04 Jan 2010
Jan. 4 (Bloomberg) -- Japan's Prime Minister, Yukio Hatoyama, swept to power by a public seeking an end to economic and political stagnation, is failing to arrest the nation's decline.Japanese gross domestic product shrank to an annualized 471 trillion yen ($5 trillion) in the third quarter, without accounting for changes in prices, the lowest level since 1991. The tumble is unprecedented among the biggest economies since the 1930s, according to Paul Sheard, global chief economist at Nomura Securities International Inc. in New York. As a result of the contraction, the Finance Ministry projects tax revenue this year will drop to a quarter-century low.
Hatoyama's 2010 budget, released Dec. 25, does nothing to rein in record deficits that threaten Japan's Aa2 rating, said Carl Weinberg, chief economist at High Frequency Economics. It avoided consumption-tax increases or deregulation to boost productivity; without policy changes, deflation and a shrinking population risk eroding the savings pool restraining Japan's bond yields.
"Japan's fiscal conditions are close to a melting point," said Takeshi Fujimaki, a former adviser to billionaire investor George Soros and now president of Fujimaki Japan, an investment advising company in Tokyo. "My biggest concern is whether the Japanese government will be able to sell all the bonds at auctions," he said, adding that such failures might send 10- year note yields climbing through 2.4 percent.
Yield Comparison
Yields on benchmark 10-year notes were at 1.305 percent at 10:30 a.m. in Tokyo -- about 2.5 percentage points lower than comparable Treasuries, even while Japanese debt is larger than America's.
Auction difficulties may begin in the next fiscal year, which starts April 1, Fujimaki said. The "tipping point" for Japan's bond market will come later, in about five years, said Atsushi Nakajima, chief economist in Tokyo at Mizuho Research Institute, a unit of the nation's biggest bank.
For now, investors are signaling confidence in Japan's ability to pay its $8.96 trillion of government bonds, or JGBs - - a total that exceeds the $8.78 trillion of U.S. federal debt, according to June figures from the Bank for International Settlements in Basel, Switzerland, which serves as a bank for central banks.
Bond Auctions
Bids for the most recent auction of Japanese 10-year notes, on Dec. 1, exceeded the amount on offer by 2.81 times. The lure for domestic investors is that falling consumer prices mean so- called real yields -- at about 3 percent for 10-year securities -- are higher than the 2 percent offered in the U.S. Local residents held 94 percent of the debt as of June, Finance Ministry data show.
Before Japan embarked on 13 years of deflation starting in 1994, 10-year yields averaged 5.6 percent from 1988 through 1993. Fujimaki in November 2005 advised selling JGBs, and the yields jumped more than half a percentage point the next six months. His bets haven't always panned out: His April call for the yen to fall to 130 per dollar in six months from about 97 preceded a rally to as high as 84.83.
Yields on Japan's 10-year government notes will rise to 1.55 percent by the end of next year, according to the median forecast of 15 analysts in a Bloomberg News survey.
Credit-rating companies and investors and now buying JGBs are failing to account for diminished domestic savings in coming years, said Weinberg, 60, founder of High Frequency Economics in Valhalla, New York, a global economy and markets research company.
‘Mega Risk Problem'
"Japan is the mega risk problem; it's the next big thing that will hit the credit markets," said Weinberg, who previously worked at the Organization for Economic Cooperation and Development and taught at the University of Pennsylvania's Wharton School. Most investors and ratings firms also missed debacles such as the emerging-market crises of the 1990s and the collapse of the U.S. mortgage-securities market, he said.
Investors can bet on a deterioration in Japan's credit quality through credit default swaps. The contracts insure against losses on sovereign bonds during the next five years. The cost of protecting $10 million has climbed to $68,100 from $37,000 in August, when the Democratic Party of Japan won power, according to data compiled by Bloomberg News. The cost was $3,625 three years ago.
Savings Pool
Households have funded state spending because much of their 1,400 trillion yen in financial assets is being used by banks, pension funds and insurance companies to buy Japanese government bonds. Such purchases are unsustainable because aging savers will want their money back, say Weinberg and Derek Halpenny, the European head of global currency research at Bank of Tokyo- Mitsubishi UFJ Ltd. in London.
The "large domestic pool of savings that has been there for Japan to support the JGB market" is "going to dwindle," Halpenny said. "There hasn't been much evidence of any real appetite to tackle the core of the problem," which is soaring government spending and sliding revenue, he said.
