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Kudos to the Bank of Japan. Its heroic campaign to water down the yen has borne fruit. The Japanese may not have noticed it because it is not indicated in bold red kanji on their bank and brokerage statements, and so they might not give their Bank of Japandemonium full credit for it, but about 20% of their magnificent wealth has gone up in smoke in 2013. And in 2014, more of it will go up in smoke – according to the plan of Abenomics.
What folks do notice is that goods and services keep getting more expensive. Inflation has become reality. The scourge that has so successfully hallowed out the American middle class has arrived in Japan. The consumer price index rose 1.6% in December from a year earlier. While prices of services edged up 0.6%, prices of goods jumped 2.6%.
It’s hitting households. In December, their average income was up 0.3% in nominal terms from a year earlier. But adjusted for inflation – this is where the full benefits of Abenomics kick in – average income dropped 1.7%. Real disposable income dropped 2.1%.
Abenomics is tightening their belts. But hey, they voted for this illustrious program. So they’re not revolting just yet. But they’re thinking twice before they extract with infinite care their pristine and beloved 10,000-yen notes from their wallets. And inflation-adjusted consumption expenditures – excluding housing, purchase of vehicles, money gifts, and remittances – dropped 2.3%.
But purchases of durable goods have been soaring. Everyone is front-loading big ticket items ahead of April 1, when the very broad-based consumption tax will be hiked from 5% to 8%. Pulling major expenditures forward a few months or even a year or so is the equivalent of obtaining a guaranteed 3% tax-free return on investment. That’s huge in a country where interest rates on CDs are so close to zero that you can’t tell the difference and where even crappy 10-year Japanese Government Bonds yield 0.62%. It’s a powerful motivation.
And it has turned into a frenzy. In December, households purchased 32.2% more in durable goods than the same month a year earlier, in November 25.2%, in October 40.4%. These front-loaded purchases have been goosing the economy in late 2013. But shortly before April 1, they will grind to a halt. The Japanese have been through this before.
In 1996, after the consumption tax hike from 3% to 5% was passed and scheduled to take effect on April 1, 1997, consumers and businesses went on a buying binge of big-ticket items to dodge the extra 2% in taxes. The economy boomed. But it ended in an enormous hangover. In the spring 1997, as the tax hike took effect, business and consumer spending ground to a halt, and the economy skittered into a nasty recession that lasted a year and a half!
First indications of a repeat performance are already visible. The Japan Automobile Manufacturers Association (JAMA) forecast last week that sales of automobiles, after an already lousy 2013, would plunge 9.8% this year to 4.85 million units, the lowest since 2011 when the earthquake and tsunami laid waste to car purchases.
In response, automakers will curtail production for domestic sales. Other makers of durable goods – those that still manufacture in Japan – will prepare for the hangover in a similar manner. Housing and construction will get hit. Retailers will get hit too. During the last consumption tax hike, many large retailers tried to keep their chin above water by not passing the 2% tax hike on to their customers but shove it backwards up the pipeline to their suppliers. This time, having learned its lesson, the government is insisting on inflation, and it passed legislation last year that would force retailers to stick their customers with an across-the-board 3% price increase.
In 2014, the hangover will be even worse than in 1997. Businesses and consumers are dodging a hike of three percentage points, not two percentage points. Hence, the motivation to front-load is even stronger, the payoff greater, and the subsequent falloff steeper. This, on top of the already toxic concoction of stagnant wages and rising prices. Oh, and the plight of the retirees, whose savings and income streams are gradually getting eaten up by inflation. The glories of Abenomics.
But there are beneficiaries. Japan Inc. benefits from lower cost of labor. The government, without having to reform its drunken ways, might somehow be able to keep its out-of-control deficits and its mountain of debt from blowing up in the immediate future. Throughout, the Bank of Japan, which is buying up enough government bonds to monetize the entire deficit plus part of the mountain of existing debt, will remain in control of the government bond market, what little is left of it – even if it has to buy the last bond that isn’t totally nailed down. But for the real economy the party is now ending, and by spring, a pounding hangover will set in.
According to Japan’s state religion of Abenomics, devaluing the yen would boost exports and cut imports. The resulting trade surplus would jumpstart the economy and induce Japan Inc. to invest at home. It would save Japan. But the opposite is happening. Read…. Why Japan’s Trade Fiasco Worries Me So Much
While the distraction of Japanese currency collapse, the resultant nominal offsetting surge in the value of the Japanese stock market, the doubling of the Japanese monetary base and the BOJ’s monetization of 70% of Japan’s gross issuance have all been a welcome diversion in a society still struggling with the catastrophic aftermath of the Fukushima explosion on one hand, imploding demographics on the other, and an unsustainable debt overhang on the third mutant hand, the reality is that Japan, despite the best intentions of Keynesian alchemists everywhere, is doomed.
