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5/2/2019 When Will Japan's Debt Crisis Implode?

When Will Japan's

Debt Crisis Implode?
Peter Pham Contributor

I write financial newsletters for investors on how

to profit in Asia.

Japan is one of the most

developed and most
influential countries in
the world. However, it is
also the most indebted
country in the world,

Money traders in Japan

carrying a substantial
watch the monitors at a debt roughly 233% of
money market brokerage
company in Tokyo. (AP GDP on its shoulders.
The ‘runner-up’ is
Greece with 177%, which is still relatively
small in comparison.

One may expect that Japan, with its eye-

watering debt levels, would be an
investment "leper," where foreign direct
investment (FDI) would actively avoid this
frail and debt-ridden economy.

We witnessed that since 1997, debt levels

grew consistently, GDP growth stagnated 1/11
5/2/2019 When Will Japan's Debt Crisis Implode?

and the returns of the 10-year government

bonds were negative. Despite of these
worrying indicators, Japan continues to be
a stable and creditworthy nation that
attracts investors.

How Can Japan Tolerate Its

Enormous Debt Level?

First off, let’s have a look at how Japan got

trapped in debt, especially after WW2 when
the economy rose to power and

Deflation has been Japan’s economic

setback since the early 1990s. As we
pointed out in previous dailies, the
expected asset bubbles that were created
after the WW2 had finally burst in 1989,
after the increase of inter-bank lending rate
from the Bank of Japan.


Once the stock market crashed and equity

prices dropped, banks and insurance
companies were left with lots of bad debt. 2/11
5/2/2019 When Will Japan's Debt Crisis Implode?

The Japanese government and central bank

supported these organizations by bailing
them out and providing low-interest credit.
Thus, these firms have to rely on support.
But this eventually became unsustainable,
so banking institutions had to be
consolidated and nationalized.

Throughout many years, other fiscal

stimulus initiatives were also used to help
reboot the stumbling economy. Because of
these government-approved actions,
Japan’s debt level skyrocketed to become
the highest in the world.

But all is not lost.

Many other countries, including Greece,

owe mostly to foreign creditors. However,
most of Japan’s debt (including
government bond liabilities) are held by its
own citizen, so the risk of defaulting is
much lower.

Japan is still well-off because it can adjust

interest rates at low levels so that
repayment values stay low relative to the
overall debt level. 3/11
5/2/2019 When Will Japan's Debt Crisis Implode?

Japan is unlikely going to default anytime

soon, but what will happen in case its debt
interest rate starts to peak?

Japan in Debt and Danger

Japan currently has such a high level of

debt that it’s doubtful the country
can ever repay the full amount.

To know more about the complexity and

seriousness of Japan’s debt predicament,
we have to understand how the government
pays for its commitments and public
services annually.

In all economies, governments fund public

services by levying tax to its citizens.

If total tax revenue exceeds public services

costs, then there is a fund surplus.
However, if the total amount of tax is less
than government spending requirements,
then is a fund deficit, and the government
has to figure out how to cover this loss by

To make up for this deficit, governments

issue bonds, or IOUs, and sell them to
investors along with paying interest. 4/11
5/2/2019 When Will Japan's Debt Crisis Implode?

If the level of debt is small relative to tax

revenues, the interest payment has a small
value. But once the government borrows a
higher amount, national debt level
increases, and thus investors become more
concerned over the risk of default.

The higher the risk of default, the higher

the bond interest rate – the additional
amount that covers the added risk for

To lower the burden of debt, Japan’s

central bank reduces the interest rate and
purchases government bonds to supply the
financial system with more cash.
Theoretically, this artificially minimizes the
total interest repayment.

Because the Japanese government’s debt is

so high, the interest expense can easily be
affected by rate increases. In fact, Japan’s
debt was 15 times higher than the tax
revenue collected by the government in the
end of 2016.

Based on this trend, we can figure out when

the government will not have enough tax
revenue to cover interest payments. 5/11
5/2/2019 When Will Japan's Debt Crisis Implode?

