While the world worries about Greece and Spain, Japan also has its share of debt problems. Are financial markets missing the real problem?
Predictions of the date may differ, but the general consensus on Japan remains the same. In a matter of just three to 10 years, the world’s third-biggest economy may start running out of the savings needed to fund its massive public debt.
Is it time to start selling yen, or are the doomsayers off target concerning the world’s biggest creditor nation?
The days of Tokyo’s finance mandarins being admired for their fiscal prudence are long since gone.
According to the International Monetary Fund, Japan’s general government debt first broke above 100 percent of gross domestic product (GDP) in 1997 as the authorities tried to pump prime the economy out of its post-bubble funk.
Ending the credit binge – and its famous “bridges to nowhere” construction projects – has proved challenging for governments dealing with a deflationary downturn, rising welfare costs and dwindling tax revenues.
In 2011, general government gross debt totaled nearly 230 percent of GDP and is projected to reach 245 percent in 2013, with the government’s fiscal deficit currently around 10 percent of GDP.
Net public debt, which subtracts from gross debt government assets such as public pension funds, has also increased tenfold over the past two decades to reach more than 125 percent of GDP.
In comparison with Europe’s indebted economies, Greece reached crisis point with its debt to GDP ratio of just 150 percent, while the Spanish government has faced a storm with a debt ratio below 100 percent.
Prime Minister Yoshihiko Noda, the first leader since Ryutaro Hashimoto in 1997 to raise the sales tax – Hashimoto’s move cost him his job – has already sounded the alarm.
"The European debt crisis is definitely becoming something that is not just someone else's problem," Noda has said. "We’re aware that it’s an urgent situation and want to explain that properly to our countrymen."
Despite the urgings of economists and finance bureaucrats, it took a bruising political battle for Noda to succeed in pushing through a consumption tax hike seen as barely containing projected growth in welfare spending.
The increase in the consumption tax to 8 percent in April 2014 and 10 percent in October 2015 received approval in August, but Noda was forced to pledge to call fresh elections “in the near term,” a vow that the opposition has used to block a key debt issuance bill in hope of forcing elections by year-end.
Should the bill not be enacted by the end of November, the government has warned it will run out of cash, prompting warnings from credit-rating agencies of another downgrade in Japan’s sovereign debt rating as well as volatility in the bond market.
Meanwhile, an aging population, declining birthrate and a contracting workforce are putting pressure on household savings, adding to concerns that the nation’s legendary savers will no longer be able to buy government bonds.
According to a McKinsey study, savings rates in Japan decline markedly after the age of 50, meaning that the rising proportion of elderly will further diminish household savings.
In addition, the cost of increased energy imports to cover the shutdown of nuclear power plants has eroded the trade balance. Exports to Japan’s biggest trading partner, China have been hit by a slowdown that may mark the end of double-digit growth in the Middle Kingdom.
In its August 2012 report, the IMF warned that “even a moderate rise in yields would leave the fiscal position extremely vulnerable…Failure to implement a credible fiscal consolidation plan could lead to sovereign downgrades and trigger similar actions for financial institutions, which could eventually erode confidence in the JGB [Japanese government bond] market.”
Higher JGB yields would further damage public finances, with the government’s budget already at a point where bond issuance exceeds taxation revenues. The IMF calculates that a spike in bond yields would slash output by 6 to 10 percent over 10 years, potentially harming not only other Asian economies but also the United States and Eurozone.
Despite the highest public debt to GDP ratio in the industrialized world, Japan remains the world’s biggest creditor with net foreign assets of around US$3.1 trillion, with its 2011 per capita GDP of US$34,294 above Italy, Spain and South Korea and four times the size of China’s.
Household assets of an estimated 1,500 trillion yen, surplus funds held by the private sector and the demand from Japanese banks and other financial institutions for low-risk investments have given the government a ready market for its JGBs.
In addition, Japan’s low ratio of taxes to national income provides scope for increasing the burden. According to OECD data, Japan’s 27.6 percent ratio in 2010 compared with the United Kingdom’s 35 percent and was below the average 33.8 percent of tax revenue as a percentage of GDP.
Japan economist Jesper Koll, Japan Director of Research at JP Morgan, said while the nation’s current account surplus would fall into deficit “in early 2015,” the crisis had been “overstated” and the nation was in no danger of becoming another Greece.
Thanks to a steady stream of income from foreign assets – an amount that may increase due to the past year’s record overseas investments – the current account has remained in surplus even as the trade balance declined.
“Japan is not Greece as it funds its own debt, whereas in Greece 70 to 75 percent of government bonds were owned by non-Greeks. Crises happen when your creditor goes on strike, and the fact is that Japan’s debt is held almost exclusively by the Japanese themselves so any comparison just doesn’t make sense,” he said.
Unlike Greece, Spain and other members of the Eurozone’s monetary straightjacket, Japan has its own currency which could prove an important advantage, Koll added.
“If it comes to a point where domestic savings can’t fund the deficit any more, the currency is likely to weaken, making yen assets such as Japanese bonds more attractive. That’s something you can expect to happen from late 2014 to early 2015 onwards,” he said.
“The fact that it hasn’t weakened yet and has continued to strengthen shows you the Japanese are capable of funding their debt. Once the yen starts to weaken, that will be in parallel with Mr and Mrs Watanabe no longer having enough savings and Japan needing to attract money from American pension funds, for example.”
Junko Nishioka, head of research, Japan at RBS Securities said the fiscal deficit was likely to continue to worsen.
“The fiscal deficit is already around 10 percent of GDP, and considering there’s no way for the Japanese government to further support the economy, the deficit is likely to increase further,” she said.
