

Demographics

To me, Japan's poor demographic position is at the heart of its economic developments, both the previously good and the currently bad. In part this is of course due to the direct connection between the working-age population, and hours worked (ceteris paribus). To illustrate, I have added a graph on the population outlook (courtesy of United Nations Dept of Economic & Social Affairs). First, notice how the young and working age population peak between 1990 and 1996, coinciding with the start of Japan's lost decade(s). Next, the additional deterioration of Japan's growth prospects ten years ago overlapped not only with the global financial crisis, but also with an absolute decrease in the population. Looking forward, the UN's population forecast suggest that the current low population growth (and, ceteris paribus, low growth in hours worked) will continue for at least another 30 years.

Macrobond Document
Chart 1: “Ubasute”

To ease the demographic situation, a couple of standard remedies are often suggested:

1. Increased immigration. Unambiguously, a less restrictive immigration policy (in a broad sense) could alleviate Japans demographic pressures. That said, the political attitude towards immigration has, as the low per capita migration numbers demonstrate, been less than welcoming ( at least until now );


Macrobond Document
Chart 2: “Migration not yet on the menu”

2. Policies to increase female labor force participation are, although somewhat less intuitive, perhaps, also suggested to ease negative demographic pressures. No, you’re right, this does of course not have any direct effect on population developments, but since female labor force participation is very low in Japan, it would go some way to mitigate the fiscal strains1 of a rapidly aging population. And, more to the point, experiences from Scandinavia suggest that extended and affordable child care and parental support do not only stoke higher female participation rates, but also higher birth-rates.

1The research referenced here suggests that the implied income-loss of the gender gap is up to 15% of GDP, which we can probably equate with a similar loss of Government tax revenue. Macrobond Document
Chart 3: Low hanging fruits

Whatever the case, Japan needs to act fast, as the number of women of reproductive age is set to decline sharply over the coming few years. To illustrate the gravity of the situation: Japan's total population is expected to drop by 4 million people, roughly the population of Los Angeles, from now until 2025. Thenceforth, the decline in population is set to accelerate.

But there are also other links between Demography and GDP; not via stronger employment and more hours worked but via productivity. Possible direct linkages between demographics and productivity go, for example, from the accumulated work experience of older workers and aging (retired) citizens demanding relatively more labor-intensive services (e.g., health care) to the detriment of more productive sectors (similar to Baumol's cost disease). Also, it is possible that there are negative network effects from a shrinking size or, rather, lower density of the population2. On a more general level, demographic developments also drive deeper changes in economic developments via expectations, politics, institutional set-ups, etc.

To be more specific, age effects on economic developments are observable and the coefficients in different studies (cf. here, here and here) on the impact of aging on the economy suggests that our productivity is at it peak from 40-50 (or even 65) and moving into retirement has a negative beta of 1½ to 3 on GDP and/or productivity growth.

2The inverse often used as an argument behind continued urbanization processes and the talk of “super star cities”.

Will Japan go bankrupt?

This question is undoubtedly interrelated to demographics, but given the uncharted territories that Japanese debt metrics are exploring, it does attract a lot more interest. And to answer in the simplest possible terms: No. Probably not.

Macrobond Document

Chart 4: Japan has the highest debt ratio in the world

For starters, any country with its own currency cannot go bankrupt in a traditional sense. They can simply order the central bank to "print more money" and purchase (monetize) the debt. Hence, as long as they do not choose to cancel payments on the debt a sovereign cannot default3 (on domestically nominated debt). This holds regardless of where (whether?) we find the "debt threshold" for Japan (or not).

3When I talk about default in this post I will also refer to what is often called “an inflationary default”, which is what a number of (mainly) emerging markets; Argentina, Brazil, Hungary, Yugoslavia, Zimbabwe etc, have gone through. The mechanism in an inflation default is that the fundamental function of money as store of value is being eroded and money loses its intrinsic value.

Adding fuel to the flames of an ongoing monetization, the Bank of Japan’s (BoJ) continued purchases of Japanese government bonds (JGBs) have rapidly pushed its holding towards 50% of the outstanding public debt stock. The official view is, nonetheless, that the main objective of current BoJ purchases is not to keep the government from going bankrupt, but to keep interest rates low and financial conditions expansionary, which is a different story altogether. From the looks of it, i.e. from the continued low inflation, it seems economic agents are giving the BoJ the benefit of the doubt.

Interestingly, and in contrast to what a recent FT-article discussed, there are nonetheless some indications of rising inflation expectations (albeit from low levels).

Macrobond Document
Chart 5: Monetization without the side effects

Taken together the two graphs above imply that the BoJ owns almost 3/5 of net debt4 (equivalent to approximately 80% of GDP). Furthermore, and despite the BoJ taking a step back from the previous JPY 80 trillion per year purchase target, we can clearly see that central bank purchases continue to handsomely outpace government new issuance of less than JPY 30 trillion per year5, equivalent to BoJ increasing its stake of net debt by 5-8 percentage points per year6. Make no mistake about it, if there ever was a successful monetization (by stealth), this is it!

