Friday 23 December 2011

Japanese debt

Japan Proposes Nonsensical Deal to China: "I'll Loan You a Nickel if You Loan Me a Nickel"; Japan Worries About Servicing Its Debt

20 December, 2011

Circular lending theories have spread from Europe to Asia. 

Japan is discussing with China possible purchases of Chinese government bonds, Finance Minister Jun Azumi said, a sign the nation is diversifying foreign- exchange holdings by tapping into the world’s second-largest economy.

“I think it’s mutually beneficial” for the two countries to be investing in one another’s debt, Azumi said at a press conference in Tokyo today. “We’re not abandoning the dollar or euro, but we’re adding the yuan to deepen our relationship.”

Japan Scared to Death

As I was reading the article it was immediately apparent what the problem is. The last paragraph explains nicely.

China, which is also Japan’s largest trading partner, sold the second-biggest net amount of Japanese debt on record as the yen headed for a postwar high against the dollar and benchmark yields approached their lowest levels in a year. It cut Japanese debt by 853 billion yen ($11 billion) in October, Japan’s Ministry of Finance said on Dec. 8. China sold a net 2.02 trillion yen of Japanese debt in August 2010, a record based on data going back to January 2005.
Japan Records Trade Deficit in October

The above chart from Trading Economics.

Japan's Exports Collapse

Japan’s exports fell for the first time in three months, indicating that the yen’s appreciation and financial turmoil in Europe are slowing the nation’s recovery from the March disaster.

Shipments dropped 3.7 percent in October from a year earlier, the Ministry of Finance said today in Tokyo, worse than all 29 estimates of economists surveyed by Bloomberg News.

Exports to China, Japan’s biggest market, slid 7.7 percent, the largest drop since May, today’s report showed. Weakening overseas demand has led companies including Toshiba Corp. and Nippon Yusen K.K. to call on the government to follow up on last month’s yen intervention with steps to prevent the currency from appreciating further.

Function of Math

As I have talked about numerous times before, foreign debt buying is a function of math: Countries that run current account surpluses accumulate foreign currency and bonds.

As trade deficits or surpluses change so will accumulation of foreign reserves.

Thus the discussion between Japan and China is complete silliness, although it clearly highlights Japan's concern as to servicing its enormous national debt.

If China has a trade surplus with Japan, then over the long haul China is likely to buy Japanese bonds, just as Japan and China buy US treasuries today.

However, everyone cannot be a net exporter to everyone else. Please see Another Preposterous Proposal to "Fix the Unfixable"; Political, Economic, and Mathematical Realities for the latest proposal from Europe on how to save the euro by increasing exports.

It is mathematically impossible for every country to have a trade surplus, not matter how hard they all attempt to export themselves to nirvana.

Moreover, and more importantly, yields on Japanese bonds are unlikely to remain low if Japan's vaunted export machine takes a sustained hit and Japanese corporations and banks slow their buying of Japanese bonds as a direct consequence.

All hell will break loose when Japanese bond yields rise high enough that Japan struggles to service its debt.

How Can Japan Service its Debt?

I have written about Japan's debt problem on numerous occasions, most recently on August 9, 2011, in Worst Demand on Record for Japanese 40-Year Bonds; Can Japan Service its Debt? How?
Inquiring minds may be wondering "With a Debt-to-GDP ratio exceeding 200%, how is Japan going to service its national debt?" 

I have been wondering that for years. Adding fuel to the debate, please consider Worst 40-Year Bond Sale Shows Cash King as Investors Flinch

The worst demand on record for 40- year Japanese bonds sold yesterday signals growing concern about Japan’s ability to service the world’s biggest debt pile and the risk of holding long-term securities while markets are volatile. 

The 400 billion yen ($5.2 billion) sale drew bids valued at 2.03 times the amount on offer, the weakest since the Ministry of Finance began selling the securities in 2007. 

Japan’s Ministry of Finance said that every 1 percentage- point increase in 10-year yields above 2 percent would add 1 trillion yen in debt-servicing costs to a projection of 22.9 trillion yen for the fiscal year starting April 2012. The nation’s total debt may reach 219 percent of gross domestic product next year, according to the Organization for Economic Cooperation and Development. 

Double-Edged Sword 

Please note that was not a failed auction. Indeed it was oversubscribed. However, nearly all of that demand is internal. 

Internal demand is a double-edged sword. Right now it is still sufficient. However, when (not if), Japan ever needs foreign buyers for its bond market, rates will not be 2.3% on 40-year bonds. 

On account of miserable and worsening demographics, bond redemptions have started. However, those redemptions are a still a trickle. That trickle will at some point turn into a torrent. 

Balance of Trade a Key Issue 

People have been talking about this for years, although I have not seen discussion of the trade angle before. 

Here is the key: If Japan does not maintain a trade surplus covering both interest on its national debt and bond redemptions, all hell will break loose. This gives rise to the question as to how long Japan's vaunted export machine can remain intact. I do not have the answer to that question, but China and the rest of Asia are nibbling away bits and pieces now. The tsunami sure did not help. 

Trade issues and demographics explain Japan's paranoia regarding a strengthening Yen. It is also another one of those global imbalances that "does not matter, until it does, and it will" kind of things. 

It is mathematically impossible for every country to maintain a trade surplus and increase exports, yet every country wants to do just that.
Rising interest rates would crucify Japan, and that is why Japan is courting China, hoping China will buy Japanese debt.

Europe did the same, for the same reason. Such pleas are useless. If Japanese exports and corporate profits sink, and Japan needs external financing to service its massive pile of debt, interest rates on Japanese bonds will head North, likely in a major way.

Japan is in deep trouble if its export machine breaks down. That time may be at hand.


In regards to my statement "foreign debt buying is a function of math: Countries that run current account surpluses accumulate foreign currency and bonds" Aaron Krowne at ML-Implode responds ...

You should also mention that this is only true so much as net trade deficits are not settled with gold (which would be the smart way to handle this, and the one based on thousands of years of history up until a few decades ago).

Aaron is correct and I have discussed this previously on several occasions.

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