Mitsubishi UFJ Runs Risk Scenarios for a Potential Fall In JGBs

Japan’s Asahi Newspaper is reporting that Japan’s largest major banking group, Mitsubishi UFJ Financial Group, has put together its first contingency plan for a potential fall in Japanese Government Bonds (JGB), which is a plan to mitigate their significant balance sheet risk from a potential sharp backup in bond yields (falling prices).

Japan’s government debt is pushing past JPY1,000 trillion US$13 trillion, of which some JPY750 trillion is borrowed from investors from issues of JGB. Over 90% of these sovereign bonds are purchased by domestic investors, with Japan’s banks holding some 38%. Mitsubishi UFJ is the second-largest holder of JGBs behind Japan’s postal bank at some JPY42 trillion, and the bank could potentially cause a panic if they ever decided to sell a significant portion of these holdings.

The contingency plan looks at 30 indicators including Japan’s GDP growth rate, exchange rates and international balance of payments for signs of a potential selloff in JGBs. One of the more important indicators is the current balance of payments. The bank sees the possibility of Japan’s current balance of payments (including income from overseas investments) falling into deficit around 2016, and fiscal deficits continuing even after the government raises the consumption tax from 5% to 10% around 2015. They see a risk of JGB credit ratings being downgraded around 2016, leading to a backup in JGB yields from around 1% presently to 3.5%, which would prompt the Bank to sell around JPY3 trillion of 10-year JGB holdings and shift to short-term notes with maturities under 1 year.

If Mitsubishi UFJ were to move to sell their 10-year JGBs and shift to short-term paper, a selling stampede by other financial institutions could quickly push JGB yields to 7%, or Italian-like bond yields.

For the time being, however, this is just a risk scenario and there is little indication that JGBs are in immediate danger of losing their role as a “riskless” asset.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

In the Midst of Crisis, Japan’s Politicians Go AWOL

In an effort to fend off a mutiny within his own DPJ party and a no-confidence vote in the Diet, prime minister Naoto Kan stated he intended to resign once the government had a rescue package in place for the Tohoku disaster. While a last-ditch effort to avoid the embarrassment of being kicked out of office, Mr. Kan has effectively declared himself a lame duck, thereby erasing any legitimacy his wounded cabinet may have had left.

In the three months since the March 11 disaster, the Diet has only managed to pass one modest supplementary budget, but the organizational foundations for reconstruction remain in limbo, and the Diet has even been able to pass the legislation needed for funding the FY2011 budget.

There is a growing sense that Japan’s political leaders, who should have risen to the occasion of Japan’s greatest postwar disaster, have been AWOL and completely out of touch with what the voters think needs to be done. Japan’s Shukan Shi magazines, where arguably the best investigative journalism is done in Japan be it in a sensationalist manner, are having a field day describing how PM Kan basically lost it during the crisis, and how Japan’s infamous bureaucracy–from the national to the local level–was caught like a deer in the headlights.

Basically, Diet members on both sides of the aisle have been bickering and fighting amongst themselves while Japan’s economy is burning, and this is what bothers the foreign credit rating agencies that have recently lined up to downgrade Japan’s sovereign debt rating.

Politicians Need to Straighten Up and Fly Right

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Rating Agency Japan Sovereign Debt Downgrades a Statement About Confidence in Kan Administration

A stronger fiscal consolidation strategy is necessary to buffer the sustainability of the public finances against the adverse structural trend of population ageing,” said Andrew Colquhoun, head of Fitch’s Asia-Pacific Sovereigns team. “Fitch looks to important fiscal policy statements expected in coming months including the revised Medium-Term Fiscal Framework, proposals on tax and social security reform, and the FY12 budget. The emergence of a stronger and more credible consolidation plan backed by credible political commitment to its implementation could see the ratings revert to Stable Outlook. Failure to strengthen the commitment to fiscal consolidation, or the emergence of substantial additional fiscal or economic costs from the process of reconstruction post-disaster, could trigger a downgrade”.

The translation is, like Moody’s and S&P, Fitch has no confidence in the Kan Administration’s ability to, a) get a credible reconstruction plan in place while b) creating a more credible debt management plan. Instead of visibly weakening, however, JPY continues to trade near historical highs and JGB yields waffle downward–pretty clear signs that Japan’s debt “crisis” is not immediate because domestic financial institutions continue to prop up Japan’s bond market.

