The below graph reflects the turnaround in real public demand or spending in Japan. Japan’s budget deficit reached a record in 2012 at 9.2% of GDP. As part of the new 2013 Abenomics plan, Japan spent an additional $10.3 trillion yen (2% of GDP) in 2013 to grow the economy and stave off ongoing recession. 2013 saw a budget deficit of 4.8% of GDP. This year, Prime Minister Abe revealed a record 95.88 trillion yen budget draft to be implemented as of April 1, 2014. Abe hoped to cut this 4.8% deficit rate in half, and to bring it into balance within five years. With a tax increase going into effect this year, it still may not be enough to hit this fiscal balance target. Regardless, additional spending should support the Japanese economy, weaken the Japanese yen, and support corporate profits for manufacturers like Sony and telecom providers like Softbank.
Deficits fuel demand
The above graph reflects the impact government deficits have had in supporting public demand growth. This trend is supportive for overall economic growth and corporate profitability for companies like Sony. Though the size of the Japanese deficit has been halved since the crisis, Japan’s ability to continue to shrink the deficit and manage its economy is still a point of concern. The following portion of this article takes a deeper look at Japan’s debt problem and considers the sustainability of Japan’s high level of debt.
For analysis of Japan’s debt problem, please see the below commentary.
To see how Japan’s weakening currency supports Third Point’s Japan strategy in Softbank in its acquisition of Sprint Communications and, potentially, T-Mobile USA, please see the next article in this series.
The impact of large deficits on Japan’s sovereign credit rating
In September 1998, Fitch rated Japan’s long-term credit AAA, though with a negative outlook. The AAA credit rating was subsequently cut to AA+ on June 29, 2000, then to AA on November 26, 2001, then AA- on November 21, 2002, then, almost a decade later, to A+ with a negative outlook on May 22, 2012—just prior to the 2013 Abenomics revolution. That represents four notches in the Fitch Rating system, moving Japan from “AAA” (the highest credit quality) to AA+, the top of the second category (very high credit quality).
Credit default spreads and Japan’s credit outlook
In 2008, the cost to buy insurance against a Japan credit default cost approximately 0.10% per annum. This cost of credit default insurance, known as a “credit default swap,” or CDS, grew to approximately 1.50% by the time Japan’s Prime Minister Abe was elected, and has since fallen to around 0.48%. CDS spreads in the USA peaked at approximately 0.65% in 2011, though it now stands at 0.17.5%. China stands at 0.89% (Bloomberg). Credit agencies point to Japan’s ballooning debt levels as a cause for concern. Rating Agency Moody’s issued a warning on Japan on August 19, 2013, noting that, “A tipping point for creditworthiness would eventually loom if growth remains elusive and the government’s debt and refinancing needs remain at very high levels.” Essentially, Moody’s, like many investors, fears that Abenomics could “backfire” as debt levels grow.
Total assets versus net debt: Japan versus USA
Much ado has been made about Japan’s debt levels. Headline news tends to point out that the USA has just over 100% of debt to gross domestic product levels, versus Japan at over 200%. Total gross debt (government debt plus non-financial corporation debt plus consumer debt) for Japan is approximately 450% of GDP for Japan, and 280% for the USA. Government gross debt is approximately 240% of GDP for Japan, and 107% for the USA. Net debt, which excludes debt held by the government itself for monetary, pension, and other reasons, is approximately 135% of GDP for Japan and 84% of GDP for the USA (Satyajit Das, The Setting Sun—Japan’s Forgotten Debt Problems).
Why Japan’s debt problem is offset by its assets
While having a net deficit of 135% of GDP is a large number in comparison to other countries, so is Japan’s pool of domestic savings. The USA had a gross national savings rate of approximately 20% of GDP in 1980, falling to around 11% in 2009, and currently standing around 17%. In 1980, Japan had a gross domestic savings rate of roughly 30% of GDP, reaching approximately 34% in 1992, and currently standing at 24%. Despite the large 135% of GDP in net debt, as noted below, Japan also has a significant savings base of roughly $20.7 trillion (Q4, 2013).
