The quote from Moody's is
"Japan's credit profile is Aa2
The unified rating of Aa2 reflects Japan's considerable strengths. These include Japan's large domestic savings, a strong home bias on the part of its domestic financial institutions and institutional investors, relatively low holdings of government debt by foreign investors, and Japan's $1 trillion of official foreign exchange holdings. Moody's believes the domestic market will absorb the record level of bond issuance this year to fund the government's economic stimulus program. However, the rating also reflects the risks of Japan's high level of debt, which leaves the country's fiscal position vulnerable to shocks or imbalances that would cause a sharp rise in interest rates. The ratings also reflect the sizable but temporary increase in the government's budget deficit caused by the severe effects of the global collapse in trade and recession on the Japan's economy. Further, Japan's large foreign exchange reserves, although large compared to those of most other countries, are only a small fraction of its liabilities and could not alone eliminate refinancing risk at a time of severe stress."
Here is a look at the trend in Japan's government debt(courtesy of Edward Hugh):
That net debt number is likely to exceed 100% of GDP in 2009. Moody's noted that very little of this debt is held by non-Japanese. Of course, one of the primary causes of this is the fact that much of this debt was issued at extremely low interest rates. So it was relatively unattractive to foreign investors. Japan's government debt amounts to the country's citizens avoiding taxation now with the expectation that the country's future productivity will be great enough support repayment of the debt in the future without ruinous taxation levels.
The Bank of Japan holds over $600 billion in US Treasury debt. In theory, the proceeds from these holdings as they mature could be used to reduce the outstanding domestic debt over time. Of course, that would put upward pressure on the yen versus the dollar and thereby weaken the country's export sector. The decision that faces Japan's leadership today is whether to continue to depend on exports, or shift policy to supporting the domestic sector more and thereby increasing the proportion of GDP generated domestically. Such a shift would result in short term difficulties, but in the long run would serve the Japanese public best.
Other weaknesses of Japan include the fact that it has no meaningful defense forces, and its agricultural sector cannot produce enough to feed the country's population for any meaningful length of time. Also, Japan relies on imported fuels for over 80% of it's energy needs.
Another issue is that somehow the fact that Japan has been running inflationary policies for 18 years now is easy to miss when their nominal numbers all are so flat. It was easy to see the inflation get exported to the US and the rest of the world through the carry trade mechanism. The question that doesn't seem to be asked is where all of those yen went after the carry trades were unwound. At some point the BoJ has to remove the excess yen, which would obviously be deflationary, or we should expect a collapse in the yen.
(A cross post by Scott Peterson from Wasatch Economics)
29 comments:
"and its agricultural sector cannot produce enough to feed the country's population"
Import figures might suggest this, but I suspect the reality is somewhat different - local production is forever being plowed under to support JA prices. And of course, Japan is self-sufficient in rice.
quick question - does the net debt to gdp number of around 100% include the $1tr fx reserves?
thanks
Hi Fredrik.
"does the net debt to gdp number of around 100% include the $1tr fx reserves?"
These two topics have no direct relation. The 100% net debt is public debt, the Fx reserves are all against potential calls from private agents. The Japan government cannot simply appropriate these to pay the debt. And they cannot even produce inflation by printing money at the BoJ to melt it down. They have been trying to do precisely that for more than a decade now. Default at some point is a real possibility, with Japanese companies and retail investors calling on the Fx reserves to park their savings abroad.
I don't understand why from an economic perspective "no meaningful defense forces" is a weakness.
m - I think it's a strength. But it does mean Japan must occasionally do favors for the US, such as buying Treasury's over the years.
The reason this article scares me is that the way things are going, the US is catching up quickly in the bankrupt-your-country game, thus having US Treasury's AAA down-graded seems like less of an impossibility
Asserting Japan "has no meaningful defense forces" is disingenuous. The Japanese Self Defense Forces receive over $40b per year in expenditures. Furthermore, Japan is a closet nuclear power. Japan has limited force projection capability, but it is quite secure from future threats.
dear Edward,
i long forgot most of my economics courses...