One can see as much in the following two charts from a seminal 2012 research piece by Takeo Hoshi and Tatakoshi Ito titled “Defying Gravity: How Long Will Japanese Government Bond Prices Remain High?” and which begins with the following pessimistic sentence: “Recent studies have shown that the Japanese debt situation is not sustainable.” Its conclusion is just as pessimistic, and while we urge readers to read the full paper at their liesure, here are just two charts which largely cover the severity of the situation.
Presenting the countdown to Japan’s D-Day.
The technical details of what is shown below are present in the appendix but the bottom line is this: assuming three different interest rates on Japan’s debt, and a max debt ceiling which happens to be the private saving ceiling, as well as assuming a 1.05% increase in private sector labor productivity (average of the past two decades), Japan runs out of time some time between 2019 and 2024, beyond which it can no longer self-fund itself, and the Japan central bank will have no choice but to monetize debt indefinitely.
and Exhibit B.
Figure 12 shows the increase in the interest rate that would make the interest payment exceed the 35% of the total revenue for each year under each of the specific interest scenarios noted in the chart above (for more details see below). The 35% number is arbitrary, but it is consistent with the range of the numbers that the authors observed during the recent cases of sovereign defaults. In short: once interest rates start rising, Japan has between 4 and 6 years before it hits a default threshold.
The paradox, of course, is that should Japan’s economy indeed accelerate, and inflation rise, rates will rise alongside as we saw in mid 2013, when the JGB market would be halted almost daily on volatility circuit breakers as financial institutions rushed to dump their bond holdings.
In other words, the reason why Japan is desperate to inject epic amounts of debt in order to inflate away the debt – without any real plan B – is because, all else equal, it has about 8 years before it’s all over.
Here is how the authors summarize the dead-end situation.
Without any substantial changes in fiscal consolidation efforts, the debt is expected to hit the ceiling of the private sector financial assets soon. There is also downside risk, which brings the ultimate crisis earlier. Economic recovery may raise the interest rates and make it harder for the government to roll over the debt. Finally, the expectations can change without warning. Failure in passing the bill to raise the consumption tax, for example, may change the public perception on realization of tax increases. When the crisis happens, the Japanese financial institutions that holds large amount of government bonds sustain losses and the economy will suffer from fiscal austerity and financial instability. There may be negative spillovers for trading partners. If Japan wants to avoid such crisis, the government has to make a credible commitment and quick implementation of fiscal consolidation.
A crisis will happen if the government ignores the current fiscal situation or fails to act. Then, the crisis forces the government to choose from two options. First, the Japanese government may default on JGBs. Second, the Bank of Japan may monetize debts. The first option would not have much benefit because bond holders are almost all domestic. Monetization is the second option. Although that may result in high inflation, monetization may be the least disruptive scenario.
Finally, this is how the BOJ’s epic monetization was seen by the paper’s authors back in March 2012.
Bank of Japan could help rolling over the government debt by purchasing JGBs directly from the government. The Bank of Japan, or any other central bank with legal independence, has been clear that they do not endorse such a monetization policy because it undermines the fiscal discipline. However, at the time of crisis, the central bank may find it as the option that is least destructive to the financial system. If such money financing is used to respond to the liquidity crisis, this will create high inflation.
The prospect for high inflation will depreciate yen. This will partially stimulate the economy via export boom, provided that Japan does not suffer a major banking crisis at the same time.
An unexpected inflation will result in redistribution of wealth from the lenders to the borrowers. This is also redistribution from the old generations to the young generations, since the older generation has much higher financial assets whose value might decline, or would not rise at the same pace with inflation rate. This may not have such detrimental impacts on the economy, since many who participate in production and innovation (corporations and entrepreneurs) are borrowers rather than lenders.
For now monetization is indeed less disruptive. The question is for how much longer, since both Japan and the US are already monetizing 70% of their respective gross debt issuance. And once the last bastion of Keynesian and Monetarist stability fails, well then…
Once the crisis starts, the policy has to shift to crisis management. As we saw above, the crisis is likely to impair the financial system and slow down consumption and investment. Thus, the government faces a difficult tradeoff. If it tries to achieve a fiscal balance by reducing the expenditures and raising the taxes, the economy will sink further into a recession. If it intervenes by expansionary fiscal policy and financial support for the financial system, that would make the fiscal crisis more serious. This is a well-known dilemma for the government that is hit by debt crisis…. If not helped by the government, the banking system will be destroyed, and the economy will further fall into a crisis. Rational depositors will flee from deposits in Japanese banks to cash, foreign assets or gold.