FT Alphaville: Fitch Goes Negative on Japan

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Japan’s Econometric Models Cannot Account for Government (In) Competance

The triple Tohoku disaster has piled on a heavy reconstruction burden to an already enfeebled economy, a shriveling population and massive sovereign debt. Normally, while mega-disasters like Japan’s earthquake-tsunami are deadly and dramatic, but economists who study them are in near-total agreement: They don’t cause much long-term economic damage, particularly in developed countries.

Cynical domestic and foreign observers however point out that a full recovery would leave Japan merely with the same gloomy economy it had in the first place. In Q1 2011, Japan’s GDP contracted at a 3.7% annualized rate, for a second quarter of negative growth that tipped Japan back into recession. Some 200,000 jobs were lost as a result of evacuation and building destruction, according to one research firm. Japan’s domestic and overseas production Toyota was hit hard by supply chain interruptions, forcing Japanese and foreign companies to draw up contingency plans for alternative supplies in southern Japan or outside the country.

Over the next several years, Japan ostensibly will need to come up with JPY25 trillion or more for reconstruction, pushing debt-to-GDP to 309% of GDP by 2020 versus prior estimates of 301% before the disaster–if Japan’s mountain of debt does not simply collapse in on itself before that.

There is one thing that economists cannot program into their econometric models, and that is government (in)competence. Political gridlock was bad before the disaster, and Japan’s politicians are already back to bickering and jostling for advantage even within the ruling DPJ. With many even within his own party pushing for Kan’s resignation, the prime minister and his cabinet have little political muscle to keep their promises. Indeed, Japan may see its seventh or eighth minister in as many years before the disaster-struck region is restored to any semblance of normality.

Consequently, more domestic economists and international agencies now see negative growth for Japan in 2011 and less of a “V-Shaped” recovery.

Washington Post: In Japan, The Same Old Problems

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Tohoku Reconstruction Being Delayed by Political In-Fighting

Less than a month is left in the current Diet session, and there is still no legislation to issue deficit-covering bonds due to opposition political parties (the LDP and Komeito) pushing the Kan Administration into a corner in the hopes of toppling his government. As the opposition does not have enough votes to pass a no-confidence vote against the Kan Administration, the deficit-covering bond legislation is being used as a lever to topple Kan’s government.

The MOF can cope by delaying transfers to special accounts and issuing short-term financing bills, which are capped at 20 trillion yen a year, but that would still leave a revenue shortfall to the end of the fiscal year. Thus Japan is now facing its own budget funding crisis.

Diet politicians are also bickering about bills to revise the cabinet law and to establish a basic law that outlines a framework for reconstruction after the March 11 earthquake. The Kan Administration has still has not gotten round to appointing ministers with remits for reconstruction measures and the nuclear disaster. The government has also yet to ascertain what people in the disaster areas need, swiftly amend laws, deregulate industries and designate special economic zones–i.e, create an integrated, comprehensive reconstruction plan.

Submission of a second supplementary budget for fiscal 2011 will probably be put off until a extraordinary Diet session convenes in the summer or later, while Reuters is reporting the supplementary budget even if completed in a timely fashion could be less than JPY1 trillion because of the funding bills issue.

Thus it is already back to politics as usual in Nagata-cho, i.e., political gridlock. As Lee Myung-bak, South Korea’s President said, “never waste a good crisis”. In Japan however the Tohoku crisis is being twisted to further opposition political agendas on the one hand, and by the DPJ to extend the shelf-life of the Kan Administration–while both parties leave 110,000 people still living in temporary evacuation centers hanging, as well as key decisions needed before serious reconstruction work can proceed.

An old quote in the U.S. is “God helps them who help themselves”. In other words, what’s left of local communities and businesses in the disaster-stricken Tohoku region will be much better off if they just get on with trying to rebuild their lives and communities without waiting for the government, because they still could be waiting for the government to take action this time next year.

Tensions Rise in Standoff Over Bond Bill

Recovering Being Slowed by Bickering Over Rebuilding Bodies

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Moody’s Cuts Japan Sovereign Debt Outlook. So What?

Following S&P, Moody’s has put Japan’s sovereign debt rating (Aa2) outlook to “negative” from stable. The downgrade was ostensibly due to concern that the current economic and fiscal policies of Japan’s DPJ-led government “may not prove strong enough” to achieve the government’s debt reduction plan and counter the inexorable rise in Japan’s debt. At the same time, Moody’s said that a debt crisis in Japan was unlikely in the “near or medium term”.