Hatoyama, 60, last month announced a record 92.3 trillion yen budget for the year starting April 1, which includes funding for his campaign promises such as child-care allowances and reduced tuition fees. His Cabinet also announced a nominal GDP growth target of about 3 percent in the coming decade, with a goal of about 2 percent for the real rate.
While Hatoyama backpedaled on some of his platform -- maintaining a gasoline surtax and asking local governments and businesses to shoulder some child-care costs -- the measures were insufficient to trim the government's borrowing needs. New bond sales were maintained at 44 trillion yen.
Shrinking Population
More than a fifth of Japanese are over 65, according to the National Institute of Population and Social Security Research. The nation's population began shrinking in 2006 from 127.8 million, and will drop by 3.2 percent in the coming decade, the Tokyo-based, state-sponsored institute estimates.
"National saving will soon decline," leading to higher interest rates, said Charles Horioka, a professor of economics at the Institute of Social and Economic Research of Osaka University and co-author of a paper with Harvard University's Martin Feldstein on international investment and savings patterns. "There is an urgent need to reconstruct the finances of the Japanese government."
Japan's credit rating is Aa2 at Moody's Investors Service, the third-highest grade, an equivalent AA at Standard & Poor's and AA-, one step lower, at Fitch Ratings. The U.S. and Germany have top ratings from all three companies.
‘Stable Outlook'
"We have a stable outlook on Japan's rating, but of course, given that budget deficits are so high in Japan and there's no firm target to reduce these budget deficits, we are somewhat concerned," said Thomas J. Byrne, senior vice president of Moody's in Singapore. "There's no clear, credible policy yet from the new DPJ government to set a fiscal target," he said, adding that while Japan can "can get away with large budget deficits" for now, that won't necessarily be the case in the longer term.
Japan faces the biggest fiscal gap among the Group of 20 advanced and emerging nations during the coming five years, according to a Nov. 3 report by the International Monetary Fund in Washington. Its deficit will remain as high as 8 percent of gross domestic product in 2014, compared with 6.7 percent in the U.S. and a balanced budget in Germany.
Debt Ratios
Japan's debt is projected to be 246 percent of GDP that year, compared with 108 percent for the U.S. and 89 percent for Germany, according to the IMF report. Greece, whose deficit the IMF estimates at 7.1 percent this year, saw its credit rating lowered to five steps above noninvestment grade by Moody's this month and also cut at S&P and Fitch.
Because Japan's government bonds are in yen, credit risks are limited by the central bank's ability to boost the supply of money to pay the debt, said Simon Johnson, a professor at the Massachusetts Institute of Technology in Cambridge, Massachusetts, and former IMF chief economist.
"Typically if you have a debt in your own currency, that can be a tax-burden issue and a burden-on-growth issue but not necessarily a sovereign-credit issue," said Johnson, who is also a senior fellow at the Peterson Institute for International Economics in Washington. "It's not a five-to-10-year threat to them."
BOJ Options
Weinberg responds that the Bank of Japan isn't capable of creating the money supply needed to pay off the debt without sparking "hyperinflation" -- or increases in consumer prices so large that they destabilize the economy, such as occurred in Argentina in the 1980s.
Bank of Japan Governor Masaaki Shirakawa and his policy board have already cut their benchmark interest rate to 0.1 percent. The central bank released a 10 trillion yen credit program on Dec. 1 that economists say was largely to appease government officials and will do little to spark domestic demand.
"Japan has never really escaped from the deflation situation of the 1990s," said Sheard at Nomura Securities, a unit of Japan's largest brokerage. The central bank's response to the global recession and financial crisis has been "somewhat timid," given the risk of a prolonged decline in prices, he said.
Shirakawa has said that adding cash to the banking system does little to spark the spending that's needed to drive up consumer prices.
The economic malaise may be creating another problem by eroding employment opportunities for the diminishing ranks of young Japanese. The proportion of college students with offers for work tumbled 7.4 percentage points from a year earlier to 62.4 percent, according to a November report by the Education Ministry -- the steepest drop since the survey started in 1996.
Ayumi Okada, a fourth-year economics student at Nihon University in Tokyo, has interviewed with 40 companies.
"I feel I'm never going to get a job offer, no matter how hard I try," she said.
