Download Japan: Fragility of the consolidated government debt structure

Japan: Fragility of the consolidated government debt structure
~ Will insolvent BoJ be rescued by public fund injection or a bank tax? ~

This is an extended version of Macro Matters of 17 November 2016
In an earlier report (Economic Desknote dated 28 October, “Japan: Why support for Abe is up
when economy is flat”), we explained why public approval for the Abe administration remains
high, despite the economy’s dull performance, entailing marginally positive growth and barely
positive inflation (new core CPI basis).
For starters, as far as households are concerned, persistent manpower shortages, reflecting the
shrinking workforce, mean it is very easy to find job. Because the economy’s ceiling (supply
capacity) has declined, the job offers-to-applicants ratio, a critical indicator of labor supplydemand, has climbed to a level not seen since the heyday of the “bubble economy” in the early
1990s. Secondly, there has never been an administration so sensitive to possible changes in
business conditions that it resorts to fiscal spending financed by the BoJ every chance it gets.
As far as companies are concerned, therefore, the current situation is very comfortable, with
minimal downside risk for the domestic economy. In the wake of the Brexit vote, Japan was the
only developed country to undertake aggressive fiscal spending out of concern over fallout on
the domestic economy. Even Britain, the nation directed affected, has not acted. Now if growing
uncertainties following Trump’s surprise victory, the Abe government could respond with
another package of fiscal spending (a third extra budget for FY 2016).
A third reason is that households prefer the zero inflation that prevails because nominal wage
growth, despite full employment, refuses to accelerate, owing to the impact of negative
demographics and Japan’s dual labour-market structure (Japan’s misery index, calculated by
adding the jobless rate to the inflation rate, is at an extremely low level). Quickly achieving the
2% inflation target by deliberately weakening the yen will only hurt the government’s approval
ratings by virtue of reducing households’ real purchasing power, hence the BoJ’s decision to
shift to a gradualism strategy on inflation.
Reforms do not make
headway despite the high
government approval
ratings
Now one might normally assume that having such high public approval ratings ought to
embolden the government to undertake needed structural reforms, like overhauling the social
welfare systems and restructuring state finances. Paradoxically, though, while enjoying approval
ratings that could facilitate the implementation of long-term reforms, the government only adopts
short-sighted measures to shore up the GDP so as to prolong its tenure in power.
When will matters come to
a head?
But fiscal spending only derives its simulative effects by bringing future income forward (via JGB
issuance) for immediate spending. In other words, today’s stable political scene is being
maintained by the front loading of future income. If this were to lead to the expansion of the
economy, Japan’s public debt problem could be somewhat alleviated. But because the trend
Chart 1: Cabinet approval ratings
(Abe administration, December 2012–present)
Chart 2: Private sector savings and outstanding balance
of government debt (% of GDP)
80
250
Private sector savings
Approval
70
200
60
50
150
40
100
JGB and FILP bonds
30
20
50
Disapproval
10
0
2013
2014
2015
0
1998
2016
Source: Nikkei Shimubun, BNP Paribas
2002
2004
2006
2008
2010
2012
2014
2016
Source: Cabinet Office, MoF, BNP Paribas
Ryutaro Kono
Economic Desknote Japan (No.208)
2000
18 November 2016
(w.690)
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growth rate has declined close to zero, resolving the debt problem with future tax revenue alone
is becoming increasingly hard. Making matters worse, the increased tax receipts generated by
exporters, reflecting the profits they enjoyed at the expense of households thanks to yen
depreciation, have started to decline alongside the yen’s strengthening, with the result that the
tax haul in FY 2016 is likely to fall short of initial estimates. With government’s plans to “grow
out’ of the public debt unravelling, when might matters come to a head? This is the topic we will
address in this report.
Fiscal sustainability could
be lost in the latter half of
the 2020s
Last May (Economic Desknote dated 22 May, “Simulations for Japan’s fiscal sustainability”), we
ran simulations to determine how long it might take until Japan’s fiscal conditions become
unsustainable. A fiscal crisis was defined as a situation where the amount outstanding of central
government debt exceeds the private sector’s financial assets. In other words, when financial
assets available in the private sector for purchasing the government debt cannot cover the
government debt, a fiscal crisis will occur. The results of our simulations suggested that, even in
a scenario of high growth (= 2% envisaged by the government), a fiscal crisis could occur in the
latter half of the 2020s if nothing was done to rein in the swelling costs of social welfare, and if
the VAT rate stayed at 10% (where it was slated to be raised in April 2017). Our conclusion was
that the minimal requirement for averting such an outcome was the early implementation of a
50% reduction in the growth of social welfare costs, coupled with hiking the VAT rate to 15%.
Delaying the VAT hike
again could bring the
crisis forward to the mid2020s
Needless to say, such steps alone won’t revolve everything. But without these measures in
place by the early 2020s, the risk of a fiscal crisis will increase. As things would have it, though,
despite being in full employment, the government opted to again delay the VAT hike, so the tax
rate has yet to reach the 10% level (it is currently 8%). Additionally, nothing has been done to
rein in social welfare costs out of concern for what might happen to the economy. And there are
concerns that reckless spending could be ramped up in the name of support for childcare and
nursing as part of Abe’s plan for the Dynamic Engagement of All Citizens. Currently, the
delayed increase of the VAT rate to 10% is scheduled to take effect in October 2019, but
whether it will really happen or not is far from certain. If the VAT rate stays at 8%, the timing for
the end of fiscal sustainability could be pushed forward to the mid-2020s.
Fiscal sustainability could
be destroyed by
snowballing interest costs
Of course, because Japan is not a closed economy, even if outstanding central government
debt were to exceed the private sector’s financial assets, the difference could conceivably be
covered by importing capital from abroad. But like Japanese investors requiring high risk
premiums when investing overseas, foreign investors will also demand high risk premiums to
invest in Japan. If the investments involving financing Japan’s public debt, at a time when fiscal
restructuring is continually put off, the fiscal premiums being demanded will be all the greater.
Paying such high premiums could cause interest rates to soar, and Japan’s fiscal conditions
would rapidly deteriorate on the snowballing cost of debt interest payments.
Can’t the BoJ’s JGB
buying prevent an
explosion in debt interest
payments?
That being said, with the BoJ currently holding almost 40% of all outstanding JGBs, and that
share (at yearend) likely to hit, at the current pace of buying, 50% in 2017, roughly 60% in 2018,
almost 70% in 2019, and then approximately 75% in 2020, some may doubt that debt interest
payments will become a problem at all. Indeed, if government debt can be financed by the BoJ,
what need is there to import capital from abroad? If the long-term interest rate target can
suppress 10-year JGB yields to zero, there should be no explosion in debt interest payments.
What should we make of such views?
BoJ to face huge losses
when interest rates rise
Certainly, if the BoJ further expands its balance sheet with the acquisition of more JGBs, the
problem of a surge in the government’s interest payments can ostensibly be suppressed
because the rise in the long-term interest rates can be checked. But that would mean that the
BoJ’s operating target has changed to supressing the long-term rate, which means rate hikes
needed for price stability could prove hard to implement. Then again, because much of the
government’s liabilities have been locked into super-long-term debt, even if interest rates were
hiked, the pace of growth of the government’s interest payments could stay extremely low. In
any event, the problem is that, when interest rates rise, the BoJ, with its bloated balance sheet,
will be obliged to pay massive interest payments on its liabilities to private banks.
Problem is the same if the
government and BOJ are
seen as consolidated
Whether the massive interest burdens fall on the government or on the central bank may not
technically be the same, but the difference is irrelevant if we consider the government and the
BOJ as a consolidated entity. Seen in this light, the timing of the loss of fiscal sustainability,
Ryutaro Kono
Economic Desknote Japan (No.208)
18 November 2016
(w.690)
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when the “consolidated government debt exceeds the private sector’s assets,” will not
fundamentally change. Even so, if we take the quality of consolidated liabilities into account, the
bloating of the BoJ’s balance sheet will make the situation even worse. The reason is that, while
the government has taken advantage of the super-low interest rate environment to lock its
liabilities into super-long-term debt, the BoJ’s acquisition of JGBs from private financial
institutions effectively swaps those long-term bonds for the super-short-term liabilities of central
bank reserves parked at the BoJ. In other words, in terms of the consolidated government
account, liabilities to the private sector are increasing alongside the swelling of the BoJ’s
balance sheet and also being converted from super-long-term debt to super-short-term central
bank reserves.
Public fund injection could
be needed if BoJ turns
insolvent
What this means is that the government’s consolidated financial account is extremely fragile to
a rise in short-term interest rates. As noted above, because much of the government’s liabilities
are locked into super-long-term debt, even if short-term interest rates rise, a sharp jump in the
government’s interest payments can certainly be avoided. But on the BoJ’s side of the
consolidated ledger, because the return on asset holdings is extremely meagre, rising interest
rates will trigger a sharp jump in interest payments on the liabilities owed to financial institutions,
resulting in a huge negative spread. The BoJ has started setting aside more reserves to prepare
against such a negative spread. But because the BoJ’s balance sheet has ballooned to such
massive proportions, the reserves are a mere drop in the bucket. If the BoJ faces massive
operating losses, not only will it be prevented from making transfers to the national coffers but it
could, if the losses lead to insolvency, require a capital injection by the government. Ultimately,
therefore, the burden could be passed on to the government. Then again, because money all
looks the same, perhaps BoJ will just end up printing the money to purchase the JGBs that the
government issues to raise the capital for injecting into the BoJ.
BoJ to mull scaling back
its JGB purchases
Of course, if inflation does not pick up, there will be no need for interest rate hikes. But in such
an event, the BoJ will, in the meantime, be obliged to continue buying JGBs. Since the BoJ
balance sheet will continue to expand, when inflation finally rises and interest rate hikes become
necessary, the negative spread facing the BoJ will be all the larger. It was concerns about this
that promoted the BoJ to shift from its quantitative target to interest rate targeting, thereby
making way for the BoJ to mull scaling back its JGB purchases, so long as the yen does not
dramatically appreciate.
BoJ’s interest costs could
swell to almost 4% of GDP
As indicated above, if the BoJ were to continue buying JGBs at the pace specified before the
latest policy regime change, its holdings share will climb close to 75% of all outstanding JGBs
by the end of 2020. If, once this happens, the inflation rate were to rise to 3%, the O/N rate will
have to be raised to at least 3%. With such a policy rate, simple calculations will be put the
BoJ’s interest payment costs at almost JPY 20 trillion, which translates into almost 4% of GDP.
Of course, if the O/N rate hikes are gradual, the return on BoJ asset holdings will also rise. But it
is also probable that part of currency in circulation (cash balance), which has currently swollen
to JPY 95 trillion, will flow toward BoJ current accounts. So while the losses that the BoJ could
incur may be somewhat smaller, the risk of falling into insolvency remains.
Critical moment could be
when capital stock starts
declining
Moving along, in concrete terms when might the markets start anticipating a fiscal crisis? It is
conceivable that Japan could, mathematically speaking, be in a situation where “government
debt exceeds the private sector’s assets” but a crisis does not occur simply because interest
rates won’t be raise so long as inflation stays subdued. Accordingly, while the crisis will certainly
take place in the financial markets, we think that the catalyst could very well be changes in the
real economy. Developments in Japan’s external balance could play a big role here, but it is our
supposition that more influential factor for determining the timing when the markets begin
pricing in a crisis is when Japan’s capital stock starts to be depleted.
Government deficits are
devouring net private
savings
Currently, Japan’s trend growth rate has declined close to zero, and the process of domestic
capital formation has, accordingly, also largely stopped. While corporate Japan continues to
undertake capital investment, the level of investment these days only matches that of the
consumption of fixed capital. In short, a trend growth rate of almost zero is fully consistent with
the rate of growth of net capital stock declining to around zero. The problem is that, if
government deficits continue to expand unabated, net private savings will be devoured and the
reduction of net private capital stock will become inevitable.
Ryutaro Kono
Economic Desknote Japan (No.208)
18 November 2016
(w.690)
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Consumption has surged
out of balance with the
scale of production and
income
Broadly speaking, we could illustrate this as follows. Of the total value added created in the
Japanese economy each year (GDP), roughly 60% is applied to private consumption,
approximately 20% is appropriated by government consumption, and the remaining 20% or so
is directed toward capital formation (capital investment, etc.). As indicated earlier, capital
formation is not expanding, as new investment is being undertaken to only make up for
depreciation. Consequently, the value added that we are creating is being entirely used up by
private consumption and government consumption, with the result that nothing is left over for
net domestic savings, which are the financial resources for net private investment. In Japan, the
low weight of private consumption in the GDP is deemed to be a problem, but the weight is not
necessarily low if we include social welfare costs, which are officially counted as government
consumption. Consequently, for there to be virtually no capital formation means consumption
has increased to the point of being out of balance with the scale of production and income.
Decline in net capital stock
will be obvious in 2025
Matters will only get worse moving forward. For starters, Japan’s baby boomer generation will
join the ranks of the age 75+ advanced elderly in 2022~24, whereupon medical expenses will
skyrocket. The result is that private consumption and government consumption will use up so
much of the value added created in the economy that capital investment will no longer be able
to even cover depreciation, and net capital stock will clearly begin the process of declining. Put
in terms of the afore-mentioned illustration, while private consumption will continue to account
for roughly 60% of the GDP, the share appropriated by government consumption would
increase from 20% to 25% (on skyrocketing medical costs), thereby reducing the share
assigned to capital formation from 20% to 15%, with the result that the growth of net capital
stock will clearly turn negative. Because negative demographic continue to cause Japan’s
workforce to shrivel, Japan’s trend growth rate will definitely turn negative unless total factor
productivity growth can be robustly elevated.
Debt resolution with future
tax receipts will clearly no
longer be feasible
Needless to say, because tax revenue is greatly dependent on the economy’s scale, if trend
growth falls below zero, the economy’s scale will shrink and future tax receipts will also decline.
In other words, future tax revenue will clearly be unable to repay the public debt. Of course,
compared to VAT rates in Europe, Japan still has much room to raise its VAT rate. But raising
taxes will not get any easier politically once trend growth has turned negative. After all, despite
full employment, the government opted to delay raising the VAT rate to 10%, twice, out of
concern for the economy’s direction at a time when the low growth is due to weak trend growth.
VAT hike slated for
October 2019 could be the
turning point
In view of this, the looming crisis might not wait until the “2022~2024 Problem” but it could
actually be brought forward. For example, if the VAT hike, now slated for October 2019, is put
off yet again, the financial markets could become convinced at that juncture that the public debt
can’t be repaid with future tax revenue. Even before the real economy is affected, big changes
could occur in the financial markets in response to such policy alteration because expectation
formation is forward looking.
Will there be a spiral of
yen depreciation and
inflation?
How might the markets react when it becomes clear the public debt can no longer be repaid
with future tax revenue? Upward pressures would likely mount on the long-term interest rate,
and the yen rate should also markedly weaken. While the rise in the term interest rate could be
Chart 3: Corporate sector gross fixed capital formation
and consumption of fixed capital (JPY trn, nominal, FY)
Chart 4: Net national savings (JPY trn, nominal, FY)
90
100
Gross fixed capital formation
80
Net national savings
80
70
60
60
40
50
Private sector net savings
20
Consumption of fixed capital
40
0
30
-20
20
-40
10
1980
-60
1985
1990
1995
2000
2005
2010
Source: Cabinet Office, BNP Paribas
1980
1985
1990
1995
2000
2005
2010
Source: Cabinet Office, BNP Paribas
Ryutaro Kono
Economic Desknote Japan (No.208)
Government net savings
18 November 2016
(w.690)
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curbed if the BoJ is willing to pay the price of further balance sheet expansion, controlling the
exchange rate is outright impossible. What is more, if the BoJ suppresses the long-term interest
rate, real interest rates will be pushed down, stoking further yen depreciation. With rising
inflation and yen depreciation exerting more downward pressure on real interest rates, a
deepening spiral of yen depreciation and accelerating inflation could ensue.
Public fund injections into
BoJ will be the focal point
Of course, to avoid a spiral of yen depreciation and accelerating inflation, the BoJ could
gradually raise both the O/N rate and the target level for the long-term interest rate. But that,
needless to say, will widen the BoJ’s negative spread, pushing the central bank into insolvency.
As for the government, even if interest payment costs increase to some degree, the pace of
increase will be extremely slow because so much of the government liabilities have been locked
into super-long-term debt. A rise in interest rates should not create serious problems for the
financial sector because, with the exception of pension funds and life insurance companies that
maintain long-term JGBs to match their liabilities, most banks have already sold off much of
their JGB holdings to the BoJ. Consequently, the focus will be on whether the government
undertakes a public fund injection into the BoJ to cover the losses resulting from the large
negative spread.
Will the reserve
requirement be hiked?
But there is a blind spot here that could pose difficulties. Namely, the public is very wary of
favourable treatment given to financial institutions. Seeing how the BoJ’s excessive debt woes
will be due to the massive scale of interest payments to financial institutions, the public might
not like the thought of injecting taxpayer money into the BoJ so that it can continue paying this
interest. To lessen such a public backlash, the authorities could raise the legal reserve ratio.
Because legal reserves, being non-interest-bearing, are like a tax on banks, this could
somewhat reduce the BoJ’s excessive debts, and lessen the scale of any public fund injection.
Of course, banks would likely pass the costs onto depositors, so deposit interest rates will likely
stay at zero, even if the policy interest rate rises. Ultimately, the bank tax could fall on the public
as a tax on deposits.
Financial repression
should still ultimately
unfold
If this were to happen, the result would be fundamentally the same as that of the stealthy
inflation tax. With interest rates unlikely to rise even if inflation does, the public at large, fearing
that their savings will lose value in real terms, will likely cut back on spending to safeguard their
livelihoods. Well-off segments of the population, on the other hand, will likely shift their money
toward socks, real estate, and foreign assets so as to avoid the tax on deposits. The result
could be the incongruity of booming share prices amid stagnant economic activity. While the
inflation tax is inevitable if the BoJ avoids interest rate hikes, a de facto bank tax will ensue if
rates are raise. Either way, the end production will be financial repression.
Chart 5: Population pyramid (2025)
Male
4
3
2
1200
Female
100+
95-99
90-94
85-89
80-84
75-79
70-74
65-69
60-64
55-59
50-54
45-49
40-44
35-39
30-34
25-29
20-24
15-19
10-14
5-9
0-4
1000
800
600
400
2
3
4
80～84
85 and older
75～79
70～74
65～69
60～64
55～59
50～54
45～49
40～44
35～39
30～34
25～29
20～24
5
(million)
(million)
Source: National Institute of Population and Social Security Research
Source: MHLW, BNP Paribas
Ryutaro Kono
Economic Desknote Japan (No.208)
15～19
Age groups
1
1
10～14
0
0～4
200
5～9
100+
95-99
90-94
85-89
80-84
75-79
70-74
65-69
60-64
55-59
50-54
45-49
40-44
35-39
30-34
25-29
20-24
15-19
10-14
5-9
0-4
Baby boomers
5
Chart 6: Per capita medial expenditures
(unit: JPY 1,000)
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The “2032~2034 Problem”
will be an even bigger
challenge
Perhaps Japan will be fortunate enough to weather through the “2022~2024 Problem”
unscathed. After all, with GDP statistics in general, and data for net private capital investment in
particular, likely being underestimated, there still might be some room before capital stock starts
declining (lower oil prices from the fall of 2014 also elevated Japan’s savings level). But if
nothing is done to overhaul social welfare and reform state finances, an even bigger challenge
awaits in the “2032~2034 Problem. At that juncture, the remaining baby boomers will start
entering the super-elderly 85+ population in droves, and a very high percentage will require fulltime nursing care. As things now stand, the average longevity for Japanese men has increased
to 81 years and that of women is 86 years. In 2032~2034, many boomer females should still be
alive. Their offspring, the boomer juniors, will be entering their 60s, and many will not be able to
maintain full-time employment because of the needed to care for their elderly mothers. Normally,
because Japan needs to maintain its workforce, it is important that boomer juniors stay in
employment after reaching age 65. But that will become increasingly difficult. In macroeconomic terms, government deficits will further expand owing to the snowballing cost of social
welfare resulting from the surging costs for medical and nursing care. At the same time, there
will be an overwhelming deficiency in savings because the private sector’s consumption level
will likely not change, but the income level should decline alongside the further shrivelling of the
workforce. As a result, with investment only being implemented at a level well below that of
depreciation, private net capital stock will sharply decline and the trend growth rate will weaken
further. Without needed structural reforms, it is very doubtful that Japan will make it safely
through the “2032~2034 Problem.
Tax hikes alone won’t
solve anything
Before closing, we should stress here that tax hikes alone will not solve anything. Certainly,
raising taxes can make it seem like Japan’s fiscal position has become more sustainable. But
tax increases only transfer income from the private sector to the government. In other words,
there will be no change in net national savings because net private savings will decline by the
same amount that the government deficit shrinks thanks to the tax receipts. Net national
savings cannot be scrounged up to cover net private investment. The essence of the problem is
that net private savings, which should be directed toward capital formation, are devoured by
escalating social welfare costs, so the only solution is that social welfare benefits, which are
excessive compared to the scale of nation’s production and income, must be reduced.
Why don’t myopic policies
end?
Virtually alone in a world gripped by populism, Japan enjoys such uncommon political stability
that the Abe Administration, with is high approval ratings, is in a position to purse needed longterm reforms. With the political capital to do this, will the government only purse myopic policies
with the aim of only prolonging its tenure in power? Japan does not have much time left before
its day of reckoning comes.
Chart 7: Growth accounting framework analysis
(annualized, % contribution)
5.0
Male
GDP growth rate
4.4
4.0
3.0
Capital input contribution
1.9
2.2
-1.0
0.6
0.7
1.0
0.0
Female
100+
95-99
90-94
85-89
80-84
75-79
70-74
65-69
60-64
55-59
50-54
45-49
40-44
35-39
30-34
25-29
20-24
15-19
10-14
5-9
0-4
Second‐
generation baby TFP contribution
1.6
2.0
Chart 8: Population pyramid (2035)
1.5
0.7
-0.3
0.4
-0.3
0.6
0.2
Labor input contribution
1980s
1990s
0.2
0.2
-0.2
2000s
2010-2014
0.2
-0.1
-0.1
0.0
2015
5
4
(million)
Source: Cabinet office, METI, MHLW, MIC, BNP Paribas
2
1
Baby boomers
1
2
3
4
5
(million)
Source: National Institute of Population and Social Security Research
Ryutaro Kono
Economic Desknote Japan (No.208)
3
100+
95-99
90-94
85-89
80-84
75-79
70-74
65-69
60-64
55-59
50-54
45-49
40-44
35-39
30-34
25-29
20-24
15-19
10-14
5-9
0-4
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Ryutaro Kono
Economic Desknote Japan (No.208)
18 November 2016
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Ryutaro Kono
Economic Desknote Japan (No.208)
18 November 2016
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