You can see this trend using the graph


Japan Tax Revenue v.s Interest Rate ONE ROAD RESEARCH

By 2041, assuming tax revenue remains

constant and there won’t be any economic
shocks, Japan’s interest repayments will
exceed tax income. Note that we also
assume interest rate to stay at 1.1%, because
if this figure increases then the government
will default more quickly.

An Economic Pandemic

As we stated above, Japan is still on the

high ground because the government can
sell most of its debts to its citizens, which is
known as domestically held debt. Deflation
(decreasing prices of goods and services)
that occurs for long periods of time make 6/11
5/2/2019 When Will Japan's Debt Crisis Implode?

government debt and other low yielding

assets much more attractive.

For example, if the price of goods drops by

1% while government bond yields 1%, then
the overall return would be 2%. Japanese
investors are currently satisfied with these
returns, but the country has to increase
national savings so that domestic
purchasers continue to buy new
government debt.

Yet Japan’s population is shrinking and

aging, so it’s highly doubtful that the
country can increase national savings to a
point where purchasing government bonds
is sustainable. And because Japan is a net
importer of goods, the only way to reduce
debt is by having foreign investors.

It is difficult for Japan to grow its GDP partly because of its aging
population. (Photo by Tomohiro Ohsumi/Getty Images) 7/11
5/2/2019 When Will Japan's Debt Crisis Implode?

Who will cover the cost?

So far, this strategy has been successful.

The world today is in an odd place, as many
developed markets have all-time low
interest rates. Investors are playing safe by
trying to reduce losses on fixed income
assets. That means for now, Japanese
government bonds don’t seem that bad.

The second highest levels of Japanese debt

are held by the U.S. The upside of this is to
reclaim financial leverage and have some
autonomy over Japan (the largest holder of
U.S. debt), while optimizing the exchange
rate between the Yen and Dollar. Another
important reason to hold Japanese debt is
to weaken the Chinese stronghold that is
casting its shadow over Yen-denominated

To ensure that Japan’s interest payments

and spending obligations will not be
defaulted, the government has to make sure
foreigners are buying its debt.

Nowadays, buyers should be supporting

debt auctions. But in the future, continual
reduction of interest rates and satisfying 8/11
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foreign investors can raise debt servicing

costs to unreachable levels.

Therefore, the only option to gain more

foreign investors is to have higher yielding
debt options. From the graph below, you
can see that Asia is buying more Japanese
debt. This is mainly because China is
diversifying, by exposing more into Japan
while relying less on Europe and the U.S.

Foreign Investor Bond Holdings by Region ONE ROAD RESEARCH

Window Guidance Nullifies Asian

Capital Development

Alternatively, Japan can increase economic

growth to outpace its growing debt burden.
But for this method to work, it has to
enhance industries that provide the highest
tax incomes. 9/11
5/2/2019 When Will Japan's Debt Crisis Implode?

A proven method to achieve this is the

Asian Capital Development (ACD) model,
which brought much success after WW2.
However, subsidization and window
guidance require so much funding that the
country may have to increase borrowing
(which is detrimental if the country is head
over heels with debt!).

Watch out!!!

To provide more attractive debt options,

the government will have to tolerate more
interest liabilities. That means increased
loaning to pay for this.

This is a typical perpetual debt trap, a

vicious cycle where borrowing to service an
ever-growing interest repayment. The more
you’re borrowing to pay debts today, the
more interest and obligations you’ll have to
face tomorrow.

Japan may be a prodigal debt manager for

now, but because the structure of its society
will not change significantly and its
economy is not productive enough, the only
viable option is default. 10/11
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This scenario is what economist claim to be

impossible. Unless Japan attempts a leap of
fate to ensure economic grow outpaces
interest payments, then the die is cast.

Stimulus packages have failed one after

another, and Japan must find new ways to
swim out of its economic quicksand.

In the next daily, we’ll go through different

economic remedies for Japan to escape its
debt trap and the outcome of each course of

Peter Pham is director of One Road Research, host of One Road

Podcast,author of The Big Trade, and founder of Phoenix
Capital, Acquisition Finance Magazine's 2015 Emerging Markets Fund of
the Year. 11/11