While Nishioka said the current account surplus would help keep JGB yields low, the situation could change soon.
“We expect the current account balance to fall into negative territory after 2017, if you assume there’s no resumption of nuclear power plants under the DPJ [Democratic Party of Japan] policy,” she said.
“This would increase the fiscal risk, but Japan also has massive foreign reserves and external assets, which are likely to cover the current account deficit likely in 2017 or 2018.”
1997 all over again?
PM Noda succeeded where others failed in increasing the consumption tax, a move that, like Hashimoto in 1997, may cost him his position at upcoming elections due next year at the latest.
However, the tax hike is expected to generate only an additional 10 trillion yen a year in revenue, below the expected 10.9 trillion yen annual rise in spending due to higher pension costs.
Spending on seniors already accounts for around 30 percent of the annual budget, and with lawmakers reluctant to curb benefits the situation is likely to worsen. Nearly a quarter of the nation’s 127 million population is over the age of 65, and this proportion is forecast to reach 40 percent by 2060.
According to the OECD, Japan’s tax revenue in 1991 totaled some 66 trillion yen in individual and corporate income taxes. By 2009, this had fallen to 36 trillion yen, with bond issuance exceeding tax revenues in fiscal 2012 for the third straight year.
The IMF has warned that the increase in consumption tax goes only halfway toward achieving a desired fiscal adjustment of 10 percent of GDP over the next decade to put the debt ratio on a downward path.
With some fiscal adjustments, the public debt to GDP ratio is forecast at 300 percent of GDP by 2030, with further cuts deemed necessary to stabilize and then start reducing the ratio.
Bringing the primary balance, where fiscal expenditures can be covered without borrowing, into equilibrium is estimated to require an additional 5 to 6 percent hike in the consumption tax.
The government has forecast a primary deficit of between 1.9 and 3.1 percent of GDP by fiscal 2020, compared with the fiscal 2011 deficit of 7.4 percent.
RBS’ Nishioka said the tax hike “wasn’t enough” to cover rising welfare spending, saying the next government would have to consider further cost cuts as well as tax increases. Some economists have even called for the consumption tax rate to climb to 16 or 17 percent to eliminate the budget deficit.
Yet when Hashimoto increased the rate by just two percentage points to its current level, the economy plunged into a 20-month recession, albeit worsened by the Asian financial crisis.
While forecasting a mild recession this summer before a recovery in 2013, JP Morgan’s Koll said he was less concerned about the impact of the consumption tax hike.
“It’s the right thing to do as Japan has a very inefficient tax system, so raising the tax base by lifting the sales tax helps build a better system that actually will collect revenue if and when the economy starts to grow,” he said.
“With luck, by the end of 2013 the global economy will be in better shape and there will be recovery momentum in Europe beginning to emerge. You have to start somewhere and I’m not worried about this pushing Japan back into recession.”
Koll said the government had also managed to cut its payroll costs by reducing public sector pay and pensions – a “step by step” process to reduce the government wage bill.
Structural reform or inflation?
Proposed solutions to Japan’s economic woes have included measures to deregulate the agricultural, electricity and service sectors, along with the politically sensitive measures of joining the Trans-Pacific Partnership and increasing immigration.
The IMF has suggested the fiscal consolidation include raising the consumption tax rate to 15 percent – closer to the OECD average – while reducing corporate taxes, broadening the personal income tax base and increasing the pension retirement age to 67.
“If the consolidation was coupled with structural reforms to support growth, it could boost confidence and help raise private consumption and investment over the longer-term,” it said.
Venture capitalist Hitoshi Suga suggested a “debt-equity swap” where the government converted JGBs into 100-year debts, similar to Britain’s “perpetual bonds” issued after the First World War, as well as more fiscal prudence.
“The Japanese government must learn how to use funds more efficiently, liquidate and sell its unnecessary current assets which amount to a substantial percentage of the debt, rather than increasing consumption and other taxes and raising social welfare insurance premiums,” he said.
“Importantly, healthy economic growth should be strategically planned and implemented to increase tax revenue automatically and substantially.”
Another solution has come from the World Economic Forum, which in its Gender Gap Report for 2012 noted that some studies have found “closing the gap between male and female employment would boost Japanese GDP by as much as 16 percent”.
However, the easiest fix might come from that bugbear of central bankers everywhere: inflation.
Rising inflation helped the United States nearly halve its debt burden from World War II over the period from 1946 to 1955, but Japan’s policymakers, including the Bank of Japan (BOJ), have struggled in recent years to overcome persistent deflationary expectations.
However, with the current BOJ governor, Masaaki Shirakawa’s, five-year term expiring next April, the nation’s then political leader will have the perfect opportunity to force a policy change.
Should Liberal Democratic Party (LDP) leader Shinzo Abe win office, the BOJ would be under pressure to escalate its quantitative easing policies, according to Koll.
“Mr. Abe wants an outright inflation target of 3 percent, rather than the current 1 percent figure,” Koll said, saying that fundamental change was only likely if the LDP took the helm.
“The BOJ has always done the right thing, but it’s fairly easy to accuse it of doing too little, too late compared to what we’ve seen in America and Europe,” he added.
Ironically, despite its recent crises, Europe offers an example to Japan of managing fiscal reconstruction while also raising growth. Both the Netherlands and Sweden achieved this feat in the 1980s and 1990s through persistent public finance reforms along with greater labor market mobility and other market opening measures.
Pulling off the same success would go a long way toward ensuring that the sun does not set anytime soon on the land of the rising debts.
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