Memo to Moody’s. We hate to steal your thunder, but no one believed the current DPJ government economic and fiscal policies would help stem the rise in Japan’s debt. Indeed, most in Japan believed that the DPJ’s “progressive” policies will actually make it worse.

Memo to Investors. How credible are the very same people that kept giving CDOs triple-A rating even as the US housing house of cards was collapsing?

Of course, every one who has looked closely at Japan’s ballooning government debt situation knows that this will end badly—eventually. Our trigger is when Japan’s structural balance of payments surpluses turn negative–after which its only a matter of (relatively short) time when Japan runs out of money. However, that day is not tomorrow, next year or perhaps even a few years from now.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Japan’s Debt: One for the Record Books

Japan’s debt in the government sector — both central and local levels — rose to 217% of nominal gross domestic product in 2009, the largest figure since comparable data became available in 1875, according to the IMF. The IMF’s latest forecasts suggest the balance will reach 232% of GDP in 2012–only a year from now. During WWII, Japan’s went heavily into debt to wage a global war, but the ration peaked at 204% in 1944. The lesson of the 1940s however was that postwar inflation slashed the real value of JGBs, reducing the debt balance to only 56% of GDP just two years later, in 1946.

Japan doesn’t have the developed world record yet, The U.K.’s debt hit 269% of GDP in 1946, which was the worst so far for any developed nation except Germany’s Weimer Republic. The lesson again from the U.K. was that the U.K. was was forced to accept financial support from the IMF in the 1970s after its foreign currency reserves dried up as it was plagued by inflation and a weak currency. At the current pace, however, Japan’s debt-to-GDP ratio will exceed the U.K.’s and reach 277% by 2016.

The end game for Japan is two scenarios; a) default, or b) excess inflation like in the 1940s, as Japan is now beyond the point where it could ever hope to pay down this debt with economic growth or austerity. We believe the point of no return will be reached when Japan starts to record a current balance of payments deficit and begins eating into its hoard of over USD 1 trillion of foreign exchange reserves.

However, since Japan’s balance of payments surplus is now largely provided by income from overseas investments (like US treasuries) and dividend repatriation from overseas subsidiaries, a balance of trade deficit won’t immediately mean a current balance of payments deficit. Further, even a significant rise in JGB yields would take several years to work its way into significantly higher interest rates paid on new debt and existing debt rollovers.

This means that Japan could still tolerate its growing mountain of debt for the next 5~10 years before the end game is upon us–i.e., you will probably still lose money shorting JGBs.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

Some Sobering Scenarios for Japan’s Debt Problem

In a January 2011 BOJ working paper, Selahattin Imrohoroglu, and Nao Sudo do some econometric number crunching scenarios to model what could be done to reduce Japan’s ballooning government debt, as Japan’s net debt in 2010 reached 104.6%.

Prime Minister Naoto Kan has recently reshuffled his cabinet and brought in consumption tax hawk Kaoru Yosano as Economic and Fiscal Policy Minister and is taking the politically unpopular consumption tax hike issue straight on. On the table is a substantial consumption tax hike, ostensibly by three-fold to 15% from the current 5%.

But the econometric modeling in the working paper shows that even a three-fold increase in the consumption tax would not be enough to make a permanent dent in Japan’s public debt. Further, it is unlikely that Japan can simply grow itself out of debt, as a “growth miracle” of 6% per annum total factor productivity (TFP)/GDP growth would be needed for the next decades to meaningfully reduce Japan’s debt over the next 40 years.

What Japan realistically needs is a combination of a) a three-fold hike in consumption taxes to 15%, b) cuts in government expenditures/entitlements of at least 10%, and c) TFP/GDP growth of 3%~4% over the next decade, versus historical and expected growth of more like 1% per annum. Moreover, it is likely that bond yields/interest rates would rise significantly given substantially higher GDP growth rates, which would only raise the debt reduction bar even higher because of the increased interest rate/debt servicing burden.

Thus Naoto Kan and anyone who replaces him in the next decade, is facing some sobering, politically difficult choices in getting Japan back on the road to fiscal stability.

Will a Growth Miracle Reduce Debt in Japan?

