Japan’s debt problem has been well known but little understood. The country has had the worst debt and growth metrics of the three major developed currency blocks for decades.
Richard Howard of Hayman capital says that market re-pricing of debt and a devaluation of the Yen could happen sooner rather than later.
“If you think of where the most interesting shift in dynamic has occurred for the last three month, it’s in Japan,” says Howard, managing director and global strategist for Hayman Capital.
Hayman Capital Management, LP was founded by Kyle Bass in December of 2005. The firm is based in Dallas with 22 employees and currently has approximately $1.5 billion in assets under management. The firm has been successful in recognizing both the subprime and the euro crisis early. Now its focus has shifted to Japan.
A new government and a shift in monetary policy might finally usher in the end game of a credit bubble that popped in the early 1990s, but whose ultimate costs still have to be fully recognized.
Japanese Debt Issues
This view is again unique among professional investors who cling by the old adage that Japan was able to stabilize the economy and maintain a decent quality of living for decades, despite ballooning government debt and low growth. They think that modest deflation and low growth will continue and don’t see the danger ahead.
“It’s important for people to understand how bad the economic environment has been in the last five years,” says Howard who points out that virtually all major developed economies have seen a rebound in economic activity from the troughs of the last financial crisis. Japan has not.
In addition, the country has a debt-to-GDP ratio of 240 percent, according to 2012 projections by the International Monetary Fund (IMF), far worse than the United States with 107 percent. Since 2009, the country has run deficits of around 10 percent every single year.
Previously, Japanese exports were relatively strong, which allowed the country to maintain a current account surplus and accumulate $1.1 trillion worth of U.S. treasuries as foreign exchange reserves. This has shifted since the financial crisis. “The Japanese absorbed an enormous amount of the world currency debasement and exported deflation over the last five years,” Howard says, and explains that the aggressive move by other central banks to ease monetary conditions after the crisis cheapened their currencies and made Japanese exports less competitive.
Korea, which devalued the won in response to the crisis is an example. “A lot of Japanese exporters and Korean exporters are now chasing the same customers,” he says, with Japanese firms being on the losing end of that competition. Indeed, according to the IMF, the Japanese current account balance shrank from 4.9 percent of GDP to a projected 1.6 percent of GDP in 2012.
The reversal of these supporting factors makes Howard believe that a final re-pricing of bad Japanese debts will finally happen in the near future. Despite a collapse in the value of equities and real estate over 20 years, debts accumulated during the credit bubble of the 1980s are still lurking on the balance sheets of banks and corporations. Despite the price drop in the value of collateral, they have not been written down.
“The value of the debt has already been crushed. The losses have already been incurred through the mal-investment of that capital. All that remains is to realize it. Either it gets realized through inflation or it gets realized through some sort of debt restructuring or write down,” says Howard.
Monetary Easing to Have Future Consequences
He also thinks that the government’s debt accumulated in a bid to prop up the banks and the economy is unsustainable and will lose in value. Major pension funds have announced that they will start selling Japanese Government Bonds (JGBs) in order to provide retirement income for an ageing Japanese population.
This leaves the Central Bank as a buyer of last resort.
“We’ve moved into a world that is more comfortable with the concept of truly aggressive monetary easing,” says Howard who thinks that the unlimited monetary easing that the Bank of Japan (BoJ) announced in January 2013 is a game changer.
“That is a sort of unorthodoxy and aggression that we haven’t seen previously. It’s a question of scale and scope,” he comments on the BoJ’s plans to buy $145 billion of government securities per months starting in January 2013 in order to reach a 2 percent inflation target.
While 2 percent inflation sounds relatively innocent, according to Howard, it will be enough to cause people to sell JGBs and the Japanese Yen.
“You could see a big sell-off there as people migrate out of those assets because we don’t believe that there is a natural buyer out there in this new inflationary environment… with bonds at current yields were they are,” says Howard. Investors want to be compensated for inflation to earn a real return. In order to get that real return, nominal bond yields will have to rise.
Higher yields means indebted sectors need more cash flow to service the debt. This creates problems for the sectors of the economy which are highly leveraged, including the Japanese government.
“The problem with trying to create inflation is that debt is going to be harder to service. The hope is that the inflation creates enough nominal growth to enable the higher debt service costs. That makes sense for a portion of the economy that is not highly levered and can afford to service their debts,” explains Howard.
In his scenario, government debt service will increase much faster than tax receipts, as markets move faster than the broader economy on which tax receipts depend. This vicious spiral could ultimately bankrupt the government, absent even more intervention by the central bank.
“The policy makers who are overseeing this process, they are convinced of the correctness of their views. Lots of experts out there will tell you that a government can never go bankrupt if you have a compliant central bank out there that can always buy your debt. As long as the BoJ cooperates there will never be a problem,” says Howard.
However, more liquidity injected by the BoJ will cause more inflation, further accelerating the vicious circle. Ultimately, this dynamic will lead to a massive sell-off in the Japanese Yen and to a re-pricing of bad debt in real terms, thus delivering the economy and the banking system.
“We expect the Yen to devalue from here and we expect interest rate to rise in a sharp sudden fashion at some point over the next couple of years,” says Howard.
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