Is the World's Second Biggest Economy On the Ropes?

SUNDAY, APRIL 11, 2010

Is the World's Second Biggest Economy On the Ropes?

Iceland has approximately the 101st biggest economy in the world.

Dubai is also tiny.

Greece is somewhat bigger, with the 27th biggest economy.

When Iceland, Dubai and Greece tanked, that was horrible ... but not catastrophic.

Portugal - the 37th biggest economy - may be next. It would be horrible if Portugal tanks.

But Spain is also in real trouble. As the 9th biggest economy, a default by Spain could bemajor.

But none of these are in the same ballpark as Japan - the world's 2nd biggest economy. Only the U.S. is bigger.

So it is newsworthy that S & P cut Japan's sovereign credit rating in January.

And that, as Bloomberg wrote April 2nd:

Japanese National Strategy Minister Yoshito Sengoku said the country should have a greater sense of urgency about the nation’s fiscal situation, comparing it to the plight of Greece. “So far some have been crying wolf, but Greece’s situation isn’t entirely unrelated to Japan’s,” Sengoku said at a news conference in Tokyo today. “At the end of the day, Japan’s situation right now is not that good. There hasn’t been a sense of crisis about this, including from ourselves.”

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Sengoku is not the only policy maker to compare Japan with Greece, whose fiscal woes weakened the euro and forced the government to adopt austerity measures as its borrowing costs surged. Bank of Japan board member Seiji Nakamura said in February that Greece’s example shouldn’t be regarded as “a burning house on the other side of the river.”

And AFP reports today:

Greece's debt problems may currently be in the spotlight but Japan is walking its own financial tightrope, analysts say, with a public debt mountain bigger than that of any other industrialised nation.

Public debt is expected to hit 200 percent of GDP in the next year as the government tries to spend its way out of the economic doldrums despite plummeting tax revenues and soaring welfare costs for its ageing population.

Based on fiscal 2010's nominal GDP of 475 trillion yen, Japan's debt is estimated to reach around 950 trillion yen -- or roughly 7.5 million yen per person.

Japan "can't finance" its record trillion-dollar budget passed in March for the coming year as it tries to stimulate its fragile economy, said Hideo Kumano, chief economist at Dai-ichi Life Research Institute.

"Japan's revenue is roughly 37 trillion yen and debt is 44 trillion yen in fiscal 2010, " he said. "Its debt to budget ratio is more than 50 percent."

Without issuing more government bonds, Japan "would go bankrupt by 2011", he added.

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The system of Japanese government bonds being bought by institutions such as the huge Japan Post Bank has been key in enabling Japan to remain buoyant since its stock market crash of 1990.

"Japan's risk of default is low because it has a huge current account surplus, with the backing of private sector savings," to continue purchasing bonds, said Katsutoshi Inadome, bond strategist at Mitsubishi UFJ Securities.

But while Japan's risk of a Greek-style debt crisis is seen as much less likely, the event of risk becoming reality would be devastating, say analysts who question how long the government can continue its dependence on issuing public debt.

"There is no problem as long as there are flows of money in the bond market," said Kumano.

"It's hard to predict when the bond market might collapse, but it would happen when the market judges that Japan's ability to finance its debt is not sustainable anymore."

Japan also has very unfavorable age demographics. As I wrote last October:

The following chart shows that Japan has the worst demographics of all, with a staggering percentage of elderly who need to be taken care of by the young:

Chart 2: Old Age Dependency Ratios for Selected Countries

Source: http://data.un.org/

On the other hand, as AFP notes, Japan has some good things going for it, including a large current account surplus, and the fact that Japanese are largely financing their debt themselves:

The system of Japanese government bonds being bought by institutions such as the huge Japan Post Bank has been key in enabling Japan to remain buoyant since its stock market crash of 1990.

"Japan's risk of default is low because it has a huge current account surplus, with the backing of private sector savings," to continue purchasing bonds, said Katsutoshi Inadome, bond strategist at Mitsubishi UFJ Securities

And, as AFP points out, Greece is part of a currency union with strict exchange rates, while Japan has a fiat currency with flexible exchange rates:

The likes of single-currency Greece and non-eurozone countries are also different in that the latter group have flexible currency exchange rates which are more closely calibrated to their fiscal conditions, [Nomura Securities economist Takehide Kiuchi] said.

The Bank of Japan is also taking radical measures to keep interest rates low, but I don't think that's a very helpful approach for the long-term.

Of course, no country can be analyzed in a vacuum. It is - to some extent - a beauty contest, and bondtraders could change horses when they decide that the horse they've been backing is a nag.

As Bruce Krasting comments:

Japan sure looks like it is trouble. But some comparisons to the US are more troubling.

From the CIA fact book:

Japan External Debt = $2.13 Trillion

Japan Reserves = ~$1 Trillion

US External Debt = 13.45T

US Reserves = 75b

From this you get the Japanese External Debt/Reserves as 2:1. For every dollar of debt they owe outside the country they have 50 cents in a piggy bank in real reserves.

The US External Debt/Reserves is 180:1. Our reserve coverage ratio is 1/2 cent for every dollar of external debt.

GW makes the case that Japan is broke because they owe 200% debt to GDP. He is right. They are broke. But the real question of solvency come down to "Who do you that debt to?"

Japan's GDP to external debt is 2:1.

The same ratio for the US is 1:1.

So by this calculation Japan has a much more managable debt load than the US. They owe it largely to themselves. We owe it to non US persons.

Please don't tell me that the US has the ability to print reserves. That argument is not going to fly in 2010. We have a much bigger problem that does Japan.

And if Exeter is right, then the holders of all nations' bonds might get nervous and flee into cash or gold. This would drive many debt-heavy countries into default