Is Japanese debt a ticking time bomb?

Abenomics crashes on sending the Topix higher and higher to investors’ glee, but an implicit bet on the creditworthiness of Japan accompanies the trade.

After decades of deflation, the nation that was once on track to overtake America as the world’s largest economy stagnated. Nominal GDP is in the same place since it was in 1990, which is why the relative debt has ballooned.

Its pile of debt has grown ever greater as tax revenues fell and deflation pushed the real value of the government’s obligations higher. In 1989 it was half of GDP, now at ¥1,034trn (£5.5trn) it is more than double GDP.

Neptune Japan Opportunities manager Chris Taylor says the stage is set for the nation’s great escape, because otherwise it will be the nation’s fiscal demise.

“Japan is in a situation where it has only one way out to avoid bankruptcy; that is to get tax revenues up and that is predominantly corporate profit-driven,” he says.

“There are a few key multinationals that are able to save a country.”

Between 99 per cent and 95 per cent of corporate taxes came from the Topix 100 companies, he explains.

He thinks that will offer a strong environment for Japanese equities as the government looks to garner the tax it needs to pay its debts while not strangling the golden geese.

It will take at best five years – more likely seven – to correct the overspending, and the clock is ticking on the rescue effort, he adds.

“The Japanese have only five to seven years to avoid bankruptcy; they run out of money after that, it’s as simple as that.” 

The nation’s stock of securities and foreign exchange is likely to add a further two years, but the ability to sell them at booked value in a crisis is suspect, he adds.

The attempt to reap more revenue through a hike in the VAT rates has been put on ice after the first phase led to a massive slowdown in the economy.

Earnings growth of 367 per cent from 2013 levels is needed by 2018 for the country to get its debt in order, he says.

That jumps to 415 per cent if the government cannot go ahead with the second VAT rate increase.

Taylor believes Japanese corporate earnings have been grossly understated and there is potential for large leaps in profits.

Earnings doubled in the first half of 2013, while analysts had predicted 35 per cent growth for the entire year.

If the government fails to raise the cash it needs, the perpetually resilient sovereign bonds may finally crack with yields headed sharply up.

That would send shockwaves through the entire economy.

GAM Star Japan Equity manager Ben Williams says Japan’s fiscal situation is overstated and the country “has nothing to fear but fear itself”.

The “unjustified fears” have crimped investment and consumer confidence and a change in mindset could be all that is needed for Japan to turn its situation around, he says.

While it is true the debt continues to rise, counter-intuitively yields continue to fall, he says.

Bond vigilantes – investors who sell sovereign bonds to protest fiscal irresponsibility by boosting yields – are scared to take on the authorities and therefore less powerful than some believe, he argues.

The existence of the bond vigilante is “crucial” to the fiscal hawk argument that a heavily indebted country will have its yields boosted by market action, he says. 

“If they do exist why did they give up in Europe as deficits continue and debt piles up? If it is because they are unwilling to take on the authorities this is instructive in itself,” he explains.

“It tells us that bond market investors recognise the power of the authorities, particularly central banks. To me, this is an important point.”

Most importantly, however, is the massive stock of savings in the country which offsets the massive government debt, he says.

“Whilst a huge amount of angst exists concerning the enormous level of Japanese government debt, few seem to look at the flip side, which is the huge stock of private sector savings.

“This seems strange because it’s intuitive to me that this helps explain how the debt is funded, and at such low cost. The frequent question is: ‘Look at the size of the debt – how on earth are they going to finance it?’ One could just as easily ask the question, ‘Look at all those savings in Japan – where on earth are they going to invest that?’”

Many tough-talking bond investors appear to have “turned up to a gunfight with a penknife”, he says.

Especially as they own just a 4 per cent of the debt. Most is held by long-term Japanese institutional investors such as the banks and insurers, along with the Bank of Japan.

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