Compare U.S. debt to Japan, taking into account total savings or net worth
In Japan (2012) government net debt and gross debt reached $7.4 trillion and $13.1 trillion, respectively.
Household net assets ($13.3 trillion) + net assets of domestic non-financial sector ($2.7 trillion) + net foreign assets, including foreign reserves ($4.7 trillion) totaled $20.7 trillion (stock basis).
In the U.S. (2012), government net debt and gross debt reached $13.8 trillion and $16.7 trillion, respectively.
Household net assets ($67.3 trillion) + net assets of the domestic non-financial sector ($20.3 trillion) + net foreign assets including foreign reserves (-$3.7 trillion) totaled $83.9 trillion.
Japan has a total assets–to–net debt ratio of 2.8, whereas the USA has a ratio of 6.1.
(Source: Household/Non-Financial Sector Data for Japan: Bank of Japan, Flow of Funds Data, external assets from Ministry of Finance, Balance of Payments Data. For USA: Household/Non-Financial Sector Data from US Fed, external assets from BEA, Q4 2013.)
Though Japan has slightly less than half the U.S. asset–to–net debt ratio, Japan still has the asset base it needs to support this large amount of debt for a significant amount of time. Abenomics skeptics are more focused on the dynamics of this debt, and point to the fact that national debt levels are 24 times national government revenues and that 25% of tax revenue goes to service the debt.
Abenomics debt concern
The concern is that the reflationary policies of Abenomics could lead to higher nominal and possibly real interest rates, and this could take an even larger bite out of the Japanese government’s budget on a both nominal and real basis. With a weakening yen, Japan is expected to become a larger importer in the near term, as we discussed in the related series on Japanese exports, Japan’s export growth: Will General Motors’ loss be Japan’s gain? Japan’s historical trade surplus is showing signs of turning into a trade deficit over the past few years, with trade deficits starting to grow.
The trade deficit accelerates with weak yen inflationary impact
Should Japan’s trade deficit maintain a similar trajectory over the next five years, the annual trade deficit could grow from around $120 billion per year to $360 billion per year, or from 2% of GDP to 6% of GDP—similar to the highest levels seen in the USA in 2007. Simply drawing such a trajectory would suggest that Japan would start to eat into its $20.7 trillion in assets at a fairly significant rate. However, such simplistic assumptions would ignore other factors, such as Japan’s weakening yen, which would likely lead to export growth as well, though perhaps on a lagged basis. This is the inter-temporal uncertainty that drives the speculative fervor surrounding Japan’s potential interest rate rise.
Hedge funds bet on collapse: The dollar to the yen at 200?
Abenomics skeptics like Heyman Capital’s Kyle Bass think Japan’s interest rates will rise significantly and potentially cause some form of economic collapse. With total assets to net debt at nearly three times, it would seem that Japan has a significant store of assets to finance its debt for the forseeable future. However, Kyle Bass points to higher interest rates as a ticking time bomb for Japan. With 25% of government spending going to service government debt in an ultra-low rate environment, it’s possible that an increasing amount of government spending goes to servicing debt as interest rates rise under Abenomics. The big question is, should interest rates rise under Abenomics, will increases in nominal private sector savings and nominal increases in government revenues be enough to offset the nominal increase in debt service? Bass thinks not, and that the Japanese yen will weaken dramatically to 200 per dollar or more.
To see how Japan’s weakening currency supports Third Point’s Japan strategy in Softbank in its acquisition of Sprint and potentially T-Mobile USA, please see the next article in this series.
Japan’s equity outlook
As 2014 progresses, investors could see a continued outperformance of the Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan ETF (EWJ) versus China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further clarification as to why DXJ could outperform both EWJ and other Asian equity indices, please see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.” Plus, as Japan pursues unprecedented monetary expansion and the U.S. Fed tapers its bond purchases, Japanese equities could also outperform broad U.S. equity indices, as reflected in the State Street Global Advisors S&P 500 SPDR (SPY), the State Street Global Advisors Dow Jones Index SPDR (DIA), and the Blackrock iShares S&P 500 Index (IVV).
