Japanese Debt Debacle Now Imminent
I first warned about the impending bust of Japanese Government Bonds (JGBs) when I wrote “Abe Pulls Pin on JGBs” back in January of 2013. In that commentary I laid out the math behind a collapse of the Japanese bond market and economy stemming from the nation’s massive amount of government debt, combined with the Bank of Japan’s (BOJ’s) folly of pursuing an inflation target.
It was my prediction back then that a spike in interest rates was virtually guaranteed in the not-too-distant future. I also predicted that debt service payments would soon reach 50% of all government revenue, which would be the catalyst behind the rejection of JGB’s on the part of the entire global investment community. Sadly, that prediction should come into fruition during the next few months.
The Japanese Finance Ministry recently predicted that debt service payments would reach $257 billion (25.3 trillion Yen) during this fiscal year; up 13.7% from fiscal 2013. Also, revenue for this year is projected to be 45.4 trillion Yen. This means interest expenses as a percentage of total government revenue will reach 56%. Therefore, it should now be abundantly clear to all holders of JGBs that since over half of all national income must soon go to pay interest on the debt, the chances of the principal being repaid in anything close to real terms is zero. A massive default in explicit or implicit terms on the quadrillion yen ($10 trillion), which amounts to 242% of GDP, is now assured to happen shortly.
Exacerbating the default condition of Japan’s debt is the BOJ’s increasing obsession with creating more inflation. Central Bank Governor Kuroda said recently that the inflation goal of 2% is well on track to being realized. Core inflation is already up 1.3%, and overall prices have climbed 1.6%, while fresh food prices have surged 13.6% from the year ago period. In fact, Japanese inflation is now at a five-year high.
Surging debt levels and rising prices belie the quiescence of the Japanese bond market. For example, the 10-Year Note offers a miniscule yield of just 0.62% as of this writing. That yield seems especially silly when viewed in historical context: the average yield on the 10 year Note is 3.04%, going back to 1984. And you only have to go back 6 years to find a 2% yield on that benchmark rate. Of course, those much-higher yields occurred in the context of significantly less debt and inflation than we see today.
The facts are that Japan has a record amount of nominal debt and also a record amount of debt as a percent of the economy. Deflation has ended, thanks to hundreds of trillions worth of Yen printing by the BOJ, and the central bank’s increasing success at creating inflation will lead to insolvency for the nation’s sovereign debt.
How can it be possible for interest rates to be at record lows if the nation is insolvent and inflation is rising? The answer is of course that the central bank is the only buyer left. For now, the ridiculous pace of 70 trillion Yen per annum worth of BOJ money printing seems to be enough to prevent rates from spiking. But as inflation waxes closer to the central bank’s target, interest rates must rise. The BOJ will soon have to stand up against the entire free market of investors who will be betting more and more with their feet that JGBs will default.
The bottom line is the BOJ will have to dramatically step up its pace of bond buying, as interest rates rise and bets against JGBs intensify.
Unfortunately, Japan isn’t alone in the insolvency camp. The U.S. and parts of Europe face the same fate. There will soon be an epic battle taking place between the developed world’s central banks and the free market. The sad truth is there isn’t any easy escape from the manipulation of sovereign debt on the part of the ECB, BOJ and Fed. The exit of government bond buying from these central banks will lead to a massive interest rate shock and a deflationary depression. On the other hand, if these central banks continue printing endlessly it will lead to hyperinflation and total economic chaos.
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