What ever happened to the Japanese debt nightmare?
Early last year no less a figure than Kaoru Yosano, then minister for economic and fiscal policy, warned of “a dreadful dream” in which long-term interest rates would shoot up.
S&P had just downgraded Japan’s credit rating, and high-profile hedge funds were anticipating a bond market bloodbath. Given Japan’s gaping fiscal deficit and Mount Fuji-sized government debt burden, shorting ten year bonds trading at the extraordinarily low yields of 1.2% looked like a one way bet.
Except that it wasn’t. Fast forward sixteen months, and ten year bond prices have risen further, causing yields to drop to 0.85%. The entire yield curve out to thirty years has now slid below 2%. While the bond market vigilantes are causing uproar in the eurozone periphery, in Japan they appear to have gone as quiet as the sound of one hand clapping.
The reality is that the world’s bond markets are delivering two radically different types of bad news.
The first type, peculiar to eurozone countries with current account deficits, comes via excessively high bond yields. The message is a loss of faith in these countries’ ability to service their debts to foreigners.
The second type comes via excessively low bond yields and the message is a loss of confidence in growth prospects. Japan is the most extreme case, but no longer unique. The high bond prices and low yields visible across the developed world are no badge of honour for policy-makers, but a warning sign that economies are sinking into a morass of weak growth and joblessness.
The fact that Japan’s bull market in government bonds is still intact twenty two years after its asset bubble burst should set red lights flashing elsewhere. In an era of stagnation, time passing does not indicate progress, but merely the hardening of pessimistic expectations.
At first sight the co-existence of a soaring debt-to-GDP ratio and rock-bottom interest rates seems anomalous, but they are two sides of the same coin. What causes them both is economic debility.
The key factor in Japan’s fiscal deficits had been the long slup in central government tax revenues, which have halved since 1990. Large numbers of workers have seen their pay fall below the income tax threshold. Corporate tax revenues have been hit by loss carry-forwards and carry-backs. The long slide in land prices has eaten into inheritance taxes and made capital gains a distant memory.
Prime Minister Noda plans to deal with the government deficit by doubling the consumption tax to 10%, a long-standing goal of the Ministry of Finance. But if you tax something, you usually end up with less of it, and Japan needs to encourage, not penalize consumption. Instead, the government should consider taxing savings, particularly the 300 trillion yen of deposits and long-term investments sitting on corporate balance sheets.
It should also take advantage of what the bond market is offering. Instead of a dreadful dream, Japan’s policy-makers are facing a golden opportunity. They can issue debt on more favourable terms than any borrower in history.
Reportedly the British Treasury is considering the issuance of “Osborne bonds”, nicknamed after the British Chancellor of the Exchequer. These would have maturities of a hundred years or more or perhaps no maturity at all, like the perpetuals floated to fund various British wars.
The Japanese government should beat George Osborne to the punch. Prime Minister Noda has likened himself to the unglamorous, but hardy loach-fish. Super-long maturity or perpetual “loach bonds” could probably be floated with coupons of under 2.5%.
In the west loaches are rarely eaten, but in Japan they are considered solid fare and served up fried or marinated in sake. Likewise, loach bonds might not attract foreign investors, but Japanese insurance companies and other yield-starved institutions should have an appetite for the extra income in their home currency.
Currently Japanese bond yields exceed the growth of nominal GDP. If this gap is not reversed, the debt-to-GDP ratio will carry on rising for ever. The gap is modest and can be addressed by sensible stimulus and aggressive monetary policy.
The US, the UK and the strong credits of the eurozone are in better positions, but need to ensure that growth does not slow any further
The outlook is much bleaker for the weaker credits of the eurozone (not just Greece) where bond yields are likely to remain locked far above the growth rate. For them Mr. Yosano’s nightmare is all too real.