4The net debt ratio, excludes the debt the government owes itself (not counting the central bank) and is therefore often considered a better measure of indebtedness than gross debt. However, the deducted public debt is often held by public pension funds and/or the social security system. And to me, in extremis, this is also why this measure is deeply unreliable (and how is it calculated?). Net debt only subtract the future liabilities that are funded. It does not show to what extent future pensions and welfare systems are unfunded (which probably goes some way to also explain why gross debt seems to lead net debt).
5Here I have used the annual change in public debt as a proxy for net financing (circa JPY 25-30 trn). This rhymes well with the >4% net lending estimate that the IMFs latest article IV consultation on Japan suggests.
6 Assuming, erroneously, that all freshly minted JPYs are invested in government bonds (BoJ also invests in ETF:s etc).

Macrobond Document
Chart 6: ...and it continues

In turn, this means that at the current clip, the Japanese consolidated (incl. BoJ) public sector net debt will reach zero (or, put in another way, the BoJ holdings of net debt will reach 100%) in five to six years! No mean feat and, admittedly, positive developments from a long-term fiscal sustainability point of view.

Macrobond Document
Chart 7: Will anything happen on the road to zero net debt?

Linear wisdoms

This is probably the point where analysts start to differ in opinion. Many analysts often claim that Japan could simply cancel the debt owned by the Bank of Japan, especially as the monetization of Japans debt has been “surprisingly” undramatic (thus far, I feel obliged to point out).

In extremis, the BoJ could of course purchase virtually all the outstanding debt. In practice, however, the BoJ purchases are probably capped by (some non-zero level of) private sector holdings (i.e., the net debt). To indulge, let us nonetheless assume that in a couple of years’ time, the BoJ somehow manages to reach holdings equivalent to net debt and at that time the government decides that the BoJ should cancel its holdings of government debt.

In a stroke, the gross debt ratio would plummet from 234%7 to 120% of GDP (all of which would be publicly owned). In a stroke, Japan would no longer have a public debt problem – it would only “owe itself”. To be sure, even at current, lower, levels of holdings, a BoJ “debt jubilee” would push Japan’s net debt ratio well below most other developed nations.

7According to IMF:s latest article IV consultation

And, since the BoJ purchases have been paid for with cash or reserves, there should be no aggregate balance sheet effect on the private sector, only compositional. Economic prospects are considered stable or have even improved (less government interest rate payments) and confidence in monetary policy is hopefully intact, despite the gargantuan but presumably harmless (after all, a central bank can finance itself) negative equity of the central bank, following the debt cancellation.

From my perspective, this line of reasoning feels considerably more plausible when trying to describe recent BoJ behavior, than the official view of the BoJ trying to reduce real wages to make the labor market clear (if anything, the labor markets appear tight) and lowering the real interest rate to stimulate consumption and investment8. Heck, I can even go as far as saying this monetization-by-stealth-experiment-thingy might actually work.

8The latter arguments become even harder to fathom given Japan’s demography and considering the high relative income level of Japan.

“Gradually, and then suddenly”

My lingering skepticism (misguided maybe) has more to do with the very linear view of economic developments in the scenario outlined above. I adhere, in practice, to a more non-linear response of the private sector. As the BoJ's holdings of JGBs steadily increase, while we see little acceleration of GDP-growth, I expect a more "adaptive" private sector to at some point start questioning the purpose of the BoJ's purchases. If the suspicion is that the BoJ has only engaged in overt monetary financing (or classic monetization, if you prefer), inflation (expectations) might shoot up quickly, stoking a conversion of JPY denominated assets (incl. cash and reserves) into real assets and FX denominated assets. Such developments can, in turn, be instigated by, for example, a demography induced reappraisal of prospects for GDP-growth and/or fiscal sustainability (in a broad sense, i.e., including, e.g., pensions and other future welfare services).

Put another way, it is probably no coincidence that previous high-/hyperinflation periods have often been preceded9 by deep and drawn-out recessions and even deflation. Hence, what it all boils down to, as usual, is the actual developments of future incomes (GDP).

9Allais: “Reformulation de la théorie quantitative de la monnaie” (1965), and; Cagan: “The Monetary Dynamics of Hyperinflation” (1956)

...or not

Despite all wacky ideas and thoughts on display above, the official Japanese view is still that all BoJ-owned government debt will eventually be resold to the private sector, necessitating future public surpluses that pay for the debt. These future surpluses can only come about via higher revenues (taxes) and/or lower expenditures ("welfare"), to which Japanese households may very well respond to by increasing current savings, effectively offsetting current fiscal deficits (in some semi-Ricardian way). Given the demographic situation, a GDP-growth spurt seems highly unlikely. Which is why redistributional policies, not least between generations, and increased female labor participation, are likely to constitute the main revenue increasing policies (e.g., via shifting income to households with lower propensity to save). In addition, deep spending cuts are also necessary, but how households will respond to such measures remains an open question.

A more plausible way forward would probably be to convert the BoJ holdings into non-interest bearing perpetual loans to the government. That said, any such action risks instigating a reappraisal of growth prospects and/or confidence in the current monetary policy regime. As such, it is paramount that such monetization is clearly and credibly executed.

For investors, a crude warning signal is offered in a lasting concurrence of higher market interest rates AND a weakening Yen. This would suggest that domestic players, despite increased domestic returns, are trying to divest into other currencies. Over the last year, such patterns have clearly re-emerged and warrant heightened attention.

Macrobond Document
Chart 8: A worrying sign

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We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of our resident chief economist. While we think he’s very smart, Macrobond Financial does not expressly endorse the views he presents here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have the application you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have the application, now you have a great reason to get it.