Countries do not collapse gradually. No one predicted the fall of the USSR, the Hapsburg Empire and the French monarchy, but fall they did. To an outside observer, each of these entities was chugging along just as it always had until it wasn’t.
Reviewing these collapses with the benefit of a different perspective, a certain degree of inevitability is assigned to each of them. Yet, when each transpired, everyone, including politicians, financiers, bureaucrats, commentators and citizens, was caught completely off guard.
Do not be blindsided by the coming Japanese crisis. The country has hit an inflection point. The crisis has already started but has yet to be priced in by markets.
Let’s start by examining the accounts of the Japanese Government Pension Investment Fund and end with the price of oil in yen, and you can see what I mean.
The GPIF is the excess money that Japanese citizens have paid in contributions to the government for their retirement pensions. It is the largest pension fund in the world managing ¥108tr.
In order to pay obligations, it must earn ¥6.4tr this year, which translates to a 5.9% return. Nowadays, with ZIRP and QEternity, there is virtually no way for a mammoth wealth fund to achieve such a high rate of return at acceptable risk levels.
The problem is worse because about 64% of the GPIF is invested in JGB earning a meager .76%. The yearly income from that portion of the portfolio is ¥72tr leaving the other 36% of the portfolio comprised of Japanese stocks (11%), foreign stocks (12%), foreign bonds (9%) and cash equivalents (4%) to earn about €5.7tr to avoid eating into the principal.
That’s a required 14.75% rate of return, which would be miraculous for such a large portfolio in today’s investment environment and even in the midst of the greatest stock market bubble in history in the late 90’s.
Since retirees must be paid their pensions, the GPIB has been liquidating itself since 2009:
From 2009 to the end of the current fiscal year in 2013, the fund would have declined by 15.5%. It’s wasting away at a rate of about 4% a year, but the rate is increasing as more Japanese retire. Currently, 26% of the Japanese population is older than 65, and the number is growing at a rapid clip.
While ¥6.4tr would have funded obligations this year, the number will be higher every year for the foreseeable future. Since the principal is decreasing, the GPIB must achieve an even higher rate of return. Next year, assuming the obligations remain constant and they won’t, the GPIB will require a 6.2% rate of return; hence, the chief of the fund is telegraphing a rotation out of bonds and into stocks in this Bloomberg article.
People make much of Japan’s savings rate and how they domestically finance more than 90% of the national debt, but this dynamic has changed. The second largest holder of JGBs is being forced to sell off its holdings and must decrease the holdings further to shift money into riskier, but higher yielding stocks.
So far, we have avoided the discussion of Japan’s abysmal government finances. The Japanese government budget for the current fiscal year looks something like this:
In the blue circle, note that half of Japan’s budget is paid for by issuing new debt. Taxes cover less than half the budget. In the green circle, you can see that social security and interest account for over half of expenditures. Every factor in these charts has started to move against Japan and will continue to do so at an accelerating pace.
As the number of retirees increases, the social security payments from the green will increase as the populations continues to gray. Moreover, the blue side will see a decrease in tax receipts as the workforce shrinks causing an increase in debt issuance. More debt means more interest, so an increase in debt servicing will occur in the green.
When the supply of a product increases, in this case JGBs, the price in the form of a rising yield will eventually fall to compensate when demand is held constant. We have already reviewed the fact that demand is not remaining static but decreasing as the GPIB sells JGBs to pay pension obligations. In order to suppress interest rates, the Bank of Japan has been purchasing JGB by creating more yen. And that’s where we are, a highly complex stable disequilibrium.
In order to continue the game, the supply and demand for JGBs must remain in this state, so the Japanese have to sell an increasing amount of debt to foreigners and the Bank of Japan must print yen to maintain a favorable rate of demand.
The QE performed by the Bank of Japan is supposed to be a game-changer weakening the yen to a point that causes inflation and increases Japanese exports. The problem is that once inflation increases, investors will demand higher bond interest to compensate. This will not happen gradually. There will be one bad inflation report released, and things will change overnight.
Of course, commentators have been saying this for years, and eventually they will be right. What makes the present situation ripe for disaster is that Japan may actually get the inflation that its leaders want. As an industrialized country, Japan uses a lot of oil and must import virtually all of it. Whenever there is an oil shock, Japan’s economy enters a severe recession, and that is exactly what is happening. Priced in yen oil has moved up 32% from ¥6747 to ¥8902 per barrel*:
The oil price shock will hurt Japan in three ways. First, it will cause a rise in the trade deficit as the amount imported will not decline in the short term. Second, it will reduce spending in other sectors of the economy as consumers spend a greater share of their disposable incomes on oil-related products. These two factors will make it more difficult for Japan to finance itself as the Japanese will have less money to purchase JGBs and falling tax revenues require more JGBs to be issued, but the third is the killer. As the higher price of oil feeds through the economy, Japan will get the inflation it has wanted for years.
When the rate of inflation picks up, Investors will immediately require higher rates of interest to purchase Japanese bonds, and this whole house of cards will fall. I wish I knew when this will occur, so I could retire. The endgame is impossible to predict. It is in no one’s interest for Japan to fail, so the world central banks will come together and attempt a rescue. Eventually, the rescue will fail, but it will delay the denouement for quite some time, long enough for you to lose all your money betting against Japan.
*I updated this post with closing prices of yen and oil as of 02/01/2013. An earlier version used data only up to 1/25/2013.