Why Japan will Blow Up

The S&P crawled back up last week with a 2.5% gain, most of which was realized on Thursday and Friday–despite several pieces of bad news.  Volume was lighter than it was during the prior weeks when the sell-offs dominated.  In other words, equities rose, but NOT because the buyers rushed back in to accumulate shares.  The VIX index fell, as expected, when share prices rise.

Most of the economic data hinted at the slowing economic recovery.   Consumer credit came in as expected, but as is often the case with monthly data sets, the prior month was revised much lower–meaning the combined effect was negative.  Mortgage applications for home purchases tumbled again.  They’re not down 34% in one month; they’re down 30% from the same week a year ago, and they’re back down to the same levels last seen in 1997–all despite record low mortgage rates.  The housing market is poised for another nasty downturn.  Jobless claims–again–came in much worse than expected.  Most ominously, retail sales (both headline and ex-auto) plunged, when they were expected to rise.  Because the consumer represents 70% of the US economy, this drop in retail sales portends a serious downturn in end-user demand for goods and services.  Not good.

Technically, the S&P is looking like it wants to bounce back up on a daily basis.  Given the steep sell-off since late April, such a bounce is perfectly normal.  In fact, it would be more surprising if it didn’t occur.  But not to be deceived, most professional traders and investors are closely watching the weekly charts, which are still extremely bearish.  The weekly data is suggesting that the S&P is still quite overbought.  So on any meaningful bounce, the pros will look to sell or lock in gains, leaving the dumb money holding the bag.

Let’s look at Japan.

Government debt to GDP is 200%, a shockingly high level that no other nation in the OECD even approaches.  And this figure excludes private debt which adds another 200% (estimates vary) of debt to GDP, bringing the total credit market debt to GDP to 400%–even higher than the 380% level in the US.

So why hasn’t Japan blown up already?  Simple–it can borrow most of this debt at super low interest rates, averaging only 1.5%.

How can it borrow at such low rates?  Japan, for 30 years after WWII, saved money at incredibly high rates, building a savings pool of about 300% of GDP.  And the government has used about 200% of this total, leaving the rest for private borrowers.  Amazingly–and luckily for Japan–domestic savers have not fled the country; instead they’ve tolerated the super low nominal rates of return, partly because negative inflation (deflation) raises the real return.

So why will Japan blow up?  Japan is aging rapidly and starting to drain its massive savings pool–even as the government continues to increase its borrowing.  When (in 2-4 years) Japan runs out of cheap domestic savings, it will be forced to borrow from international creditors–who will never accept only 1.5% for ten-year loans to the government.

So what happens when rates rise from super low to say, somewhat low?  As the chart below demonstrates, the Japanese government pays out about half of its tax revenues–today–to service its debt at 1.5%.  Notice how the blue (debt service line) ramps up as rates creep higher.  At only 3.5% (still a reasonably low rate when compared to the last 50 years), the Japanese government would need to pay out virtually ALL of its tax revenues to service its debt.

At that point, the game would be over.  Japan would face a funding crisis and then a currency crisis.  Japan would blow up.

Why should we care?  Two reasons.  First, when Japan does blow up, a tsunami of capital could rush out of the country creating massive stress in credit markets and their related derivatives markets across the globe.  In short, if Japan dies, the rest of the world would suffer from a heart attack.  Second, the impending catastrophe in Japan ought to be a warning to the US.  The US is experiencing many similar financial and economic pains that Japan has experienced since 1990.  In many ways, the US is just like Japan–only several years behind.

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