1) could you explain more specifically how we get from Gross Debt to Net Debt ? What are the assets that go against the Gross Debt ?
it seems in your answer it is NOT those $1tr FX reserves ?
2) about those FX reserves. why are those potential calls from private agents ? arent those reserves held in the BOJ or the MOF ? (which exactly ?)
3) who cares about what Moodys / S&P say anymore ??? they rated many crap CDOs AAA for years...now they want to avoid more govt ire by not giving them the (bad) rating they deserve..
Just so you know, I believe Japan is the 5th largest military spender in the world. http://en.wikipedia.org/wiki/List_of_countries_by_military_expenditures
Hi Francois Guillaume,
"could you explain more specifically how we get from Gross Debt to Net Debt ?"
Well all of this is quite complicated, and I am certainly no expert, but there are various items:
a) Simple inter departmental balances
b) Land and other assets acquired under earlier bailout programmes and valued on a held to maturity basis (rather than a mark to market one) which no one really knows the value of (just like the toxic assets being acquired now by the Fed and the ECB).
c) funds held in the social security system.
(c) is quite important, since you need then to offset against these the implicit liabilities of the system being under funded.
If you take all of these into account true net debt may be about mid-way between the net and gross number, but who knows. The important thing is the trend, and they are both on the up and up.
"it seems in your answer it is NOT those $1tr FX reserves ?"
Nothing whatever to do with it.
"about those FX reserves. why are those potential calls from private agents ? arent those reserves held in the BOJ or the MOF ? (which exactly ?)"
This stuff is so complicated, I really haven't a clue, since the MoF does have its own accounts (I think). But we are talking here about BoJ reserves. These accumulate with the trade and current account surplus as Japanese companies and retail investors bring home Fx earnings and deposit them with a bank. The titleholder to these earnings is the private agent (minus tax), and these have nothing to do with the Japanese government.
Basically the yen is convertible, so if there was a financial crash in Japan, every yen could be moved into dollars to avoid the "corralito", and the reserves would disappear overnight. My honest feeling is that people are disproportionately obsessed with this issue.
The important thing is Japan's GDP growth potential, its elderly population fiscal liabilities, and just when Japanese citizens become net dis-savers. When the latter happens on a sustained basis the whole game set and match is done. If no one acts first.
I'm sure Japan's (and the world's) rating of Moodys is considerably lower...
m,
Let's say Japanese-flagged ships are being captured by pirates in the Strait of Malacca or off Somalia. It would be useful for the Japanese government to provide protection against this independent of any other country's actions.
Hi,
"I'm sure Japan's (and the world's) rating of Moodys is considerably lower..."
Well mine isn't. Genuinely I'm not sure what the beef is here. Fitch, Moody's, S&P's, the IMF etc are evidently far from perfect, but do you know anyone better?
I far prefer having Moody's Japan rating to one provided by the MoF, or the BoJ.
"I'm sure Japan's (and the world's) rating of Moodys is considerably lower..."
And another thing I notice is that the nearer a country gets to bankruptcy, the less they like the ratings agencies. They are absolutely hated across the CEE. Absolutely unjustly in my view.
anwynd,
I agree that Japan has the capability to quickly develop a nuclear force; given the country's experience with reactors for power supply and launch systems for its space program. I was thinking more along the lines of developing conventional forces including ships and air forces. Directing public funds in this direction would provide economic stimulus and allow Japan to take a greater role in international affairs, independent of the USA.
Edward,
Could you please help me with three questions?
1) I think the reason BoJ can't use FX reserve to pay down the debt is not because it is private claim but because most of its debt is issued in JPY and FX reserve is in US$. I.e. BoJ has to sell US$ reserve in the market to buy JPY which will push up JPY.
