Tick! Tick! Tick!
The Japanese public debt market is still a time bomb. Public debt now exceeds 135 percent of Japan's gross domestic product. If state pension liabilities are included, the ratio rises to over 240 percent. There is worse to come.
The central government budget for FY2000, prior to any supplementary budgets, calls for 84 trillion yen in spending, against 48 trillion yen in revenues. This leaves a gap of 36 trillion yen to be financed with new debt. Of the 84 trillion yen in planned spending, debt servicing accounts for 22 trillion yen, legally required transfers to local governments for 15 trillion yen, and central government civil service salaries for 11 trillion yen. These mandatory expenditures amount to 48 trillion yen, which means that all other spending must be financed with debt. If we add the local government deficit and the deficits of government-backed organizations to the central government deficit, the general government deficit approaches 10 percent of GDP in FY2000. Sadly, there is no sign of improvement going forward.
To date, this deficit has been financed surprisingly smoothly, and the currency and bond markets have remained stable. Adding to the false sense of security, Japan's economy has posted recent rises not only in industrial production and exports, but also in capital expenditures and corporate profits. To the casual observer, the Japanese economy, having grown by 0.5 percent in FY1999 in real terms, appears to be on the mend.
In Japan's present deflationary circumstances, however, these "real" figures have little meaning. What is more significant is that the Japanese economy actually declined by 0.7 percent in FY1999 in nominal terms. Including Q2 2000, the Japanese economy has declined year-on-year in nominal terms on a quarterly basis for eight of the past ten quarters. Financial stability has not come as a result of the Japanese economy being strong or sound. On the contrary, Japan remains mired in a deflationary recession. Ironically, the Japanese Government Bond (JGB) market has remained stable only because the Japanese financial sector is still so weak.
Japanese savers, risk averse as ever, are still keeping the bulk of their money in the bank deposits and life insurance products which make up Japan's traditional "indirect financing" system. At the same time, Japan's current account surplus continues to mount. Japanese financial institutions, if able to fulfill their original function, would be recycling this surplus by investing overseas. However, the normal cycle has been interrupted by the delayed recovery of Japanese financial institutions' balance sheets following the collapse of the bubble economy.
Banks and insurance companies have been weakened by an effective lack of shareholders' equity, and are unable to take on risk, particularly exchange rate risk. Indeed, Japanese financial institutions are perhaps in worse shape now than ever, and are hence more risk averse than ever. Rather than recycling Japan's current account surplus into international financial markets, the banks and insurance companies have ploughed funds into "risk-free" JGBs. This has kept the yen overvalued and interest rates at rock bottom in spite of the huge accumulated government debt and rising deficit.
Perhaps the worst consequence of this warped flow of funds structure has been the postponement of restructuring. Ultra-low interest rates have allowed the weakest and least efficient Japanese firms to continue to survive. At the same time, the ongoing low-interest-rate environment has allowed the government to maintain its wasteful pork barrel-spending, thereby propping up the lamest of Japan's lame-duck industries.
The obvious example is construction. The construction industry employs seven million people, or over 10 percent of the workforce in Japan, compared with only 4 percent to 5 percent in most developed economies. The continued high level of construction employment in Japan is partly the result of pressure from the U.S. administration on Japan to pursue Keynesian demand-side policies during the 1990's. Japan has bowed to this pressure and has wasted an excessive amount of taxpayers' money on unnecessary public works projects. For Japan to reform its economic structure, the number of construction workers needs to fall by at least three million, equivalent to the current total number of unemployed.
Such a drastic rise in unemployment may not be far away. The era in which Japan could afford to insulate its weakest industries from market forces is rapidly drawing to a close.
While still risk averse, Japanese domestic savers are slowly becoming more wary with regard to the stability of Japan's financial system, and more frustrated with returns of only 0.2 percent p.a. on bank deposits. Domestic savers have started a gradual shift out of yen deposits and into U.S. dollar deposits earning 6 percent p.a. or more. This is a significant development. Japanese savers are taking the decision on capital allocation and currency risk out of the hands of the domestic financial institutions. Moreover, some savers are slowly starting to bypass the traditional Japanese "indirect financing system" altogether, by seeking investment products such as U.S. dollar money market funds.
