Usually a visit to Japan means boring meetings in airless rooms where the only spot of colour is the green tea. But this was not one of them. The senior government official sitting opposite me shook his head vigorously twice in affirmation. “Yes, Japan’s budget deficit would grow. Yes, there would be a government bond crisis.” And then he said: “The best scenario for Japan would be an earthquake that struck the downtown headquarters of the ruling Liberal Democrats when all its senior politicians were in attendance. Then we may get some of the reform that Japan needs.”
It’s a too bloody a solution for me, but it does emphasise the problem and the solution for Japan. It needs a political earthquake that sweeps away the old politicians and their way of doing things. Since the financial asset bubble burst in late 1980s, the politicians have applied huge dollops of fiscal stimuli to stop the economy collapsing. Japan really needed this like a hole in the head, but supply-side reform was beyond the politicians’ ken. And being in a decade-long recession meant that more spending pushed the government into massive deficits.
As public debt rose, the government tried to avoid paying high interest rates (anyway Japan’s reeling economy would have gone deep into deflation if it were asked to). So Japan’s savers had to be made to keep their savings at home and put them into government bonds at vilely low interest rates. As returns from equities and bonds were much higher overseas, how was this to be done?
The answer was to create ‘Mr Yen’ in the person of Finance Ministry international secretary, Eisuke Sakakibara. At regular intervals he would talk the yen up and so scare domestic investors into keeping the money at home. And financial institutions were forced to value their foreign investments in currency-adjusted terms. In this way, Japan’s massive domestic savings surplus — made worse by recession — stayed at home and the current account surplus, which is the flipside of the same coin, was not recycled abroad in capital outflows. Thus the yen stayed strong and Japanese investment returns looked better than foreign ones (in currency-adjusted terms). The result was that Japanese government bonds were the world’s lowest-yielding, but best-performing bond market in the world for an unhedged Japanese investor!
However, this cunning plan contained the seeds of its own undoing. By pouring its citizens’ savings into the economy’s most unproductive sector (the state), Japan deprived itself of the very means to get its economy growing productively. Doing so also worsened the black hole of the Japanese public sector balance sheet. That means that as soon as corporate Japan starts investing again (and it is), available capital will become scarce, even though the state’s appetite for it remains unabated. This will increase competition for capital between the most efficient (highest-return) and most inefficient sectors of the economy and drive up yields. A government bond crisis must eventually be the result.
Balancing act
The writing is on the wall. It will be written in red on the banks’ (the major suckers for the JGB scam) books, as they mark their holdings to market, which they must start to do from the beginning of April 2001. Last month, the Finance Ministry published the first realistic statement of Japan’s public balance sheet. It’s not clear how good it's been at marking to market all those unfinished bridges to uninhabited islands, but the estimate that comes closest to my own (as it includes unfunded pension liabilities) shows the net worth of Japan’s public sector at minus Ñ780 trillion, or 156% of GDP! And this is still an underestimate as it excludes local authorities debt and the hidden losses that government agencies have racked up with loans to various pork barrel projects favoured by politicians.
A few other things are happening too that will push the seismic process along. Maturing post office savings accounts are making it more difficult for the state to access long-term capital. During fiscal year 2000 and fiscal year 2001 up to March 2002, Ñ106 trillion of post office savings deposits mature. From April to August 2000, maturities totalled Ñ14.4 trillion, of which Ñ6.5 trillion left the post office and was not re-deposited. That's a retention rate of 55%. If that rate was maintained through to March 2002, then around Ñ47 trillion will leave post office savings and it could be more as the attraction of investing in equities grows. Such an outflow is equivalent to 22% of total postal savings, or 6% of annual GDP over the next two years.
At the same time, the accumulation of new postal savings has slowed almost to a trickle. Indeed, from April to August 2000, total postal savings actually fell, which implies that new deposits have not compensated for outflows. As outflows pick up over the next year, postal savings deposits will decline further. That's why the government’s Trust Fund Bureau (TFB) and the government’s investment projects programme (FILP) plan to issue their own bonds to finance government profligacy. Postal savings flows are no longer available.
The other negative for the government is that the appetite for long-term bonds is waning. The ‘Italianisation’ of Japan’s public debt is already well under way, with short-term debt now accounting for around a third of issuance. The increasingly short duration will cause the cost of public debt to explode and the budget deficit to spiral as soon as short-term interest rates rise.
Postponing the inevitable
The politicians will try to avoid Armageddon for a while longer. One tactic is to force the Bank of Japan to increase liquidity in money markets to keep interest rates down and provide funds for the banks to buy government bonds. Another is to inject liquidity into the overnight market and to encourage the banks to repo (that’s buying with an agreement to sell back) the TFB’s bond holdings. The BoJ has also increased the credit facility to the government’s Deposit Insurance Corporation so that it can bail out the depositors of any bankrupt banks.
These new measures are just a temporary patching-up. The BoJ has made it quite clear that it will raise interest rates again as soon as a consumer recovery is confirmed. And consumer confidence is already pretty high and household savings rates — as well as corporate ones — are falling. So the trend in JGB yields is inevitably up.
The main buyers of new government paper are now the banks. And they also have to absorb a few shocks from their bankrupt borrowers — particularly in the construction sector. So they will soon be running scared of volatility in the JGB market, while the good old three stooges of the Post Office Savings, the TFB and the FILP agencies won’t be there to take up the running!
Tremors in the market
This means two things. As the Japanese economy slowly recovers and as mark-to-market rules keep up the pressure on the financial sector and ultimately on government to do likewise, fund flows out of JGBs and the yen will accelerate. So the first shock of the earthquake will be in the JGB market.
The second will be political. It’s no secret that the LDP wins elections by distributing cash to gerrymandered rural constituencies through the vehicle of fiscal “stimuli” distributed through crooked and bankrupt construction companies. Well, the squeeze on government finances means that they can’t do it any more. The latest fiscal package announced last month is too small to stop public construction spending falling next year — a critical election year for the upper house of Japan’s parliament.
My guess is that the LDP-led coalition will lose its narrow majority there next July. Then the leader of the LDP’s reformist wing, Mr. Kato, will probably take over from current PM Mori and form an alliance with the progressive wing of the opposition Japanese Democratic Party. I don’t know whether Kato is the Gorbachev or the Kim Dae-jung of Japan, but he is the starting point. And once the lid is taken off Japan’s state finances, the lava is going to pour down the hill all over Japan’s ageing politicians.
Only then will Japan reform. In the final analysis, Japan creates and makes so many of the products wanted by the new global economy that it will take relatively little change in the way its corporations work to make Japanese equities attractive. And beneath the mirror-flat surface of Japan’s economy, corporate Japan does seem to be changing – at least that’s my impression after a recent visit, although admittedly there is only partial evidence there to prove it!
So the ultimate outcome of the earthquake ahead is tremendously positive. Investors should be looking to buy the equities of those Japanese corporations that recognise that the LDP-designed architecture, linking the corporate and political superstructures of Japan, is part of their history, not their future.
David Roche is head of research firm Independent Strategy.
