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8 March 2010

8 March 2010

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Macro Commodities Forex Rates Equity Credit DerivativesPlease see important disclaimer and disclosures at the end of the document
8 March 2010
Global Strategy
 Alternative view
www.sgresearch.com
Popular
Delusions
More on Japan
s brewing fiasco, and some musings on recent pushback
Dylan Grice
(44) 20 7762 5872dylan.grice@sgcib.com
Global Strategy Team
Albert Edwards
(44) 20 7762 5890
albert.edwards@sgcib.com
Dylan Grice
(44) 20 7762 5872
dylan.grice@sgcib.
com
 
A few months ago I wrote about an impending government funding crisis in Japan. Thepushback was so interesting I thought it worth writing up. None of you really disputed thelong-term problems facing Japan but, for various reasons – which I’ll look at below – very fewof you thought it was worth worrying about just now. Meanwhile, the biggest JGB holder onthe planet – the Government Pension Investment Fund (GPIF) – which has already admittedit’s no longer able to roll maturing bonds, has announced that it will open credit lines so itdoesn’t have to
sell
them to fund its obligations. With ¥213 trillion of JGBs to roll this year, oraround 45% of GDP (see chart below), maybe I’m not the only one scared stiff after all!
 
One of the great things about doing this job is the feedback you get from pieces youwrite. I have to admit, I
m poor at predicting the reaction a report will generate. In a warningto anyone following the few predictions I do make, my own favourite pieces have so fartended to be the ones eliciting the
 least 
reaction, while those that have made the biggestsplash have often been the ones which seemed the most obvious. Anyway, philosophically Ibelieve in reaction more than prediction, judging the response is always more interesting.
 
Broadly there are two types of
pushback
which make you think you
re on to something.One is outright hostility, sometimes verging on hate mail you receive when you know you
vetouched a nerve (recently I
ve been called
dishonest
and
immoral
for holding certainviews!). The other is complete apathy suggesting a broad disinterest in the topic.
 
The stuff I
ve written on Japan
s fiscal problems recently has fallen into that lattercategory. I should stress, it
s not an apathy born of a lack of understanding of the issues
 everyone acknowledges the long-term seriousness of Japan
s fiscal position. But peopleseem almost fatigued with the idea that a country which has defied bond market logic for solong now is
ever 
going to change. This is what I wanted to talk about this week.
JGB maturity distribution; ¥213 trillion to roll over this year (about 45% of GDP)
-50100150200250201020122014201620182020202220242026202820302032203420362038InterestAmountY213tr roll this year … GULP!!!
 
Source: Bloomberg
 
Popular Delusions
8 March 20102
To recap, the thesis I outlined back in January
1
 
was that since Japanese households
thebiggest effective drivers of JGB demand
are set to dis-save in coming years as they retire(left-hand chart below) there will soon be no one left to finance the government
s nosebleeddeficits at current yields. Indeed, the chart below suggests households are already runningdown assets. And because the interest rates which
 might 
attract international investors willinevitably blow up the budget (debt service is
 already 
35% of government revenues at
existing
yields) there is a very clear and present danger that the government reverts to the well-established historical precedent for cash-strapped governments of currency debasement.
Japanese households are set to dis-save (savings as %disposable income)Japanese households are
already
running down wealth (non-equity, non life assurance household assets)
0246810121416182003/83 03/85 03/87 03/89 03/91 03/93 03/95 03/97 03/99 03/01 03/03 03/05 03/07 03/09
 
840860880900920940960Q4 1997Q4 1999Q4 2001Q4 2003Q4 2005Q4 2007
 
Source: SG Cross Asset Research
The most common argument I received on why I was wrong to worry was along the lines thatJapan has had rising debt ratios and huge deficits for many years now. Not only have yieldsfallen, but the economy has struggled with deflation, not inflation.To me this feels like
recency
bias at work, which is a type of
availability
bias by which weoverweight events we find easy to imagine relative to those we don
t. Japanese debt marketshave been stable for such a long time it
s difficult to imagine anything different, so we don
timagine anything different and predict that the future will look like the past. Now, Japan
s debtmarkets may well remain very stable in the future and I
m very open to the strong possibilitythat I
m barking up the wrong tree. But
logic
like that outlined above is lazy indeed. It echoesBernanke
s nowinfamous2005 conclusion that nationwide housing collapse in the USwouldn
t happen because it hadn
t happened before.More thoughtful critics argued that I was ignoring the Japanese government
s significantfinancial assets. Taking this into account shows a net debt position of closer to 100% of GDP(chart below), considerably more manageable than the 200% gross debt-to-GDP ratio andmore in line with other OECD economies such as Italy and Belgium (great!).But I
m not so convinced by this argument, or to be more accurate, I
m not so convinced the
 numbers underlying this argument are correct 
. For a start, around 40% of the assets recordedon the asset side of the Japanese government
s balance sheet don
t actually belong to theJapanese government. They belong to Social Security and therefore to the Japanese public.That the vehicle which owns the assets happens to be publicly owned doesn
t change the fact
1
 
See
 A global fiasco is brewing in Japan
Popular Delusions 11/01/10
 
 
Popular Delusions
8 March 20103
that it is a
very real 
liability owed to individuals who must be either paid or defaulted on. Itdoesn
t just cancel out.
On a net basis Japan isn’t such an outlier: OECD gross and net debt ratios (% GDP)
050100150200250JapanItalyBelgiumUSAFrancePortugalUKCanadaGermanySpainNet Debt to GDPGross Debt to GDP
 
Source: OECD
 And who on earth knows what the other assets are worth anyway? The central government,for example, has funded projects deemed
socially useful
and which private marketswouldn
t finance. These loans, made via direct
investments
in public sector organisations(called Fiscal Investment and Loan Program [FILP] agencies), are recorded as assets on thegovernment balance sheet worth around 10% of GDP. Yet we know from decades of bankingproblems and bank recapitalisations that even the loans that markets
did 
finance souredpretty spectacularly, so one wouldn
t imagine the FILP agency loans to be of particularly highquality. Indeed, a few years agotwo economistsat the NBER reckoned that nearly half of theFILP agencies were insolvent. Maybe those assets are being provisioned for correctly on thegovernment
s books, but
and call me a cynic if you like
I really doubt it.But even if we assume those numbers are a fair reflection of asset value there is also theimplicit assumption that the Japanese government can monetise them. But I don
t think theycan. Shares and equity stakes are marked at around 20% of GDP, mainly reflecting JapanPost Bank - the
 jewel in the crown
- with $2.5 trillion in deposits. But last year, plans for itslong-awaited privatisation were shelved, apparently for fear that on a purely private sectorcalculus, many small and medium-sized companies wouldn
t qualify for the funding they needto stay afloat. Keeping it in public sector hands was the only way to ensure their life-supportcredit lines weren
t cut. Of course, I may just be being cynical again, but I note that Post Bankis also a huge buyer of JGBs and doubt it was just the SMEs life support the government wasworried about
 This leads nicely to the other argument worth thinking about, which runs like this: thehousehold sector may well be retiring and less able to absorb new JGB issuance, but thecorporate sector is expanding thanks to a vibrant export sector. Since corporate sectorsavings are as large as households
isn
t it reasonable to expect them to take over as theprimary source for government funding? The honest truth is that I don
t know. Maybe, I guess.But my gut feeling is pretty definitively no. For one, the corporate sector
doesn’t 
actually haveas large a pool of savings as the household sector.

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