Notwithstanding these pivotal changes taking place in the retail savings sector, the largest change in the Japanese financial system has been the rise in corporate sector savings. Household sector savings now amount to 7.7 percent of GDP, compared with a budget deficit of just under 10 percent of GDP. In normal circumstances, one would expect the government to have difficulty making up the shortfall. The reason there has been no such difficulty so far is that the corporate sector has also become a huge net saver, with net savings equivalent to no less than 4.4 percent of GDP in FY1999. This is unusual in any economy and is particularly unusual in Japan, where household sector savings have hitherto provided the funds to finance growth of corporate investment.
This strange phenomenon is the result of stronger Japanese firms becoming extremely cash rich as they cut wage costs and capital investment. A massive increase in free cash flows has caused these firms, firstly, to pay down their debts and secondly, to deposit excess cash at the banks. In response, the enfeebled banks have merely increased their purchases of JGBs. This unique situation is unlikely to last, however, as internationally competitive firms will soon need to put their excess funds to work.
The Japanese economy still retains a great deal of excess supply capacity. Although restructuring has brought much improvement, high cost structures continue to make domestic investment relatively unprofitable. Furthermore, given that even internationally competitive Japanese firms are falling behind U.S. firms in high technology and internet-related sectors, it is all the more likely that Japanese firms will increase investment overseas, particularly in the United States. The recent acquisition of Verio by NTT DoCoMo may prove to be the first in a wave of Japanese investments in leading technology companies.
This rise in outward investment will draw down the corporate sector's deposits at banks. This, combined with the aforementioned re-channeling of retail savings into dollar deposits and money market funds, will seriously impact the financial sector. The withdrawal of deposits will force the banks to sell JGBs, causing interest rates to rise. Rising interest rates will lead to huge losses on the banks' remaining JGB portfolios. This will also push into bankruptcy Japanese corporations that have been surviving only due to cheap credit. Approximately one third of all Japanese corporations are believed to fit into this category. As these firms go bankrupt, the banks' asset base will be further undermined. The combined result of all these factors will be another financial crisis, probably accompanied by a sharp depreciation of the yen. Once this process gains any momentum, the downward spiral towards financial disaster may be unstoppable. A possible trigger for this calamitous chain of events could be provided by foreign selling of Japanese securities, if overseas investors begin to sell the Japanese securities that they bought so aggressively in FY1999.
On the positive side, this process will finally eliminate the remnants of the bubble economy and force Japan to complete its structural adjustment. In the post-crisis period, Japan should be able to sustain growth at around 3 percent, which is a reasonable target for a developed economy. In such circumstances, long-term interest rates should rise to around 5 percent. This would sort the wheat from the chaff among Japanese corporations.
The goal of structural reform is to distinguish between good and bad firms, the good being enabled to grow faster, while the bad are forced to return their capital and human resources to the market so that these resources may be more efficiently utilized. The huge increase in government spending and in the money supply that Japan experienced in the 1990's has only worked to hinder this process. Far from facilitating growth of the new economy, the extraordinary rise in Marshallian K (the ratio of money supply to GDP) over the past decade--increasing from 105 percent to 125 percent--has served merely to help finance the budget deficit. Misguided monetary and fiscal policies have not only failed to lift the economy out of the ongoing deflationary recession; they have brought Japan to the very brink of financial bankruptcy.
The only way forward for Japan is to reduce the government's role in the economy, both through cutbacks in government expenditure and continued de-regulation. However, given the current lack of political will, and the power of vested interest groups, it will take a financial collapse to convince the public and the politicians of the need for genuine reform. That is why a financial crisis, in the long-term view, will be a positive development for Japan and for the world in general.
Tadashi Nakamae is President of Nakamae International Economic Research. He first wrote about the JGB Time Bomb in the March/April 1999 issue of TIE.
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|Title Annotation:||Japanese public debt market|
|Publication:||The International Economy|
|Date:||Nov 1, 2000|
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