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By Roger Bootle
We can all breathe a sigh of relief that the world is not going to come to an end as a result of a default by the US government. Well, for now, anyway. But this does not mean that debt problems have gone away. Indeed, across the Pacific a serious debt problem is still building in Japan.
Whereas the US debt crisis has been triggered by a disagreement between Democrats and Republicans over the role of the state in the economy and society, and specifically over “Obamacare”, Japan’s debt problem is a slow burner.
As a share of GDP, government debt has been growing since the early 1990s. This is the result of the long-running weakness of economic growth, repeated fiscal stimulus packages and a long period in which the overall price level has stagnated or fallen. Japan has managed to muddle through, but it now looks as though it is close to a tipping point.
The scale of the problem is staggering. Japan’s net government debt is about 140pc of GDP. This is way ahead of the US, which is on 87pc, and not that far below Greece. What’s more, it is easy to see the ratio increasing further. The IMF expects net debt to rise to 148pc of GDP over the next five years. In fact, if the economy performs badly, inflation remains low or borrowing costs rise, debt could easily follow an explosive path, with the ratio quickly rising towards 300pc of GDP.
So what to do? If Japan followed anything like this path, then some form of default would eventually become inevitable. Accordingly, why not cut the whole process short and get the thing over and done with by defaulting now?
Quite apart from all the usual objections to default, Japan suffers from another major obstacle, namely that its debt is overwhelmingly held by Japanese financial institutions, including banks. A default would land the financial sector with massive losses and could cause a catastrophic financial crisis.
The orthodox way to tackle debt is to impose austerity via cuts to government spending or increases in taxes. In fact, Japan will increase its consumption tax in April and quite considerable deficit reduction is promised for the next few years.
But this runs into two problems that are familiar from a European perspective. First, such austerity is not popular and the politicians in Japan may yet baulk at the scale of the tightening to be imposed.
Second, austerity tends to reduce GDP – even though George Osborne may believe that it hasn’t done so in the UK. If it does reduce GDP, then the debt to GDP ratio would probably rise.
Faster economic growth would help but is in practice difficult to achieve. The government is pursuing some supposedly radical structural reforms but it is unlikely that, even if these are pushed through, they will have much of an impact soon enough. And in trying to grow its way out of the debt problem, unlike America, Japan faces a huge demographic hurdle. It simply isn’t making enough Japanese. The size of the workforce is already falling and will continue to do so for decades.
The way out for Japan is to try to engineer a higher rate of inflation, perhaps much higher than the current 2pc target. For any given rate of increase of real GDP this would give a higher rate of growth of nominal GDP, that is to say, expressed in money terms. With debt fixed in money terms this would, other things being equal, bring down the debt to GDP ratio.
Admittedly, other things may not be equal. The danger is that markets would force up the rate of interest on Japanese debt and thereby increase the amounts that the government had to pay out in debt interest. That could easily offset the effect of higher inflation.
In fact, it could lead to the debt ratio ending up higher. Yet in the Japanese case, this is unlikely.
The Bank of Japan would continue to hold short-term interest rates at close to zero for several years. That would ensure that the rates on short-term debt remained subdued. Moreover, it would continue to buy huge quantities of Japanese government debt. It might also consider obliging financial institutions to hold extra amounts of government debt.
How would Japan achieve higher inflation? Quantitative easing (QE), or printing money, as it is colloquially known, will eventually give you higher inflation – provided that you do it on sufficient scale. This is what the Japanese central bank now seems prepared to do.
A fall of the yen would be a crucial part of the mechanism by which inflation moved higher.
This is what has happened recently. Japanese inflation has risen to 0.9pc, but almost wholly as a result of the fall of the yen from the high 70s to the dollar to about 100. There has been hardly any domestically generated inflation. But if the yen continued to weaken, that would surely follow.
Throughout the past 30 years, Japan has been a testing ground both for problems and their possible solutions that have appeared later in the West. It experienced a bubble economy in the late 1980s and then experienced the pain of a long drawn-out balance sheet recession, brought on by the collapse of asset prices and the drying up of credit.
It also went through a slow dragging deflation of consumer prices before anyone in the West thought that this was an issue. And for some time now it has faced the problems caused by an ageing and falling population.
Could it also show the way on the inflation solution to the debt problem which continues to bedevil so many countries in the West? For the UK, a deliberate embrace of higher inflation remains only a risk rather than a probability. For we are in a very different position from Japan. Our debt ratio is nowhere near as high and our potential to grow our way out of the problem is much greater, not least due to our more favourable demographic prospects. The same is true for the US.
But there are several members of the eurozone for whom this is not true. Greece and Italy spring to mind. Unless their debt is “forgiven”, some form of default appears inevitable.
While they remain in the euro, of course, they cannot default through inflation because they do not control their own monetary policy.
But if they were to leave the euro, the Japanese experience might be highly influential.
Roger Bootle is managing director of Capital Economics firstname.lastname@example.org
China’s shadow banking system is out of control and under mounting stress as borrowers struggle to roll over short-term debts, Fitch Ratings has warned.
By Ambrose Evans-Pritchard, International Business Editor
4:12PM BST 16 Jun 2013
The agency said the scale of credit was so extreme that the country would find it very hard to grow its way out of the excesses as in past episodes, implying tougher times ahead.
“The credit-driven growth model is clearly falling apart. This could feed into a massive over-capacity problem, and potentially into a Japanese-style deflation,” said Charlene Chu, the agency’s senior director in Beijing.
“There is no transparency in the shadow banking system, and systemic risk is rising. We have no idea who the borrowers are, who the lenders are, and what the quality of assets is, and this undermines signalling,” she told The Daily Telegraph.
