Published in FT – Aug 11 2011
http://www.ft.com/intl/cms/s/0/b8d489a8-c363-11e0-b163-00144feabdc0.html#axzz1Vw09X2Dl
Sovereign downgrade? Been there, done that, got the T-shirt. Such is likely to be the response of any investor in Japan to the news that Standard and Poors has removed its triple A rating on US debt.
Japanese government bonds lost their stamp of premium quality in 2002. Early this year S&P took a second shot, with another downgrade to AA-. The result? In last week’s financial turmoil the yield on Japan’s benchmark ten year bond briefly dipped below 1%. If Sidney Homer’s classic “History of Interest Rates” is any guide, this represents the lowest level of interest rates anywhere since Babylonian times.
This is no aberration. For the past decade the Japanese bond market has been making monkeys out of not just the rating agencies, but also academics, trigger-happy short sellers, and politicians and bureaucrats who see fiscal austerity as a virtue in its own right. All have been proclaiming that out-of-control public debt had set Japan on the road to fiscal perdition.
No less a person than Minster of Economic and Fiscal Affairs Kaoru Yosano warned in a Financial Times interview that “Japan faced a dreadful dream.” (http://www.ft.com/intl/cms/s/0/4c1ddc9a-23d3-11e0-8bb1-00144feab49a.html#axzz1UXzfmzbt) On the face of it the numbers appear to back him up. Japan’s net debt to GDP ratio comfortably exceeds 100% and primary deficits stretch out as far as the eye can see. Yet the markets themselves are saying something quite different – that the supply of Japanese government bonds, far from being excessive, is actually insufficient.
To call this a disconnect is putting it far too mildly. The markets and conventional opinion are on different planets.
Until recently this was a parochial Japan-only affair, but now the implications are too important to ignore. Public debt has become the hottest of political topics across the OECD. No assertion about the sustainability of public finances can be convincing unless it accounts for the Japanese paradox.
It is possible, of course, that the market is simply wrong or, in a different formulation, rigged. Possible, but unlikely. The Japanese government bond market is the second largest in the world. It cannot be dismissed like some crazy aunt in the attic. Yields have exhibited an unbubble-like stability, holding between 1% and 2% since the late 1990s. Nobody, not even Japan’s financial bureaucrats, have the wherewithal to pull off manipulation on that scale.
Furthermore, Japan is no longer such an outlier. In Switzerland too bond yields have dropped to near-vanishing point, and Taiwan and Singapore are not far behind. All these countries enjoy current account surpluses and are therefore self-financing. However even in spendthrift deficit countries like the US and UK the bond market vigilantes appear to have saddled up and left town.
Savvy investors such as PIMCO’s Bill Gross had expected the end of the Federal Reserve’s “QE2” bond binge to trigger a sharp sell off. Instead bond prices have soared, sending yields to new lows. Despite S&P’s dire warnings, the US government is currently able to borrow on the most favourable terms in modern history.
How can this be? According to Professor Kenneth Rogoff of Harvard University (http://www.ft.com/cms/s/0/6571e6c8-93f5-11df-83ad-00144feab49a.html#axzz1UXzfmzbt) serious economic problems occur once the debt to GDP ratio exceeds 90%. Policy-makers, lothe to preside over a Greek-style fiasco, have interpreted this thesis as a clarion call for fiscal tightening. Yet no OECD countries that issue their own currency are suffering from rising borrowing costs. The crisis in the periphery of the Eurozone has proved a dangerous distraction from the real risk – which, as the bond markets are signaling, is of “turning Japanese,” as weak growth leads to debt aversion and de-leveraging, which in turn reinforces the low growth.
The key point here is the de-leveraging. When Japan’s bubble economy imploded in the early 1990s, the government net debt to GDP ratio was a negligible 15%. Far from being a cause of Japan’s descent into stagnation, the build up of public debt since then was the inevitable result. The private sector, traumatized by the bloodbath in stocks and real estate, embarked on a long process of reducing its indebtedness.
But money paid back does not evaporate. It has to find another user, which, given the scale of the financial cold turkey being experienced by Japan’s companies and citizens alike, had to be the public sector. A sharp increase in saving by the private sector was matched by a sharp increase in government borrowing. The bond market was the conduit.
The lesson from Japan is that we know a lot less about debt dynamics than we think we do. There is no magic level of debt to GDP that will automatically trigger a fiscal crisis. After the collapse of a bubble of historical proportions, deleveraging by the private sector is likely to be substantial in scale and duration. One way or another it has to be accommodated. The only safe way to avoid a build-up in public debt is not to have the bubble in the first place.