TOKYO(Reuters) – Capital flight, soaring borrowing costs, tanking currency and stocks and a central bank forced to pump vast amounts of cash into local banks — that is what Japan may have to contend with if it fails to tackle its snowballing debt.
Not long ago such doomsday scenarios would be dismissed in Tokyo as fantasies of ill-informed foreigners sitting on loss-making bets “shorting Japan.”
Today this is what is on bureaucrats’ minds in Japan’s centre of political and economic power.
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“It’s scary when you think what could happen if there’s triple-selling of bonds, stocks and the yen. The chance of this happening is bigger than markets think,” says a senior official.
Leaning back in a leather sofa in his office, the official appears relaxed, but the way he wastes no time answering questions about a debt meltdown, suggests it is an all too familiar topic.
The official, like many others interviewed by Reuters, declined to be named because of the sensitivity of the subject and his alarm over Japan’s $10 trillion-plus debt overhang has yet to be reflected in public debate or action. But these officials would be the ones pulling the levers in the command center if Japan were to be hit by a debt crisis.
The government borrows more than it raises in taxes, and its debt pile amounts to two years’ worth of Japan’s economic output, the highest debt-to-GDP ratio in the world.
It costs Japan half of the country’s tax income just to service its debt. Each year, Japan’s debt level increases by more than the combined gross domestic product of Greece and Portugal.
Yet Prime Minister Yoshihiko Noda’s plan to double the 5 percent sales tax to 10 percent over the next three years is seen as far too timid to stop debts from piling up.
Furthermore, he has yet to win over many in his own party and half of the public while the opposition threatens to scupper the plan, which it supports in principle, to force snap elections.
Technocrats who might have once dismissed worst-case scenarios are now beginning to take them seriously as doubts grow over whether Japan is ready to act and as Greece’s budget meltdown stokes the euro zone’s debt crisis.
Conventional wisdom is that Japan is safe as long as it keeps covering about 95 percent of its borrowing needs at home. What emerges from a dozen or so interviews with fund managers and officials versed in monetary and fiscal policy is that a risk of domestic investors going on a strike is what makes them particularly nervous.
The fact that bureaucrats openly discuss such disaster scenarios shows their concern that the public, politicians and even some people in financial markets do not take the situation seriously enough, and that the debt blowout will become a self-fulfilling prophecy if necessary steps, such as raising taxes, keep getting pushed back.
But to some economists who have followed Japan for years, the frustration is that the country has yet to solve its underlying problems of slow economic growth and stubborn deflation. As long as those conditions persist, it will be difficult to crawl out from under the debt burden.
“If you wind the clock back five or 10 years, they’d have been saying all the same things and probably with a very similar time horizon of three to five years,” said Richard Jerram, chief economist at Bank of Singapore.
“If you’re worried about it, and you think you’re three to five years away (from a potential crisis), why not do something about it now by trying to boost growth in the economy? Awareness of the problem never seems to translate into a response.”
While officials stress it is too early for a definite contingency plan, there seems to be an agreement that financial institutions will be the hardest hit because of their big government bond holdings, and that the Bank of Japan will play a key role in shoring up the sector.
“The most important thing, in the event of a crisis, is perhaps not trying to affect fund flows by buying government bonds in huge amounts, but to make sure Japanese banks aren’t forced to sell en masse to meet day-to-day funding,” one of the officials familiar with BOJ thinking said. “Once it becomes a banking sector problem, it’s very hard to contain the damage.”
In an event of a surge in yields, the Bank of Japan could flood money markets with cash the way it did after the March 11 earthquake and act as a market-maker for the bond market, matching bids and offers if they fail to meet, officials say.
The finance ministry could also be forced to redeem bonds ahead of maturity to calm investors, says Yoichi Miyazawa, former vice finance minister and upper house lawmaker for the opposition Liberal Democratic Party.
Miyazawa, who led work on the party’s crisis plan, says the worst case scenario could involve bank bailouts and Greek-style austerity if debt servicing costs soared, threatening to eat up a big portions of revenues.
“The government should show a concrete roadmap for rebuilding public finances, including the kind of reforms adopted by Greece, which involve painful belt-tightening, slashing welfare spending and boosting sales and other tax rates,” he said.
Finance Ministry data confirms that banks, rather than the budget, would take the hardest, most direct hit. First, the 2012/13 budget plan is based on 10-year yields of 2 percent, giving the government some cushion considering those bonds are currently yielding less than half of that.
Secondly, its simulations show adding 1 percentage point to borrowing costs would add 1 trillion yen to about 22 trillion in borrowing costs over the course of one year, rather than double them as some commentators warn, because the spike would only affect newly issued and rolled over debt.
What sets Japan apart from Europe’s crisis-hit nations is that it borrows almost exclusively at home and with domestic savings of some 1,500 trillion yen ($19 trillion) it can do it paying less than 1 percent for 10-year bonds.
Deflation and the yen’s long bull run foster a “patriotic” home bias among households and institutions, turning private savings into quasi public money, always there and easily accessible.
In addition, the central bank acts as a buyer of last resort for the market, taking up large amounts of government bonds both as part of its annual quota of more than 20 trillion yen and an asset-buying plan launched in 2010.