Japanese debt: A perspective for beginners (i.e. myself!)

2012 – Japan’s central govt was 997trn in debt, that’s 200% of GDP, and more than $80,000 (USD) per capita.

To understand any debt workflow:

The government collects taxes from households and corporations.
The government spends.
If wants to spend more than revenues, issues bonds.
When outstanding debts get too large, central bank lowers the interest rates or buys bonds.
For the government to spend more, it issues debt again.
Investors buy (and receive interest).
Investors worry when debts get too large.
Then Central Bank lowers interest rates.
Investors’ worries are intermittently allayed, and they continue investing.
Eventually it leads to an inescapable trap.
Each year the government has to pay interest, and fund other expenditures.
Investors sell.
Government cannot spend what it does not borrow.
Printing press can’t help now.
Inflation been going on as well.
Investors sell bonds to account for inflation.
Debt costs are higher than tax revenues.

To put this in perspective for Japan, let’s take figures from the end of 2012 fiscal year – Japan’s debt was 23x revenues. 1% increase in average debt cost increases overall interest expense by 23% of tax revenues. By this calculation, the govt needs to keep debt costs lower than 4%. Can they do this? Yields are only 0.8% at the moment. But what about in the future? Let’s look at investor rationale.

Japanese investors – JGB bond prices are very high, and a lot has been invested in JGBs by locals. But savings are declining with an ageing population, so can they keep the demand for the debt so high?

Foreign investors see only 0.8% yield?! OK inflation in real terms is low, so the yield is now that bad. Last year yields were around -1% with inflation of -1%, that’s a real return of 2%, right?! But now, inflation has been increasing, (0.2% June YoY, -0.2% if you discount food and energy prices) and will continue to increase because of the 3 arrow approach taken by Abe and Kuroda. They are targeting 2% inflation, so to keep real returns constant the average debt cost may rise to 4% and this is the critical point.

The Kyle Bass view (Hayman Capital) is essentially that there will be a collapse in Japanese bond yields because its expansion ultimately engenders this Weimar style of hyperinflation. – and you can watch some of his talks online for example here.

What this does not take into account however is that, whilst it well know that in a recovery, bond yields go up, the extreme scenario is unconvincing. This is because it doesn’t account for the increase in tax revenue that will follow from increase in GDP – the Japanese tax structure is very pro-cyclical (although less so now than in the 1990s due to the introduction of consumption tax). The origin of fiscal stresses isn’t really fiscal spending but instead is tax revenue based – tax revenue today is only 60% of the level of 1990. Personal tax revenues have gone down compared to GDP, and consumption tax hasn’t done much to replace loss of tax revenue. However if Japan truly does grow, the increased strength in fiscal position could be enough to offset interest payment increases.