The reason I think FX reserve is not private claim is becuase, BoJ accumulates Fx reserve by A)by exporters who earned US$ exchanged the US$ to JPY or B)by local banks which received US$ deposit from exporters went to BoJ and exchanged it into JPY to lend it or C) BoJ printed JPY and bought US$
2) "inflation get exported to the US and the rest of the world through the carry trade mechanism"
--> Is it because carry trade effectively lowered the interest rate of foreigners who borrowed in JPY?
3)"At some point the BoJ has to remove the excess yen, which would obviously be deflationary, or we should expect a collapse in the yen" --> I understand the deflation part, but could you please help me understanding why the alternative result is collapse of JPY?
Thank you very much for your help.
Hi Aileen,
I think the first point I would make is that I am a macro economist, not a specialist in central banking, so I am just as capable as anyone of getting this part wrong, but...
"I think the reason BoJ can't use FX reserve to pay down the debt is not because it is private claim but because most of its debt is issued in JPY and FX reserve is in US$. I.e. BoJ has to sell US$ reserve in the market to buy JPY which will push up JPY."
It isn't quite like this. The BoJ can simply print money (in yen). This is what it has been doing for years now, and the BoJ has acquired a lot of JGBs over the year. I think I am right in saying that under the new "semi quantitative easing" they are running they are again doing this. It has nothing to do with the reserves.
Basically central banks can't normally do this (ie simply print money to expand the monetary base without causing inflation - you know the so called Zimbabwe problem - but in Japan they have been trying for more than a decade to provoke inflation, and they simply haven't been able to.
The Bank of England is now doing something similar, and the Swiss National Bank. Indeeed, the SNB is printing CHF to buy euros to try to reduce the currency parity, and the BoJ may well try to do this at some point - ie print yen to buy more dollars to try to reduce the value of the yen and fire up inflation.
The reserves are a quite separate question.
Basically, the danger is that eventually the ageing Japanese population become net disavers. At that point the whole situation inverts, and you could well tip over into hyper inflation and financial chaos. This is the big fear, since if you let the thing go on for long enough, and the population age without check, a point of no return will be reached, and then there will not be much to be done. Claus has been working on all this, so maybe he would like to chip in.
The other comments you quote are not from me, but from Scott.
But
"inflation get exported to the US and the rest of the world through the carry trade mechanism"
--> Is it because carry trade effectively lowered the interest rate of foreigners who borrowed in JPY?
Yep, ecxactly. They flooded the world with liquidity (they and the Swiss, in Eastern Europe), and all this went a long way to fuel the bubbles.
Now the big danger is that this same policy (which I am not against, NB) in the US runs the risk not of fuelling consumption inside the US but bubbles in Brazil, India etc, where the US can export, but the danger is that these economies can be driven up out of hand.
I mean, we could see even more liquidity pumped out of the US than was ever pumped out of Japan.
"At some point the BoJ has to remove the excess yen, which would obviously be deflationary, or we should expect a collapse in the yen" --> I understand the deflation part, but could you please help me understanding why the alternative result is collapse of JPY?"
Well maybe this is more for Claus, since this is his ballgame, but for similar reasons to the ones I mention above. Once Japan cannot maintain an external surplus the whole game set and match point is played.
Aileen,
To respond to your question about why I think that the yen would devalue if the monetary authority did not reverse its increases in money supply; we have to recall that the intent of the printing of yen was to stop deflation. In other words to increase prices. That means that a resident of Japan would be able to buy less of any product given the same number of yen in their pocket. One way to define inflation is as a reduction in the purchasing power of a unit of money.
Historically once currency inflation begins, it is difficult for the authorities to eliminate it. Thus far, all the extra yen have piled up in the savings accounts of Japanese citizens. At some point in the future should these citizens start to spend, the prices of things they buy could shoot up rapidly. I have no idea when that might happen. A likely time would be when a large proportion of the populace need to support themselves from their savings after retirement.
Thank you, Edward and Scott.
Just a few follow up questions, if you don’t mind..