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The private saving ceiling is the absolute maximum of the domestic demand for the government debt, but the demand for JGBs will start falling well before the saving ceiling is ever reached. One potential trigger for such a change is that the financial institutions find alternative and more lucrative ways to invest the funds. In general, when the economic environment changes to increase the returns from alternatives to the JGBs, the interest rate on JGBs may start to increase. If this suddenly happens, this can trigger a crisis. Increases in the rate of returns may be caused by favorable changes in the economic growth prospect. The end of deflation and the zero interest rate policy would also lead to higher interest rates.
In Figure 6 , the authors calculate Japan’s debt’GDP over the next three decades using the following assumptions on the interest rate:
- R1: Interest rate is equal to the largest of the growth rate (?t) or the level at 2010 (1.3%).
- R2: Interest rate rises by 2 basis points for every one percentage point that the debt to GDP ratio at the beginning of the period exceeds the 2010 level (153%).
- R3: Interest rate rises by 3.5 basis points for every one percentage point that the debt to GDP ratio at the beginning of the period exceeds the 2010 level (153%) .
R1 is motivated by the fact that the average yield on 10 year JGBs over the last several years has been about the same as the GDP growth rate during the same time interval, but constrains the interest rate to be much lower than the current rate even when the GDP growth declines further. R2 and R3 assume that the interest rate rises as the government accumulates more debt. Many empirical studies have demonstrated such relation. R2 (2.0 basis points increase) uses the finding of Tokuoka (2010) for Japan. R3 (3.5 basis points increase) assumes the coefficient estimate used by Gagnon (2010). It is the median estimate from studies of various advanced economies
A more reasonable scenario is to assume the growth rate of GDP per-working-age person (or an increase in labor productivity) to be similar to that of the 1990s and 2000s. We consider two alternative growth rates per-working-age population. The low growth scenario is that the increase in labor productivity at 1.05% (average of 1994-2010) and the high growth scenario is at 2.09% (average of 2001-2007, the “Koizumi years”).12 Table 6 shows the growth decomposition on the assumption of the 1.05% growth rate of GDP per-working-age person…. The upper bound for the debt accumulation is reached by 2024 at the latest.
Testosterone Pit – Home – What Will It Take To Blow Up The Entire Japanese Banking System? (Not Much, According To The Bank of Japan)
Hideo Hayakawa, former Bank of Japan chief economist and executive director, set the scene on Wednesday when he discussed the BOJ’s ¥7-trillion-a-month effort to water down the yen by printing money and gobbling up Japanese Government Bonds. It wants to achieve what is increasingly called “2% price stability,” a term that must be a sick insider joke played on the Japanese people. He warned that if these JGB purchases are “perceived as monetization“ of Japan’s out-of-whack deficits, it would drive up long-term JGB yields “to 2% to 3%.” Up from 0.60% for the 10-year JGB. “But once interest rates start rising, they would overshoot,” he said. So maybe 4%?
He’d set the scene for the Bank of Japan’s 81-page semiannual Financial System Report, released the same day. Buried in Chapter V, “Risks borne by financial intermediaries,” is a gorgeous whitewash doozie: if interest rates rise by 1 percentage point, it would cause ¥8 trillion ($82 billion) in losses across the banking system.
This interest rate risk associated with all assets and liabilities, such as bondholdings, loans, and deposits has been dropping since April 1, the beginning of fiscal 2013, the BOJ explained soothingly – the largest decline in 13 years. Banks would be able to digest that 1 percentage point rise.
A big part of that interest rate risk is tied to the banks’ vast holdings of JGBs. The BOJ has begged banks to dump this super-low yielding stuff that could blow up their balance sheets. The three megabanks – Mitsubishi UFJ Financial Group, Mizuho Financial Group, and Sumitomo Mitsui Financial Group – have done that. From the beginning of the fiscal year through August, their JGB holdings plummeted by 24% to ¥96 trillion. And much of what they still hold is paper with short to medium maturities that poses less risk.
The regional banks have not been able to do that, and their JGB holdings remained flat at ¥32 trillion. However, the amount of loans with longer maturities, such as those to local governments, has gone up, which raised the interest rate risk “slightly,” the report said.
Then there are the 270 community-based, cooperative shinkin banks. And they’re stuck in a quagmire. They’re stuffed to the gills with JGBs because, unlike megabanks and, to a lesser extent, regional banks, they have no other options to place their ballooning deposits. On their balance sheets, interest rate risk continued its long and relentless upward trend [my take on the shinkin bank debacle…. “We Don’t Feel Any Impact Of Abenomics Here”]
A 1 percentage point rise would cost megabanks ¥2.9 trillion, regional banks ¥3.2 trillion, andshinkin banks ¥1.9 trillion. A total of ¥8 trillion ($82 billion). If the yield curve steepened, with long-term rates rising 1 percentage point and short-term rates remaining low, the losses would be smaller. In all, it would be survivable. The banking system is safe.
