By Brian Walsh
Following the financial crisis in 2008, major OECD governments reacted to the recession with an unprecedented amount of fiscal and monetary stimulus. It seems evident that the monetary stimulus, in particular, has induced a variety of distortions in financial markets. Arguably, a weak U.S. dollar should be an outcome of Fed policy, but how does one explain the Japanese yen as a safety currency?
The yen today sits at an all-time high versus the U.S. dollar as investors and speculators flock to it as an escape from the overindebted and deficit-ridden U.S. and Europe. Ironically, Japan is in significantly worse fiscal shape than either the U.S. or any European country.
The ratio of public debt to GDP in Japan is 220%, or more than double the U.S. ratio and significantly more than Greece’s 130%.
Japan’s interest costs are more than 23% of total government revenue, despite an interest rate of 1.1%—the lowest in the world. Remarkably, that interest rate has dropped so much in the past 20 years that Japan’s interest bill of nearly ¥10 trillion is less than it was in 1990, when the total debt outstanding was about 25% of what it is today!
If Japan had interest costs of 4%, it would require approximately 75% of government revenues to fund its debt, but Japan’s total tax revenues peaked in 1990 at about
¥60 trillion, and the country’s nominal GDP peaked in 1996. Japan has yet to truly recover from the collapse it suffered following the bursting of its stock and real estate markets in the 1990s.
Japan’s savings rate has been trending lower for more than 15 years and currently is about 2%. The demographics of the country are the worst in the OECD. The population peaked in 2004; the fertility rate is only 1.2 children per mother, well below the standard replacement rate of 2.1; and the OECD estimates that about 23% of the population is older than 65 (versus 12% in the U.S.). This clearly puts burdens not only on the savings rate but on government spending on retirees, social security and health care.
Based on the above factors, some argue that Japan is an accident waiting to happen. One well-known commentator refers to Japan as a “bug in search of a windshield.” Still, the yen trades at postwar highs versus the U.S. dollar and enjoys status as a safe haven. A number of reasons are advanced for the yen’s strength, which essentially boil down to three main points: the accumulated savings of the country, the fact that 95% of yen obligations are held by Japanese, and the so-called financing provided by Japan’s current account surplus.
Although Japan’s gross debt is more than 220% of GDP, its net debt is approximately 120%. The government’s treasure of investment assets (in excess of ¥200 trillion) can be employed to postpone a day of reckoning. The problem is that the country has to pay interest on its gross debt. Moreover, a sale of foreign assets would put upward pressure on the yen, which would only impair economic growth.
While it’s true that the Japanese hold 95% of existing government bonds, the government continues to run large budget deficits that require financing; a deficit of 8% of GDP is projected for fiscal 2011. More importantly, one of the largest holders of JGBs, the Government Pension Investment Fund, has announced it will become a net seller of JGBs to meet increased outflows to retirees. And the postal savings system could be in the same position in the near future.
Japan runs the largest current account surplus after China, at 3.20% of GDP. Over the past decade, this surplus has increasingly been generated by investment income rather than by the country’s trade surplus. The trade surplus has been shrinking, and given the current price of the yen, most commentators expect this to continue. The surplus is clearly inadequate to cover Japan’s debt, requiring the country to have bond issuance that’s twice as large. Over the course of history, countries have addressed their overindebtedness in one of three ways: default; debt monetization (printing money), which typically leads to massive inflation; or economic supply-side reforms (including deregulation and tax reform) and a significant currency devaluation that stimulate an economic growth rate that exceeds the rate of growth of the country’s debt.
Most solutions have required a combination of these alternatives, and while the third alternative is clearly the most benign, all of them are negative for a country’s currency. It seems that the yen is like the character in Hans Christian Andersen’s children’s tale, “The Emperor’s New Clothes.” The yen emperor is walking around naked, but nobody can see it . . . yet.
Brian Walsh is chairman and chief investment officer of Saguenay Strathmore Capital.