Much optimism surrounds “Abenomics,” the efforts of Japanese Prime Minister Shinzo Abe to lift Japan from the maw of deflation. But Abenomics doesn’t go far enough to address Japan’s two major problems: debt and demographics.
Japan is one of the world’s most heavily indebted developed countries. Its total debt to GDP tops 500%, compared to the U.S.’s 370%. Japanese gross sovereign debt is around 240% of GDP, while its net debt is around 135%, substantially higher than most developed countries.
For the fiscal year ended March 2013, total government spending was 124.5 trillion yen (26.1% of GDP) against government revenue of 59.2 trillion yen (12.5% of GDP). The government borrowed to finance 52% of its spending. Prime Minister Abe’s program is likely to lead to further deterioration in public finances. Unless nominal GDP growth increases dramatically without an increase in Japanese government bond (JGB) rates, Japan’s debt will increase.
To stabilize debt levels, Japan would need to move to a structural surplus (budget deficit before interest payments on government debt) of 3%-4%, compared to a current deficit of around 8%. Given the lack of growth and deteriorating demographic profile, the required tax increases or spending cuts may not be feasible. There are proposals for an increase in consumption taxes, conditional on an improvement in economic activity. But the government is also looking at corporate tax cuts, which would reduce the revenue impact. Even if such policy measures were to be taken, the resulting potential contraction in economy activity would drive debt higher.
- A falling savings rate
- Driven by an aging population and
- Stagnant incomes
will increasingly make it more difficult for the government to finance spending domestically, at least at current low rates.
Forecast current account deficits will complicate the government’s financing task. Japan’s large merchandise trade surplus has shrunk and will remain under pressure reflecting
- Weak export demand and
- High imported energy costs.
With the passage of time and in absence of a change in circumstances,
Japan will become dependent on the Bank of Japan (BoJ) to finance its spending through debt monetization.
Japan may also face increasing stress on its government finances from higher rates.
Increased borrowing costs may be driven by several factors.
- If Japan has to resort to financing from foreign investors rather than domestic Japanese investors, then its interest rates may increase, perhaps significantly.
- If current policy initiatives result in inflation reaching its 2% target level, then interest rates on JGBs will need to rise.
- If Japan’s risk profile continues to deteriorate, then investors may require more compensation to purchase JGBs.
Higher interest rates will increase the stress on government finances. Despite low interest rates, approximately
25% of tax revenue is used to service outstanding government debt, compared to 6% in the U.S..
At borrowing costs of even 2% to 3% per annum, two to three times current rates, Japan’s interest payments will be an unsustainable proportion of tax receipts.
Higher JGB rates will also trigger problems for Japanese banks, pension funds and insurance companies. For example, JGBs total around 24% of all bank assets, which is expected to rise to 30% by 2017. According to the Bank for International Settlements, the JGB holdings of Japan’s banks equate to 900% of their Tier 1 capital, compared with about 25% for U.K. banks’ exposure to gilts and 100% for U.S. banks’ exposure to Treasurys.
An increase in JGB yields would result in immediate mark-to-market large losses on existing holdings, although higher returns would boost income longer term. The BoJ estimates that a 1% rise in rates would cause losses of $43 billion for major banks, equivalent to 10% of Tier 1 Capital for major banks or 20% for regional banks. Higher rates increase the risk of a Japanese banking crisis.
Higher volatility in the JGB markets can result in rapid increases in bank risk and increased capital needs. This may force sales of JGBs leading to a destabilizing cycle of higher rates, even higher volatilities and forced liquidations which happened in 2003.
An aging population, a shrinking workforce and an increasing dependency ratio of the number of aged supported by a reduced number of workers are integral to Japan’s problems.
Former BoJ governor Masaaki Shirakawa summarized the challenge: “Japan’s economic growth gradually slowed during the past two decades mainly for two reasons. In the former half of the period, the Japanese economy was hobbled by the crippling effect of the burst of the bubble. In the latter half, the rapid population aging hampered the Japanese economy through a variety of channels.”
Current initiatives will have limited impact on low fertility rates, immigration levels or increase labor force participation rates. Prime Minister Abe’s program may exacerbate economic risks without addressing the demographic problems.
The drive for higher wages highlights the contradictions. It is difficult to engineer an increase in incomes across the economy when
older workers with higher salaries and benefits are retiring while young workers replacing them are only paid entry-level wages or hired as contractors without benefits or job security. Japan’s overall consumer spending power will therefore fall, rather than rise.
Demographics may also contribute to deflation. Empirical evidence suggests links between population growth rates and inflation.
Ironically, deflation has maintained the purchasing power and consumption of consumers — especially the aged on fixed incomes, as falling prices have compensated for stagnant and falling incomes and extremely low investment returns on savings. Higher inflation would reverse this, driving consumption even lower.
The policy deficiencies point to several discontinuities.
An untrammelled belief in central planning underlies the present program. In the 1960s, Prime Minister Hayoto Ikeda introduced a plan, which was successful in helping Japan achieve strong growth. Between 1964 and 1972, Prime Minister Eisaku Sato, who replaced Ikeda, implemented three successive growth plans, which were noticeably less successful.
More recently following the onset of the global financial crisis, successive administrations have introduced a conga line of growth plans:
- Prime Minister Yasuo Fukada’s 2008 Economic Growth Strategy;
- Prime Minister Taro Aso’s 2009 Future Pioneering Strategy;
- Prime Minister Yukio Hatoyama’s 2010 New Growth Strategy;
- Prime Minister Naoto Kan’s 2011 Scenario to Bring Back A Lively Japan, and
- Prime Minister Yoshihiko Noda’s 2012 Japan Revival Strategy.
None of the plans have achieved their objectives. It is unclear why
- Prime Minister Abe’s “three arrow” program
will succeed, where similar previous initiatives have failed.
Japan’s deep-seated fundamental problems are within its real economy. It needs to deal with its
- Debt and
- Demographics problems, as well as
- Declining competitiveness and
- Industrial leadership.
These structural problems cannot be dealt with by adjustments in fiscal and monetary policy, despite attempts by governments and central bankers to convince audiences to the contrary.
Satyajit Das is a former banker and author of “Extreme Money” and “Traders, Guns & Money.”