Would it be correct if I say:
BoJ's QE failed to generate inflation, because instead of getting spent locally, the extra JPY printed went abroad through carry trade. Now with the carry trade positions are being unwound, the extra JPY is finally returning to JP, and could be a source of severe inflation, which can cause JPY to depreciate.
Do I understand you right?
And two more questions, if you don't mind..
1)During the years when JPY carry-trade was popular, people borrowed in Yen and then subsequently sold the Yen for local currency. Who bought the Yen the carry traders were selling?
2) How do you quantify the scale of quantitative easing? Say, is it possible that BoJ has been printing money for 10 years, but at a very small amount that even after 10 years the total amount they printed is insignificant?
Thank you again, in advance.
Edward-
and, why did you pick Brazil and India as the countries where current US policy can bring inflation? Any particular reason? Why not Hong Kong and China whose currencies are pegged to US$ and thus can't raise interest rates even when they experience better growth than US?
Aileen,
Your statement of the money supply situation is right.
With regard to who the buyers of yen in a carry trade would be; it could be any party that thought the yen was undervalued. The parties borrowing yen to sell are engaging in essentially a relatively short term trade as they expect to have to reverse the trade at some point.
Bloomberg quote Japanese Finance Minister Kaoru Yosano as saying it’s impossible for the government to put a target on achieving a primary balance surplus due to the continuing economic recession.
“The original primary balance target was based on three factors contributing to growth - spending cuts, revisions to the tax system and reform of public finances,” Yosano said on a program on public broadcaster NHK. “When we get back on a growth track, that’s when it will be necessary to make clear goals.”A primary surplus is achieved when revenue exceeds spending, excluding bond sales and interest payments.
Japan's former Prime Minister Junichiro Koizumi had previously (in 2006) established the objective of eliminating the primary deficit by fiscal 2011. Yosano admitted in Januarythat the government would now miss that target.
The previous imrpovement in Japan's credit outlook was based on the Koizumi objective, hence it is now logical that the rating deteriorates.
Richard Koo, chief economist at Nomura Holdings and author of the book “Balance Sheet Recession,” is quoted as saying that the government’s stimulus policies are the best way to deal with the current recession.
“I think these are extremely good measures that will be positive for the medium and long term......If the government doesn’t spend the money, it will just be saved in bank accounts and lead to a 23 trillion yen deflationary gap.”All of which is fair enough, unless the issue is not simply one of a unique crisis, but a long term structural trend upward in the debt that no one can reverse.
Also, do note that with the US now offering its broad shoulders to sustain the carry trade, coming to Tokyo to borrow doesn't seem to be as popular as it has been following previous recessions, and the Yen seems to be getting trapped around 95 to the USD, even as the dollar falls, in part due to the "carry effect".
I'm pretty convinced that "carry" is now an important driving force in the renewed "investor" (as opposed to real economy agent) confidence.
The euro hit 1:40 to the USD yesterday (and Europe's economies are in deeper recession than the US one), Brazilian central bank President Henrique Meirelles also warned yesterday against an “excess of euphoria” in the currency market following an 18% rise in the real over 3 months, implying he may well start making more dollar purchases to stop the upward drift in the value of the currency. Turkey's lira was also up and has now advanced 10 percent in the last three months, while South Africa’s rand is up 22 percent, making it the best performing emerging-market currency over the past three months. All good "carry" punts these, since Turkey’s benchmark interest rate stands at 9.25 percent, compared with a range for overnight loans between banks of zero to 0.25 percent in the U.S. Brazil’s benchmark interest rate is 10.25 percent.
Even the rible is up shaply, as Russia's economy struggles to handle growing default rates. The currency climbed to a four-month high against the dollar yesterday. making for its longest run of weekly gains in almost two years.
The ruble hit 31.0887 per dollar at one point, the strongets level since Jan. 12, and was up 3.2 percent on the week, thus closing the sixth weekly advance and extending the longest ruble rally since September 2007. The ruble has in fact now climbed 16 percent since the end of January. Russia’s has cut base interest rates twice since April 24 in an attempt to revive the economy, but the refinancing rate is still 12 percent - well above rates in the EU, the U.S., Japan and even quite attractive in comparison with those on offer in other emerging markets.