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

BOJ’s "Emergency" Monetary Policy Meeting: Much to Do About Nothing

The Kan Administration has kept up the pressure on the BOJ to take action. A Japanese ruling party panel discussed currency intervention and recommended last Thursday that the government ask the Bank of Japan to take monetary policy a step further to counter a rising yen. A prior much-reported “meeting” between Kan and BOJ governor Shirakawa merely consisted of a 15-minute phone call between Kan and Shirakawa. The contents of the 15-minute phone call undoubtedly were, (Shirakawa) “Look, I’m going to Jackson Hole next week–can’t it wait until then?” (He attended the Federal Reserve’s conference in Jackson Hole, Wyoming, and apparently getting advice from current and former Fed and Treasury officials).

But the Kan Administration kept up the pressure. Japanese Finance Minister Yoshihiko Noda said on Saturday he was ready to employ “all possible measures” to tackle the soaring yen, which was having a big impact on the country’s export-led economy. The government is apparently counting on the BOJ’s further easing to work in tandem with a package of economic countermeasures Kan is expected to announce in the next day or two. Over the weekend, MEITI (Ministry of Economy, Trade and Industry) added more pressure on the BOJ by releasing a survey of 102 mainly exporter companies, 40% of which said they would shift production overseas if the JPY continues to trade at currently levels or higher. Some 51% of the companies reported the stronger currency was having some effect on profits, while 14% said the impact was severe. That is four times more than in May when the yen was above 90 per dollar and only 14% noted any negative impact on earnings. Should the current JPY85/USD continue for six months, the proportion of companies with worsening profitability will increase to 72%, the survey showed. The hollowing-out of Japan’s production base is already underway. In 2008, before the current yen strength, the average ratio of overseas production was 17%, versus 6% in 1990, according to separate data from METI.

A Lot of Drama About Very Little

But what did the “emergency meeting” produce? Just a decision to boost the amount of funds in the lending facility by JPY10 trillion ($116 billion) to a total of JPY30 trillion from a prior JPY20 trillion($234 billion), something the BOJ was already widely expected to do. The media over the weekend was reporting an “emerging session” of the BOJ’ｓmonetary policy committee, Governor Masaaki Shirakawa was already on the plane back to Tokyo earlier than expected. To us, this seems like a lot of drama about something the BOJ was already expected to do. Prior to the meeting,
BOJ governor Shirakawa hadn’t spoken publicly about the yen since the last policy meeting. On August 10, he said that policy makers were “well aware” that a strong yen would dampen corporate confidence and hurt economic growth. He also indicated Japanese companies had become resilient to the yen’s gains compared with late last year when the yen was surging. Further,the BOJ has been reluctant to take further easing measures before finding clear evidence of economic deterioration, because up until a month or so ago, the Bank was still confident in its economic forecast of 2%+ growth.

Any half-hearted moves (including unilateral intervention) to stem further appreciation in the yen may only have a temporary impact. Despite all the concern about JPY/USD going above JPY85/USD, traders are well aware of the fact Japan’s currency needs to rise 47% to equal its strength in the mid-1990s based on Real Effective Exchange Rates, using an inflation rate that’s been mostly negative since 1998. Deutsche Bank AG, the world’s biggest foreign-exchange trader, estimates on that same basis the yen would have to gain 55% per dollar from 85.22 last week to match the record 79.75 in April 1995.

But that does not explain why the yen has appreciated in the first place. Japan’s economic growth is slowing. While the OECD forecast for Japan’s 2010 GDP was 3.0% as of May, 2011 growth was pegged at 2.0%. The IMF’s forecast was for 2.4% growth in 2010 and 1.8% growth in 2011. On the other hand, the Bloomberg media forecast is for 3.4% growth in 2010 versus 3.0% in the US and 1.4% for Euroland–meaning some of the downside in Japanese stocks of late was driven by foreign investors trimming their overly optimistic view of Japan’s GDP growth. The other factor is the renewed attention being paid to Japan’s chronic current account surplus, which basically means Japan doesn’t have to rely on foreign capital (yet) to fund its ballooning fiscal deficit, and its foreign- exchange reserves of $1.01 trillion are second only to China’s $2.45 trillion, even though some suggest that unrealized losses on these forex reserves may be as high as 30%.