Whitewash doozie because it assumes a 1 percentage-point rise. The yield of the 10-year JGB would rise from todays 0.6% to 1.6%. With annual inflation hitting 2% soon, bondholders would still get sacked. Hence Mr. Hayakawa’s warning: if inflation hits 2%, long-term interest would likely head to 2% or 3%, and once they start rising, they’d “overshoot.” So, with a little overshoot, 10-year JGB yields might rise by 3 percentage points, to 3.6%. Still a very moderate interest rate, by historical standards. What would that do to the banking system?
The report tells us what it would do: megabanks would be severely damaged; the rest of the banking system would be wiped out. If there is a parallel stock market crash, the megabanks would be wiped out as well.
The megabanks combined have ¥28 trillion in Tier 1 capital. Against it are credit risk, market risk from stock holdings, interest rate risk, and operational risk. The risk scenario the BOJ envisioned with a 1 percentage point rise in interest rates would create losses of nearly ¥17 trillion for the megabanks, a big part from its bond and loan portfolio, but an even bigger part from its stockholdings. That would leave about ¥11 trillion in Tier 1 capital.
But if the scenario plays out as Mr. Hayakawa sees it, with a 3 percentage point rise in interest rates, losses at megabanks, according to the report, would jump by ¥4.6 trillion, leaving only ¥6.4 trillion in Tier 1 capital.
Then there is the stock market risk. Traditionally, banks held large chunks of shares of companies they did business with. It cemented the relationship and propped up equities, which in turn made loans appear stronger. It worked wonderfully until the bubble it helped create blew up in 1989. Banks turned into zombie banks. Since then, 20 of these zombie banks have been consolidated into the three megabanks. And they have reduced ever so gradually their stock holdings to get out from under that risk that took them down the last time.
But in the money-printing induced mania, they’ve been adding stocks, and their exposure to the stock market remains enormous. The market downturn envisioned by the BOJ would produce around ¥7 trillion in losses. If that downturn becomes a crash, of which Japan has seen its share, losses could easily wipe out the remaining Tier 1 capital. Bailout time.
Regional banks will get wiped out by a 3 percentage point rise in interest rates. They don’t need a stock market crash. Even the BOJ is worried. According to its risk scenario with a 1 percentage point rise in interest rates, losses will eat up ¥11 trillion of the banks’ ¥15 trillion in Tier 1 capital. Leaves ¥4 trillion. If interest rates rise by 3 percentage points, another ¥4.6 trillion in losses would hit the banks, more than annihilating all of their Tier 1 capital. They’d be goners.
And the beleaguered shinkin banks? They have ¥6.5 trillion in Tier 1 capital. They don’t own a lot of stocks but are loaded with JGBs and local government bonds with long maturities. In the scenario where interest rates rise 1 percentage point, half of their Tier 1 capital would be wiped out. A 3 percentage point rise in rates would produce an additional ¥2.7 trillion in losses, wiping out almost all of the remaining Tier 1 capital.
But the 3 percentage point rise is only theoretical. If that happened, the government wouldn’t be able to make interest payments on its ¥1 quadrillion in debt. The whole house of cards would come tumbling down.
No, interest rates will not be allowed to jump this high. Even if inflation is 6%, the BOJ will see to it that yields remain low. It would impose brutal financial repression. It could use numerous tools, including a yield peg. If it had to, it could print enough money to buy the entire national debt of Japan, even if that might finally be “perceived as monetization” – with all the consequences that this would entail.
Japan is still the second richest nation in the world, according to Credit Suisse. About ¥1 quadrillion of that wealth is tied up in JGBs. But debt that yields almost nothing and can never be paid back, will eventually succumb to fate: either slowly through inflation and devaluation or rapidly through default. Abenomics has chosen the slow route.
But if the house of cards were allowed to come down rapidly, from the ashes would rise a young generation that suddenly could look into the future and actually see something other than the oppressive dark wall of the government debt hurricane coming their way.
Trade is another critical pillar of Abenomics. Devaluing the yen would boost exports and cut imports. The resulting trade surplus would goose the economy. But the opposite is happening. And it isn’t happening in small increments, with ups and downs over decades, but rapidly and relentlessly. It’s not energy imports. They actually dropped! It’s a fundamental shift. Read….Why I’m So Worried About Japan’s Ballooning Trade Deficit
- Kuroda Put Prompts Japan Banks to Shift to Longer Bonds (bloomberg.com)
- Japan banks cut JGB holdings 24 pct in March-August – BOJ (uk.reuters.com)
- PREVIEW-Global woes sap BOJ confidence in economic outlook (xe.com)
- Revenge of the Japanese Zombie Banks (elementulhuliganic.wordpress.com)