This weekend I am writing an article on "carry", and here is a summary from that article on how it works. But the basic point is that you can leverage interest rate differentials AND benefit from the changes in currency valuation that you yourself (along with the other practitioners) produce (see next comment).
But now we have a new factor entering the scene. The US Federal Reserve, along with many of the world's key central banks, has so reduced interest rates that they are running only marginally above the zero percent "lower bound", and the Fed is far more concerned with boosting money supply growth to fend of deflation than it is with restraining it to combat inflation. Not only that, Chairman Ben Bernanke looks set to commit the bank to maintain rates at the current level for a considerable period of time.
In this situation, and given the extremely limited rates of annual GDP growth we are likely to see in the US and other advanced economies in the coming years, such liquidity provision is very likely to exit the first world looking for yield, and where better to go than to those high yield emerging market economies.
The Federal Reserve could thus easily find itself in the rather unusual situation of underwriting the nascent recovery in emergent economies like India and Brazil , just as Japan did during the period of its experiment with quantitative easing between 2001 and 2006. And the mechanisms through which the money will arrive? Well, they are several, but perhaps the best known and easiest to understand of them is the so called carry trade, which basically works as follows.
Stimulus plans and near-zero interest rates in developed economies boost investor confidence in emerging markets and commodity-rich nations who have interest rates which are often in double figures. Using dollars, euros and yen these investors then buy instruments denominated in currencies from countries like Brazil, Hungary,Indonesia, South Africa, New Zealand and Australia - which collectively rose around 8% from March 20 to April 10, the biggest three-week gain for such trades since at least 1999 . A straightforward and simple carry-trade transaction would be to borrow U.S. dollars at the three-month London interbank offered rate of 1.13% and use the proceeds to buy Brazilian real and earn Brazil’s three-month deposit rate of 10.51%. That would net anannualized 9.38% - as long as both currencies remain stable, but the real, of course, is appreciating.
Other options are Turkey, where the key interest rate is currently 9.25 percent, Hungary (9.5 percent) and Russia’s (12 percent). The cost of borrowing in euros overnight between banks reached 0.56 percent last week from 3.05 percent six months ago as the European Central Bank cut interest rates while pledges of international aid reduced concern the global recession would worsen. The London interbank offered rate, or Libor, for overnight loans in dollars fell to 0.22 percent from 0.4 percent in November.
Indeed Deustche Bank last week specifically recommended buying Hungarian forint denominated assets, and according to the bank the Russian ruble, the Hungarian forint and the Turkish lira are among trades offering investors the best returns over the next two to three months. Deutsche Bank recommends investors sell the euro against the forint on bets the rate difference will help the Hungarian currency gain 10 percent to 260 per euro in two to three months from 286.55 today. Investors should also sell the dollar against the lira and buy the ruble against the dollar-euro basket, the bank said. And it isn't only Deutsche Bank, at the start of April Goldman Sachs also recommended investors to use euros, dollars and yen to buy Mexican pesos, real, rupiah, rand and Russia rubles. And Barclays joined the pack this week saying Brazil’s real, South Africa’s rand and Turkey’s lira offer the “largest upside” as investors return to the carry trade. A global pickup in investor demand for higher-yielding assets and signs the worst of the global recession is over “bode very well for the comeback of the emerging-market carry trade,” according to analyst Anfrea Kiguel in a recent report from New York. In part as a result of the surge in carry activity the US dollar declined beyond $1.40 against the euro on Friday for the first time since January. Evidently the US may now be headed down a path which is already well-trodden by the Japanese yen.
Hi again Aileen,
I hope all this is now a bit clearer.
"During the years when JPY carry-trade was popular, people borrowed in Yen and then subsequently sold the Yen for local currency. Who bought the Yen the carry traders were selling?"
