Ambrose Evans-Pritchard: Worry about Japan, not America

By Ambrose Evans-Pritchard
The Telegraph, London
Sunday, November 1, 2009

http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/648028...

Japan is drifting helplessly toward a dramatic fiscal crisis. For 20 years the world's second-largest economy has been able to borrow cheaply from a captive bond market, feeding its addiction to Keynesian deficit spending -- and allowing it to push public debt beyond the point of no return.

The rocketing cost of insuring against the bankruptcy of the Japanese state is telling us that the model has smashed into the buffers. Credit default swaps (CDS) on five-year Japanese debt have risen from 35 to 63 basis points since early September. Japan has suddenly decoupled from Germany (21), France (22), the US (22), and even Britain (47).

Regime-change in Tokyo and the arrival of Yukio Hatoyama's neophyte Democrats -- raising $550 billion (L333 billion) to help fund their blitz on welfare and the "new social policy" -- have concentrated the minds of investors at long last. "Markets are worried that Japan is going to hit a brick wall. The sums are gargantuan," said Albert Edwards, a Japan veteran at Societe Generale.

Simon Johnson, former chief economist of the International Monetary Fund (IMF), told the US Congress last week that the debt path was out of control and raised "a real risk that Japan could end up in a major default."

The IMF expects Japan's gross public debt to reach 218 percent of gross domestic product (GDP) this year, 227 percent next year, and 246 percent by 2014. This has been manageable so far only because Japanese savers have been willing -- or coerced -- into lending for almost nothing. The yield on 10-year government bonds has been around 1.30 percent this year, though they jumped to 1.42 percent last week.

"Can these benign conditions be expected to continue in the face of even-larger increases in public debt? Going forward, the markets' capacity to absorb debt is likely to diminish as population aging reduces saving," said the IMF.

The savings rate has crashed from 15 percent in 1990 to near 2 percent today, half America's rate. Japan's $1.5 trillion state pension fund (the world's biggest) has become a net seller of government bonds this year, as it must to meet payout obligations. The demographic crunch has hit. The workforce been contracting since 2005.

Japan Post Bank is balking at further additions to its $1.7 trillion holdings of state debt. The pillars of the government debt market are crumbling. Little wonder that the Ministry of Finance has begun advertising bonds in Tokyo taxis, featuring Koyuki from "The Last Samurai." If Japan's bond rates rise to global levels of 3 to 4 percent, interest costs will shatter state finances.

No one knows exactly when a country tips into a debt compound trap. But Japan must be close, even allowing for the fact that liabilities of the state loan programme (FILP) have fallen by 40 percent of GDP since 2000.

"The debt situation is irrecoverable," said Carl Weinberg from High Frequency Economics. "I don't see any orderly way out of this. They will not be able to fund their deficit. There will be a fiscal shutdown, a pension haircut, and bank failures that will rock the world. It is criminally negligent that rating agencies are not blowing the whistle on this."

Mr Hatoyama inherited a country that was already hurtling into sovereign "Chapter 11." The Great Recession has eaten up 27 percent in tax revenues. Industrial output is down 19 percent, even after the summer rebound; exports are down 31 percent; the economy is 10 percent smaller today in "nominal" terms than a year ago -- and nominal is what matters for debt.

Tokyo's price index fell 2.4 percent in October, the deepest deflation in modern Japanese history. Real interest rates have risen 300 basis points in a year. It reads like a page from Irving Fisher's 1933 paper, "Debt Deflation Causes of Great Depressions."

The Bank of Japan seems oddly insouciant. It will end its (feeble) quantitative easing in December by suspending purchases of corporate debt, much to the fury of the Finance Ministry.

"This is incredibly dangerous," said Russell Jones from the RBC Capital Markets. "The rate of deflation is shocking. The debt dynamics are horrible and there is the risk of a downward spiral."

Tokyo has let the yen appreciate violently -- 90 to the dollar, 13 to the Chinese yuan -- giving another twist to the deflation knife. Top exporters are below break-even cost, says RBS. The government could stop this, as it did in a wave of manic dollar purchases from 2003-2004. It could print money a l'outrance to stave off deflation. Yet it sits frozen, like a rabbit in the headlamps.

Japan's terrible errors are by now well known. It failed to jettison its mercantilist export model in time. It resisted the feminist revolution, leading to a baby strike by young women. It acquiesced in a mad investment bubble (like China now) in the 1980s, stealing growth from the future.

It wasted its immense fiscal firepower, scattering money for 20 years on half-baked spending projects to keep the economy afloat. Quantitative easing was too little, too late, and this is the lesson for the West. We must cut borrowing drastically over the next decade, and offset this with ultra-easy monetary policy.

Does Downing Street understand this? Does the White House? Does the European Central Bank? Clearly not.

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