Friday, 21 September 2018

Japan: Myth and reality

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Ongoing sovereign debt concerns have thrust Japan into the limelight. But Japan is a special case: it has a unique set of challenges, while some of the problems associated with other sovereigns in its position – massive personal debt levels, for example – do not apply. The situation is seen completely different inside the country to how it is perceived by foreigners. Atanas Dinov reports.

At close to 200%, Japan’s debt-to-GDP ratio is the highest in the developed world. And things are set to get worse, with a sharp increase expected this year. As the country’s deflation nightmare shows little sign of abating, Fitch Ratings has made a base estimation that the unadjusted ratio will rise to 214% by the end of 2010.

But Japan is not another Greece. The domestic conditions and the unique ownership structure of the government bonds have allowed continuous funding at low levels throughout the Greek crisis. With even high-grade sovereigns wrestling with rising yields and S&P downgrading the outlook for Japan to negative in January, logically the pressure on the JGB yield should have been intense. Yet it has remained relatively stable. The state is enjoying close to historically low yields, thanks to domestic banks’ reluctance to lend coupled with low demand. Domestic deposits have been on the increase. 

During fiscal year ended March 2010 large domestic banks bought ¥12.78trn (US$135.9bn) JGBs, according to Japan Securities Dealers Association. On the other hand, foreign accounts have been fleeing as net sellers to tune of ¥2.8trn in FY2009.

Fitch puts the Aa2/AA/AA/AAA/AAA (Moody’s/S&P/Fitch/R&I/JCR) rated Japan’s net government debt (deposits minus gross government debt) at 184% of GDP. Italy’s (AA-) was at 112% at the end of calendar 2009. However, the numbers are considerably reduced when taking into consideration other government assets, such as loans and equities. For the same period, OECD estimates Japan’s net financial liabilities at 96.5% behind Italy’s 97.4%.

Domestic and foreign market participants tend to have different views on Japan’s outlook. Foreigners hold few Japanese government bonds: after peaking at 7.7% in June 2008, their holdings dropped to 5.8% as of September 2009. With limited influence in the cash bond market, foreign investors prefer holding futures and derivatives. An aggressive move in October pushed the cost of Japanese CDS protection above that of Italy’s at 77bp, tracking rising JGB yields, with the 10-year around 1.47%.

Most domestic investors, while remaining cautious, have dismissed these moves. The Bank of Japan has also released a report saying it does not see much correlation between CDS movements and bond prices. The 10-year yield started the last week of April at about 1.34%.

Local investors, dismissing dramatic CDS moves, pointed to Japan’s huge current account surplus, which stood at over ¥1.47trn in February. In addition, much of Japan’s debt is owed to the public sector. At the end of September Fitch estimates public entitles held about 53% or ¥496.4trn of the ¥936.8trn gross government debt: Japan Post Bank had 23%; Post Insurance had 10%; and other public financial institutions excluding the latter two had about 20%. 

“The high share of Japan’s general government debt owed to public-sector creditors partly mitigates concerns over the high level of indebtedness and is one of the reasons why, along with the still relatively high level of domestic savings and net external creditor status, the Japanese government remains highly rated,” said a Fitch report published in April.

Recently the government announced it will increase the cap on retail deposits at Post Bank. A managerial reshuffle soon followed. Bankers speculated the decision related to the government’s conflict with the BoJ, which was resisting underwriting more JGBs. 

Market participants have raised flags, however. Two years of economic contraction have taken their toll, exacerbated by worsening demographics and reduced income tax. Some argue that a consumption tax increase could partly rejuvenate Japan’s fiscal position. However, Prime Minister Yukio Hatoyama has vowed not to upsize it for five years. 

Ironically, an economic recovery scenario is seen as a key risk factor that could push yields higher. Once quantitative easing stops, analysts expect the BoJ to reduce its bond holdings and banks to put more of their funds in the corporate sector. “If [the population continues to age rapidly and the decreasing saving rate turns negative], Japan’s current account also risks turning from healthy surplus to growing deficit, leaving the government increasingly reliant on foreign investors to finance its debt,” said a report by Daiwa Capital Markets Europe. “At that point, if it has not yet put its public finances onto a sounder footing the consequent jump in yields could be sharp, raising the risk of more profound financing difficulties.”

The government will announce fiscal strategy by June. One of the options being considered is to reduce the primary deficit by half by 2015, and achieve a budget surplus by 2020. The second target, seen as more realistic, is to cut the deficit to 6% of GDP by 2015 and to 3% by 2020. 

“Yet for now, other DPJ policies are not consistent with growth strategies designed to generate growth, asset reflation and increased tax revenue,” said note sent to clients by Naomi Fink, Japan strategist at Bank of Tokyo-Mitsubishi UFJ.

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