Basically the yen would be recycled via central banks in New Zealand, Australia, Turkey, Brazil, or any other country where people took the yen they had borrowed to invest in local currency denominated assets (including of course simply the currency itself). There are a myriad of trades available, but the key is the instruments should pay a higher interest rate than the one you borrow at, and the currency must be on its way up, and not coming down. From that point on its easy, I think.
"How do you quantify the scale of quantitative easing? Say, is it possible that BoJ has been printing money for 10 years, but at a very small amount that even after 10 years the total amount they printed is insignificant?"
They have basically printed massive amounts of money, but since the Japanese economy is structurally deflationary (on my view for elderly population reasons) this money simply does not produce inflation at home. So the quantity is far from insignificant.
"and, why did you pick Brazil and India as the countries where current US policy can bring inflation?"
Well Brazil and India are simply the most visible. Turkey is another, Morocco, Peru, Chile would be others. A whole swathe of emerging economies.
And my argument at present is that in the short term this does not necessarily produce inflation in these countries, since with the first world in recession and then slow growth commodity prices may not bounce back like before, and they have lots of spare capacity in terms of labour supply etc.
Basically these economies are hugely underleveraged at this point, and this is why they can grow rapidily, since they are able to assume a lot more debt.
Brazil and India simply have special significance due to their size, and strategic importance. The main factor I am looking at is demography, and the so called demographic transition. Japan is at one end, and Peru at another, as it were.
Just to follow up on the issue of Japan's military capability, Japan's constitutional provisions regarding the military are still the one's written under McArthur's post-surrender direction. Without US protection, Japan would lay open to invasion and conquest. The Mutual Security Assistance Pact between the US and Japan explicitly provides that "United States forces stationed in Japan (are)... to deal with external aggression against Japan while Japanese forces, both ground and maritime, would deal with internal threats". That treaty is still in effect.
Read this and you'll realize that to a large extent Japan is a military protectorate of the USA.
Uff,
This must the be the single biggest thread we have ever had here at JEW.
One important question here is in the context of dissaving, what it is and what it is not. Basically, standard life cycle theory predicts that a popopulation writ large will start to dissave at some point. Now, this fact which is very intuitive from an aggregate point of view has also led to all kinds of scary forecasts. Basically, in a standard Overlapping Generations model which we economists usually use to model these kinds of stuffs you DO get dissaving as the popopulation ages and in an open economy context this means that an ageing economy at some point will need savings from abroad to finance a deficit.
However, this is also where the problem arises since this is simply not a realistic scenario. Basically, there is just no way in which Japan would be able to finance an external deficit with near 0% interes rates. You can see this from the fact that most of the debt in Japan is held by domestic savers which also means that the minute Japan would need external funding the chain would break. Now, this might of course happen and as Edward points out, it is a real and quite scary potential end point.
Meanwhile however, there is a way an economy can fight this; namely by maintaining a consistent savings surplus (current account surplus) towards the rest of the world. Not only will this allow domestic investment to respond to foreign demand (thus compensating for the lack of domestic demand) it also means that the economy "never" reaches the point where it needs to finance an external deficit since this would effectively be impossible.
Of course, this is endlessly more complicated but even those authors who use the OLG models pretty much agree that the model is not capable of capturing the kind of "dissaving/saving" tendencies we observe. One obvious problem on the microeconomic level is of course what level of bequest might be in operation as well as the fact that people don't dissave to 0. Moreover, and especially in a country such as Japan the life cycle schedule of the working cohorts also need to be calibrated to the rising life expectancy as well as the precautionary motive which must arise as it becomes clear how public pension provisions will not be adequate to allow consumers to smooth consumption like the really want to (i.e. according to Friedman's pIH).
OK, this was very wonkish but basically we have to understand that IF Japan reaches a point where dissaving accelerates to such an extent that it eats up the external surplus it will almost surely be game over (i.e. default). This is then what leads to "export dependency" since Japan NEEDS the external surplus in order to achieve a "respectable" economic growth.
Claus
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