Financial Times – March 15th 2010
http://www.ft.com/intl/cms/s/0/8c72d612-3025-11df-8734-00144feabdc0.html#axzz1WV4KM3Sy
How did the people who sighted the first black swan respond to the shock? After the collapse of the assumption that all swans were white, did they then conclude that swans could be any colour – red, green, or blue?
That ‘s the kind of mistake that investors may be making now. Anyone who lived through the trauma of the global credit crisis will be psychologically primed for financial armageddon for years to come. Hence the appeal of huge “end times’” macro stories like the demise of the dollar, the break-up of the euro, and – most recently – the implosion of Japanese public finances.
The rationale for a Japanese debt crisis is clear. This year , for the first time ever, the Japanese budget will be more reliant on bond issuance than tax revenues. The ratio of Japan’s gross government debt to GDP has breached two hundred percent. A Godzilla-sized rollover of 210 trillion yen – equivalent to the entire public debt of Italy – will take place over the next twelve months. Challenging arithmetic, to say the least.
The ratings agencies have already sounded the alarm, with S&P delivering a downgrade of Japanese debt in January. Celebrated investors and academics are forecasting meltdown, and one excitable financial journalist has described Japan as “our Weimar in waiting.”
The only people who seem relaxed about Japanese public finances are the supposed vigilantes of the bond market. So far this year, while sovereign debt fears have spooked the European markets, JGB yields have been comfortably quiescent in the 1.2% – 1.4% range. Only rarely and briefly in the past decade have they drifted above 2%. Far from the next Lehman or the next Greece, the market is rating the Japanese government as the best credit on the planet. Indeed if Sidney Homer’s classic “History of Interest Rates” is any guide, Japanese government debt commands the lowest interest rate since Babylonian times.
There are only two possible explanations for this extraordinary divergence of views, both of them disturbing. Either the Japanese bond market is simply wrong, or our understanding of debt crises is flawed.
We know all too well that markets can be wrong, but developed country government bond markets are supposed to be sober affairs, and ten years is a long time for a mispricing to persist. In fact, ever since the bursting of Japan’s 1980s bubble, there has been an inverse relationship between the debt to GDP ratio and bond yields – the more bonds the Japanese government sells, the easier the terms it gets. The buyers of these bonds – deleveraging corporates, de-risking financial institutions, individuals turning their backs on equities and real estate – are hardly speculators. They have sound reasons for the choices they made. Not least is the fact that deflation – which is understated by Japan’s outmoded CPI calculations – generates an invisible tax-free gain to holders of cash and bonds.
What this suggests is that debt dynamics are more mysterious than we thought. There is no magic debt-to-GDP ratio that leads inexorably to a crisis. The eurozone’s sinners got into trouble with far lower ratios – sub-50% in Spain’s case – than Japan.. What matters is the financeability of any given level of debt, which in turn depends on the availability of savings and the preferences of the savers. Over the past twenty years, Japan’s private sector has not just been financing the home country’scountry’s bulging public deficit but a considerable proportion of the US’s too. The fact that Japan’s savings surplus is now concentrated in the corporate sector rather than the household sector doesn’t matter. With capacity utilization so low, Japanese companies will be restraining capital investment for years – which means their cashflows will pass to other sectors of the economy via dividends and financial asset purchases.
So does that indicate everything in Japan is hunky dory? Far from it. Japan’s cellar-dwelling bond yields are a product of the deflationary disease that has been gnawing away at the economy’s vital organs. While deflation persists,the debt to GDP ratio is destined to go ever higher.
Bizarrely, Japanese policy-makers have been more concerned with minimizing the current interest rate on public debt than reflating the economy and generating higher tax revenues and lower social costs over the long haul. At some point they will have to reverse strategy, and when that happens bond yields will rise. Far from portending imminent doom, that would signify that Japan’s journey back to economic health had begun. And that really would be a green swan event.