Thursday, February 25, 2010

Japanese Collapse: The Pending Sovereign Ruin

As we have been saying for some time, Japan is well past the point of no return. The country faces financial collapse brought on by two decades of unbelievable profligacy. With 10 year JGB rates at 1.5% or so vs 3.5% for the rest of the G-7, Japan's cost of financing is unbelievably cheap despite having debt to GDP of nearly 200% (vs. just over 100% for Greece and about 80% for the US, both of whom are wildly over indebted). Japan has managed to pull this off for a variety of reasons including a) they've run a large trade surplus; b) they've been dealing with price deflation that has allowed even very low nominal interest rates to still be positive real interest rates; and c) 95% of Japan's sovereign debt is financed internally.

Japan's population began shrinking a few years ago and the demographics are such that new retirees are outnumbering new workforce entrants, leading to a dis-savings trend (you save during your working years and spend during your retirement years), meaning that the ability to internally fund Japan's debt is evaporating (simply rolling the existing debt will be increasingly difficult, much less continuing to run deficits, which Japan's is >10% of GDP). Replacing that internal funding with external funding is a non-starter because if Japan's cost of funding were to exceed 3%, nearly 100% of Japanese federal tax receipts would be consumed by interest expense. So going to the external market and competing at G-7 type interest rates would quickly lead to total collapse.

As such, Japan's central bank (the BOJ) will almost certainly have to monetize the debt, leading ultimately to a hyper-inflationary depression. Japan knows this. It has burned through six ministers of finance in the past 18 months (akin to Secretary of the Treasury), the fifth of which committed suicide rather than resigning. On top of that Japan's currency has stayed remarkably strong, staggering its export oriented economy.

We predict much higher rates (ultimately greater than 10%) and a much weaker Yen (surpassing 150 to the dollar and possibly 200). This will devastate Japanese savings, force austerity and likely make Japan default or rework its sovereign debt. Assuming this happens, hopefully it happens soon enough that the US has enough time to reflect on Mad Scientist Bernanke's experiment as conducted by Japan and we choose to retrench and not pursue these horrible, suicidal crippling policies of deficits and inflation.

The piper will ask to be paid someday. Be ready.

Anyway, enjoy the slide deck.

Japan - Past the Point of No Return - Katsenelson