Why the factors allowing Japan's soft, slow depression are reaching their end...
(Read the first part of Das' Japanese economic analysis here...)
Household savings rates have declined from between 15% and 25% in the 1980s and 1990s to under 3%, a level below the US until recently. This decline reflects decreasing income and the aging population.
At around 5%, Japan's unemployment rates are low relative to international peers but higher than the 2-3% levels that existed prior to 1991. The official rate understates real unemployment because of government employment adjustment subsidies and structural change in the Japanese labour to lower costs to offset the impact of a higher Yen and global competition.
Wages have fallen, with average annual salaries including bonuses falling every year since 1999 and decreasing by around 12% in total. Between 1994 and 2007, labour costs as a percentage of manufacturing output declined from 73% to 49%. Japanese worker's share of GDP fell to 65% in 2007, from a peak of 73% in 1999.
In a change from the tradition of lifetime employment, 34% of the labour force, around 20 million workers, is employed in part-time or contract roles, an increase from 20% in 1990. These workers do not have the job security, training or benefits associated with full time work.
In 2009, previously unreleased government statistics revealed that 15.7% of Japanese, including 14% of children and 21% of the elderly, live below the poverty line.
The aging population further reduces the savings rate. Household surveys indicate that around a quarter of households with two people or more have no employment.
In aggregate, the amount of money being paid to retirees from savings exceeds the amount of new money that is going into savings funds. This is compounded by low returns on investments, which accelerates the rundown of savings.
Japan's current account surplus has also allowed the government to run large budget deficits which can be funded domestically. Since 2007, the Japanese trade account surplus has fallen sharply, turning into a deficit in 2012. The secular factors driving the fall include an appreciating Yen and slower global growth, which has reduced demand for Japanese products, such as cars and consumer electronics. In late 2012, territorial disputes with China exacerbated the decline in exports.
It also reflects the impact of the Tohoku earthquake and tsunami as well as the subsequent decision to shut down Japanese nuclear power generators, which increased energy imports, especially Liquid Natural Gas.
Deep seated structural factors also underlie changes in the trade account. Since the 1980s, rising costs and the higher Yen have driven Japanese firms to relocate some production facilities overseas, taking advantage of lower labour costs and circumventing trade barriers.
More advanced, technologically complex and high value manufacturing was kept in Japan. But post-2007 Japanese firms have increasingly been forced to close these domestic production facilities as they have become uncompetitive.
This combination of falling exports, lower saving rates, declining corporate earnings and cash surpluses is likely to move the Japanese current account into deficit. In turn, this will force Japan to become a net importer of capital to finance government spending, altering the dynamics of its finances.
If Japan continues to run large budget deficits, as is likely, then the falling saving rate and reversal in its current account will make it more difficult for the government to borrow, at least at current low rates.
Ignoring foreign borrowing and debt monetisation by the central bank, the stock of private sector savings limits the amount of government debt. In the case of Japan, this equates to around 250-300% of GDP. Japan's gross government debt will reach this level around 2015, although net government debt will not reach this limit until after 2020.
Even before Japan's government debt exceed household's financial assets, the declining savings rate and increasing drawing on savings by aging households will reduce inflows into JGBs, making domestic funding of the deficit more difficult.
Insurance companies and pension funds are increasingly selling their holdings or reducing purchases to fund the increase in payouts to people eligible for retirement benefits. Institutional investors and to a lesser extent retail investors are also increasingly investing in other assets, including foreign securities, in an effort to increase returns and diversify their portfolios.
Forecast current account deficits will complicate the government's financing task. Japan's large merchandise trade surplus has shrunk and will remain under pressure, reflecting weak export demand and high imported energy costs.
Still, Japan's large portfolio of foreign assets will cushion the effects for a time. Japan has accumulated large foreign assets totalling around US$4 trillion, making it the world's biggest net international creditor. The BoJ is the largest investor in US Treasury bonds, with holdings of around US$1 trillion. But even if net income from foreign assets (interest payments, profits and dividends) stays constant, Japan's overall current account may move into deficit as soon as 2015.
As the drawdown on financial assets to finance retirement accelerates, Japan will initially run down its overseas investments, losing its net foreign asset position. Unless public finances improve, Japan ultimately will be forced to finance its budget deficit by borrowing overseas.
Where the marginal buyers of JGBs are foreign investors rather than domestic Japanese investors, interest rates may increase, perhaps significantly.
Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan's interest payments will be an unsustainable proportion of tax receipts.
Higher interest rates will also trigger problems for Japanese banks, Japanese pension funds, and insurance companies, which also have large holdings of JGBs.
JGBs total around 24% of all bank assets, which is expected to rise to 30% by 2017. An increase in JGB yields would result in immediate mark-to-market large losses on existing holdings, although higher returns would boost income longer term. BoJ estimates that a 1% rise in rates would cause losses of US$43 billion for major banks, equivalent to 10% of Tier 1 Capital for major banks or 20% for regional banks.
To avoid the identified chain of events, Japan must address the core problems. But reductions in the budget deficit are difficult. Spending on social security accounts and interest expense now totals a major part of government spending.
Increasing health and aged care costs are expected by 2025 to be around 10–12% of GDP. An aging population and shrinking workforce will continue to drive slower growth and lower tax revenues. Tax increases are politically unpopular. Reductions in the budget deficit are likely to reduce already weak economic activity, compounding the problems.
Japanese policy makers have other options. Financial repression forcing investment in low interest JGBs is one alternative. The BoJ can maintain its zero-rate policy and monetise debt to finance the government. Japan can try to inflate away their debt. But ultimately, Japan may have no option other than a de facto domestic default or debt restructuring to reduce its debt levels.
Older Japanese, especially retirees who are major holders of JGBs, would suffer large losses. Younger Japanese would benefit from the reduction in debt and reduced claims on future tax revenues. Such a drastic alternative, with its massive economic and social costs, is difficult to conceive other than as the last option.
Investors and traders have repeatedly bet on a Japanese crisis, usually by short selling JGBs to benefit from higher rates. With low Japanese interest rates, the risk of the trade has always seemed limited while the potential profit large. But the bet has failed each time, giving the strategy its name – the widow maker.
Given its large domestic savings and also the ability of the BoJ to further monetise its debt, the status quo can be maintained for a little longer. But eventually Japan's deteriorating public finances and declining ability to finance itself domestically will coincide with weakening ratings and large refinancing needs.
Although no longer AAA since May 2009, Japan currently has a strong debt rating, put at AA3 (Moody's Investor Services) or AA minus (Standard & Poor's). In 2012, Fitch downgraded the country's credit rating to A plus from AA. Its rapidly deteriorating financial position will place continuing pressure on its rating, making fund raising more difficult and expensive, especially outside Japan.
Japan has an average debt maturity of 6 years, shorter than Spain, Italy and France. Around 60% of its debt must be refinanced in the next 5 years. This will expose Japan to the discipline of market investors at a vulnerable moment.
Once the problems emerge, they will be difficult to contain. As Economist Rudiger Dornbush once observed:
"The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought."