Download apropos… - ETHENEA

12 March 2014 • Page 1
APROPOS…
[email protected] | www.ethenea.com
… Forgotten is not forgiven
It has been over one year since Shinzō Abe was elected
Prime Minister of Japan and his economic program, dubbed
Abenomics by the financial press, has been launched. Since
then, market participants have been able to witness palpable
results in the form of a weaker currency and a much
stronger equity market in the country. Economic growth in
Japan has been among the highest in the world for 2013
and the strongest among developed markets. As a matter of
fact, investors and the press were so smitten with how well
the first steps of Abe’s program worked out that the
enormous government debt burden – which by the way still
keeps on growing – seems almost forgotten.
After all, if Japan should really succeed in stimulating
growth and increasing inflation expectations, it would be
able to finally reduce this humongous government debt –
right?
An exhaustive answer to this question could easily cover a
book (or two). So we would like to concentrate on the
reasons why Japan was able to maintain such a high debt
and such a low interest rate environment for so long and
what impact a pickup in growth and inflation might
actually have.
Looking only at the IMF’s estimate of gross debt-to-GDP
ratios for member countries of the OECD, we see that in
2013, the ratio ranged from about 94% to 176% for the
European periphery, but was a full 243% in Japan. Thus,
Japan’s gross debt-to-GDP ratio is more than three times
the average of OECD countries (75.5%) and by far the
highest in the whole developed world. Graph 1 illustrates
this gap nicely, even though for demonstrative purposes we
just concentrate on OECD countries where gross debt-to GDP ratio is above the OECD-wide average for 2013.
Nonetheless, Japan has so far not only been able to avoid
the fiscal crises of the magnitude faced by the European
periphery, but has also to enjoy extremely low nominal
interest rates: The last time the interest rate of the Japanese
10-year bond yield traded notably over 2% was in 1999.
300
250
200
150
100
50
0
Source: Bloomberg, IIMF, ETHENEA
Graph 1: Gross dept-to-GDP ratios for selected OECD countries
The simplest explanation for the past sustainability of the
high
government debt is a combination of three factors: a
prolonged period of low growth together with very low to
negative
inflation and a relatively high domestic savings
ratio
(and
strong home bias). Abenomics is aimed to
increase both inflation and growth, which poses the
problem
of how to set interest rates.
Admittedly,
with its zero interest rate policy and a national
CPI inflation that has been below 2.5% for almost 25 years,
the country has been benefitting from low nominal interest
rates
as they helped to keep a lid on debt servicing costs, at
least from a cash flow perspective. Some people would
argue
that it is actually the real interest rate that matters,
especially in the case of Japan’s deflationary environment
of the past decades. However, this author believes that that
is
only partially correct – real interest rates do matter, but
that does not mean that nominal interest rates do not.
Nominal
interest rates actually determine the implicit
amortization schedule of principal payments, which is of
particular importance to an entity whose debt servicing
outflows
take up a huge chunk of monetary inflows (in the
case of Japan, interest payments alone make up about a
quarter
of current tax revenues). Japan, as many other
countries around the world, has been lengthening the
average maturity of government bond issuances – but with
a debt balance that is still inflating. The rollover of debt
will at some point become an issue, especially if inflation
thus, nominal interest rates will rise.
and
12 March 2014 • Page 2
APROPOS…
[email protected] | www.ethenea.com
Moreover, we are not yet taking into account increasing
inflation expectations. We have to observe that inflation in
and of itself is not really a viable option for successful
public debt reduction. Inflation can only have a short-term
effect as its impact on debt works via surprise increases in
the price level. Once agents expect further inflation
increases, this will be priced in yield expectations and
consequently burden public finances. Moreover, such
policies risk un-anchoring inflation potentials and therewith
contributing to macroeconomic instability. From an
institutional point of view, central bank independence
would risk being undermined, possibly bringing down the
credibility of domestic governance structures.
As for GDP, part of Japan’s current efforts to fuel growth is
not (yet) accomplished through a sustained increase in
production, but rather through an augmentation of its share
of global exports. This poses a number of potential
fallbacks. Firstly, it is not entirely clear how Japan will be
able to sustainably revive its exporting sector in a world
suffering from low demand, excess capacities and stagnant
growth.
account must increase by that difference. If any country
increases its savings rate, an equal reduction in savings in
the rest of the world must occur or total investments in the
rest of the world must rise. A couple of years ago, the
reduction in savings in the rest of the world would likely
have been met with higher total investments financed by
higher credit. Nevertheless, given the fact that recent
deleveraging cycle developed markets have just gone
through, the reduction in savings is more likely to have
other consequences, such as higher unemployment in the
world ex-Japan.
Secondly, a depreciating currency – ceteris paribus – means
it is likely that the national savings rate will increase
relatively to the investments. Why? Depreciating currencies
act as consumption taxes on imported items and hence
reduce the real value of household income. They also
reduce the real value of household consumption if wages
do not increase at the same pace. Also, the country’s
consumption tax will actually be hiked from 5% to 8% this
April, and that implies that even if all the proceeds were re invested by the government (meaning that no outstanding
debt would be repaid with the proceeds) the national
savings rate should go up as a portion of government
investments goes to citizens in form of wages, part of
which will be saved.
Now, in order to understand the implications, let us turn to
the accounting definition of the current account balance. By
definition, it is equal to the savings gap, i. e. the difference
between domestic savings and investment spending.1 Any
rise in the savings rate that is not met by an equal or greater
increase in investment spending means that the current
In principal, nominal interest rates should be more or less
in line with nominal GDP growth, which Abenomics aims
to increase. If Japanese interest rates remain repressed,
however, a significant share of GDP is redistributed from
the households to the government. Unfortunately, the
country has been struggling with the rebalancing of GDP
towards more household consumption for the past twenty
years. While reversing this process might alleviate the
government’s balance sheet in the short run, it is difficult to
see how sustainable change can be attained this way in the
long run. Further, even though Japanese government debt is
still increasing, Abenomics could see the side-effect of
pushing up the domestic savings rate in form of higher
demand for government bonds, making it possible for
Japan to keep issuing government debt at very low
(nominal) interest rates. In the extreme case, this would
mean that Japan will find itself back at square one, but this
time with a shattered confidence and a much higher debtto-GDP ratio than it started out with.
The success of Abenomics will depend on the perfect
constellation of the domestic situation (necessarily helped
by a forceful implementation of reform programs) and
external balances. Of course we hope that Abenomics will
succeed – not just for the sake of the Japanese people but
also because this would give hope to countries in the
Western world, which are currently trapped in an
environment coined by high debt, stagnant growth and
inflation that is yet to be seen. Adverse developments, as
for example insufficient reform programs or stagnant
global growth that cannot accommodate rising Japanese
exports, will force the country to face its high debt in a
different way.
1
Explanatory notes: Domestic savings are the sum of individuals’ savings, corporate retained earnings and government savings, which refer to tax receipts
minus expenditures on current goods and services. Domestic investments on the other hand are private investments plus government infrastructure
expenditure.
APROPOS…
12 March 2014 • Page 3
[email protected] | www.ethenea.com
Debt always matters, and it must always be repaid by
someone, even in the case of a haircut or a defaulting
borrower. The high debt burden of Japan has not been
resolved. Though market participants may seem to have
forgotten about the sky-high government debt, this does not
mean that it has been forgiven.
Your ETHENEA Team
NB: Investing in an investment fund, as with any investment in securities and similar assets, involves a risk of a decrease in price/value. The implication of this is that share prices and the amount of returns would
decrease, and therefore cannot be guaranteed. Costs of investment affect the actual returns on investment. The legally stipulated sales documentation is authoritative for share purchasing. All information
published here constitutes a product description only. It does not constitute investment advice, an offer to enter into an agreement for the provision of advice or information or a solicitation of an offer to buy or
sell securities. The contents have been carefully researched, compiled and checked. No guarantees are provided regarding its correctness, completeness or accuracy. Munsbach, 12 March 2014.