How About Some Real “Shock and Awe”

If the BOJ and the Japanese government really wanted to shake loose the yen speculators, they would collude to provide some shock and awe–such as the Kan Administration announcing a really big fiscal stimulus package (i.e., one with real fiscal expenditures of +/-JPY40 trillion), with bonds that would be underwritten (monetized) by the BOJ–as finance minister Takahashi (the man credited with pulling out Japan from depression in the 1930s) and then forex market intervention as currency traders scrambled to cover their positions. While it would undoubtedly be criticized by the US, this could cause JPY/USD to fall back sharply to JPY90~JPY110/USD and JGB yields to scurry back to 2%. Ironically, it could also prove very profitable for those hedge funds currently shorting JGBs.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com

How Japan Recovered from the Great Depression

Japan’s “Zombie” economy has become a textbook case for any central banker or economist of what not to do. Hedge fund manager Kyle Bass of Hayman Investments is the latest foreign fund manager to state the view Japan has reached the point of no return on its massive debt, i.e., debt grows exponentially, revenue growth stays linear, and servicing debt becomes impossible, forcing Japan to restructure its debt within 1 to 2 years.

How can Japan dig itself out of this mess? During the Great Depression (called the Showa Depression in Japan), which Japan actually experienced first because of the Great Kanto earthquake and other factors, economic growth declined by 2.7% in 1922, 4.6% in 1923 and -2.9% in 1925. When the global depression hit after Black Thursday 1929, Japan’s growth rate really plummeted, to a nominal -9.7% in 1930 and -9.5% in 1931. Finance Minister Korekiyo Takahashi was credited with ending the Showa Depression. He did this by implementing, a) massive fiscal stimulus, b) substantially increased JGB issuance and c) debt monetization by the BOJ.

When he assumed office in December 1931, Takahashi’s first act was to re-prohibit gold exports and then formally leave the gold standard in January 1932. He then abandoned his predecessor’s fiscal austerity measures, continuously cut the discount rate and implemented foreign exchange controls to prevent capital flight. In fiscal 1932, he boosted combined fiscal spending by 34% YoY and financed this with a doubling of government bond issuance that was underwritten by the Bank of Japan. The total fiscal expenditures in FY1932 were 10% of GDP. Thus, his policies were essentially, a) lower interest rates, b) massive fiscal stimulus, and c) debt monetization by the Bank of Japan. The “irresponsible” debt monetization by the BOJ fostered inflationary expectations that helped to quell deflation as well as weaken JPY. Prices first turned upward in 1932, lowering the real debt burden, and production as well as investment began to recover in 1933.

For his efforts, unfortunately, Korekiyo Takahashi was assassinated on February 26, 1936, when a group of radical young Army officers attempted a coup with some 1,400 troops by attacking the Prime Minister’s residence and other government buildings and killing Home Minister Makoto Saito, Finance Minister Korekiyo Takahashi and Army Inspector General of Military Training Jotaro Watanabe.

But A Significantly Weaker Yen and Higher Bond Yields Could Well Force Japan to Restructure its Debt

In today’s terms, a double-digit YoY increase in fiscal spending could be created with government bond issuance of 8% of GDP (~JPY38 trillion), and the purchase of bonds issued to pay for this by the BOJ, who would also adopt an inflation target. To do this, the BOJ would have to waive its own seigniorage rule, which prevents the BOJ from holding on its balance sheets more government debt than the amount of bank notes and coins in circulation. As of August 20, 2010, the BOJ held JPY76.26 trillion of government securities, which is only JPY4.7 trillion below the JPY80.92 trillion of bank notes and coins in circulation. The underwriting of this debt would push the BOJ’s JGB and note holdings up 50%, and push general government debt and debt guarantees up some 4% to JPY967 trillion, or 203% of GDP.

But in doing so, the government and BOJ risk a full-blown collapse in JPY and a surge in JGB yields. Japan’s tax revenues at JPY37 trillion-plus in FY2010 are 40% lower than in the peak of FY1992, while general expenditures plus debt servicing costs are 34% higher. With an average interest rate of 1.4% on this debt, issuing an additional JPY38 trillion at today’s rates would actually lower the interest rate burden on general bonds with an average maturity of 6 years and three months. Kick-starting Japan’s economy in a manner used during the Showa Depression would be bold, risky gamble that could well force Japan to restructure its existing debt. At the end of the day, however, this may be what is required to get Japan’s economy and stock market from ground zero.

Regarding the possibility of intervention to stem the yen’s rise, we believe any such efforts would be an exercise in futility for the Japanese government. The BOJ still has about JPY100 trillion in yen-carry positions left over from the 2004 intervention, when the BOJ sold JPY14.8 trillion of JPY in 47 days. This legacy position means that up to 30% of Japan’s forex reserves are sitting on unrealized losses.

Tokyo Takes provides free commentary on global investments from a Japan perspective. To contact the author, please email darrel@japaninvestor.com