The power of compounding once described as being the eighth wonder of the world by Albert Einstein, is well known for being an investor’s best friend. If you manage to compound your wealth at a steady rate of say around 10% per annum for the next three or four decades, you’ll do pretty well for yourself, and you should be able to retire comfortably — barring any unforeseen shocks.
Unfortunately, the power of compounding works both ways. If you or your business is unlucky enough to be in debt, without a careful debt reduction plan, debts and interest on debts can soon spiral out of control.
This is exactly the situation Japan could find itself in if the country does not get its financial house in order according to analysts at Source, the multi-asset research platform.
Japan’s debt load is growing rapidly
To the outside observer, it may look as if Japan’s debt position has already spiralled out of control. The country’s gross government debt to GDP ratio climbed from 67% in 1985 to 248% in 2015 while the net debt ratio rose from 26% to 128%. However, there are a few unique features that have enabled Japan to run this kind of deficit without the country collapsing in default.
Japan is self-financing. The country has run a current-account surplus in every year since 1981, and the country as a whole saves more than it invests. Gross National savings are currently around 25% of GDP. Japan is an international creditor, not a debtor, with a net international investment position of 68% of GDP by 2015. Switzerland is the only country in a better position with a net international investment position of 92% of GDP for 2015. In comparison, Spain, Australia and the US are indebted to the rest of the world with ratios of -88%, -57% and -41% respectively. As a result, it’s difficult for the rest of the world to force a financial crisis on Japan; the country is in control of its own economic destiny…or it is for the time being.
Demographic trends and Japan’s existing financial position indicate that over the next few decades the country’s debt mountain will rapidly spiral out of control if policymakers don’t take action to cut spending and raise taxes.
According to UN estimates, over the next three decades Japan will see population shrinkage of 13% and working age population shrinkage of 25%. Lower tax receipts coupled with higher social security bills will form a pincer on Japan’s budget.
1,908% by 2100?
According to Source’s analysis a simple debt model that assumes zero nominal GDP growth, zero yield on government debt and a primary government balance remaining at the 2015 level of 4.8% of GDP (a continuation of the current trend assuming all other variables remain unchanged) suggests gross debt/GDP would rise to 416% by 2050 and 656% by 2100. But this favourable scenario assumes the budget surplus remains, and interest costs don’t increase two extremely optimistic assumptions.
Worsening demographics suggest that Japan’s budget surplus won’t last much longer and reflect this, Source plugs a primary budget deficit of 10% of GDP into its calculations. In this scenario, the debt/GDP ratios would rise to 598% and 1098% in 2050 and 2100, respectively. Further, assuming bond yields rise to 1%, the debt ratio would rise to 768% in 2050 and 1908% in 2100. In these two scenarios, interest payments would amount to 7.7% of GDP in 2050 and 19.1% of GDP in 2100. How much longer will Japan be able to avoid a default event in this scenario?