While the non-performing loan rate of the banks may look benign at just 1pc, this has become irrelevant as trusts, wealth-management funds, offshore vehicles and other forms of irregular lending make up over half of all new credit. “It means nothing if you can off-load any bad asset you want. A lot of the banking exposure to property is not booked as property,” she said.
Concerns are rising after a string of upsets in Quingdao, Ordos, Jilin and elsewhere, in so-called trust products, a $1.4 trillion (£0.9 trillion) segment of the shadow banking system.
Bank Everbright defaulted on an interbank loan 10 days ago amid wild spikes in short-term “Shibor” borrowing rates, a sign that liquidity has suddenly dried up. “Typically stress starts in the periphery and moves to the core, and that is what we are already seeing with defaults in trust products,” she said.
Fitch warned that wealth products worth $2 trillion of lending are in reality a “hidden second balance sheet” for banks, allowing them to circumvent loan curbs and dodge efforts by regulators to halt the excesses.
This niche is the epicentre of risk. Half the loans must be rolled over every three months, and another 25pc in less than six months. This has echoes of Northern Rock, Lehman Brothers and others that came to grief in the West on short-term liabilities when the wholesale capital markets froze.
Mrs Chu said the banks had been forced to park over $3 trillion in reserves at the central bank, giving them a “massive savings account that can be drawn down” in a crisis, but this may not be enough to avert trouble given the sheer scale of the lending boom.
Overall credit has jumped from $9 trillion to $23 trillion since the Lehman crisis. “They have replicated the entire US commercial banking system in five years,” she said.
The ratio of credit to GDP has jumped by 75 percentage points to 200pc of GDP, compared to roughly 40 points in the US over five years leading up to the subprime bubble, or in Japan before the Nikkei bubble burst in 1990. “This is beyond anything we have ever seen before in a large economy. We don’t know how this will play out. The next six months will be crucial,” she said.
The agency downgraded China’s long-term currency rating to AA- debt in April but still thinks the government can handle any banking crisis, however bad. “The Chinese state has a lot of firepower. It is very able and very willing to support the banking sector. The real question is what this means for growth, and therefore for social and political risk,” said Mrs Chu.
“There is no way they can grow out of their asset problems as they did in the past. We think this will be very different from the banking crisis in the late 1990s. With credit at 200pc of GDP, the numerator is growing twice as fast as the denominator. You can’t grow out of that.”
The authorities have been trying to manage a soft-landing, deploying loan curbs and a high reserve ratio requirement (RRR) for banks to halt property speculation. The home price to income ratio has reached 16 to 18 in many cities, shutting workers out of the market. Shadow banking has plugged the gap for much of the last two years.
However, a new problem has emerged as the economic efficiency of credit collapses. The extra GDP growth generated by each extra yuan of loans has dropped from 0.85 to 0.15 over the last four years, a sign of exhaustion.
Wei Yao from Societe Generale says the debt service ratio of Chinese companies has reached 30pc of GDP – the typical threshold for financial crises — and many will not be able to pay interest or repay principal. She warned that the country could be on the verge of a “Minsky Moment”, when the debt pyramid collapses under its own weight. “The debt snowball is getting bigger and bigger, without contributing to real activity,” she said.
The latest twist is sudden stress in the overnight lending markets. “We believe the series of policy tightening measures in the past three months have reached critical mass, such that deleveraging in the banking sector is happening. Liquidity tightening can be very damaging to a highly leveraged economy,” said Zhiwei Zhang from Nomura.
“There is room to cut interest rates and the reserve ratio in the second half,” wrote a front-page editorial today in China Securities Journal on Friday. The article is the first sign that the authorities are preparing to change tack, shifting to a looser stance after a drizzle of bad data over recent weeks.
The journal said total credit in China’s financial system may be as high as 221pc of GDP, jumping almost eightfold over the last decade, and warned that companies will have to fork out $1 trillion in interest payments alone this year. “Chinese corporate debt burdens are much higher than those of other economies. Much of the liquidity is being used to repay debt and not to finance output,” it said.
It also flagged worries over an exodus of hot money once the US Federal Reserve starts tightening. “China will face large-scale capital outflows if there is an exit from quantitative easing and the dollar strengthens,” it wrote.
The journal said foreign withdrawals from Chinese equity funds were the highest since early 2008 in the week up to June 5, and withdrawals from Hong Kong funds were the most in a decade.
Mere days after the US and Iran showed very tentative signs of some diplomatic progress being possible (and hours afterNetanyahu’s “Rouhani’s a wolf in sheep’s clothing” comments), The Telegraph reports that Mojtaba Ahmadi, who served as commander of the Cyber War Headquarters for Iran, was found dead (with two bullets to the heart) in a wooded area north-west of Tehran. This follows the assassination of five Iranian nuclear scientists and the country’s ballistic missile program head since 2007 – all blamed on Israel’s Mossad. An eyewitness said two people on a motorbike had been involved and “the extent of the injuries indicated he had been assassinated from close range.” Western officials (the ‘essential’ ones) said the information was still being assessed.
Mojtaba Ahmadi, who served as commander of the Cyber War Headquarters, was found dead in a wooded area near the town of Karaj, north-west of the capital, Tehran…
- Iran’s Cyber Warfare Commander Found Dead (israelnationalnews.com)
- Report: Commander of Iranian Cyber War Headquarters assassinated (jpost.com)
- Unconfirmed report claims Iran’s cyber commander assassinated (timesofisrael.com)
- Commander of Iranian Cyber War Headquarters assassinated (theiranproject.com)