Japan: The Next Sovereign Debt Domino

It’s looking increasingly likely that the next country to experience a serious sovereign debt crisis will be Japan. Here’s why…

Among the ten largest developed economies Japan is the most indebted with total debt as a percentage of GDP of 512% – only narrowly higher than Britain, but far higher than the likes of Spain and Italy – and Japan’s total debt continues to grow.

In the wake of the March 2011 tsunami and subsequent nuclear accident Japan was forced to close down its nuclear facilities, and today only 4 of the country’s 54 nuclear reactors are running. As a result Japan has been left with a serious energy shortfall and has been forced to buy energy in the wholesale market, something that isn’t cheap especially with the rising cost of crude oil.

The disaster also took its toll on economic activity with real gross domestic product (GDP) falling 0.9% in 2011, from a 4.5% rise in 2010.

In addition the nation’s exports have been hampered by a strong currency. Over the past 5 years the Japanese Yen has risen 45% vs. the Euro, 44% vs. the US Dollar, and 78% vs. the British Pound. This has meant that for the past 7 months Japan has been running a trade deficit, which totalled 2.49 trillion yen ($32 billion) in 2011. This is the first annual deficit since 1980.

Thanks to a steady inflow of profits and capital gains from its large portfolio of overseas investments, Japan is not expected to run a deficit in its current account yet. However the trade figures do underscore a broader trend. The fact is, Japan’s problems, not least of which is its rapidly ageing population, are leading to a loss of competitiveness in the global market.

Competing for capital

We live in a world where debtor nations must compete for capital, and it won’t be long before Japan must also compete for loans. As Jesper Koll, head of equities research at JPMorgan in Japan, puts it: “What it means is that the time when Japan runs out of savings – ‘Sayonara net creditor country’ – that point is coming closer. It means Japan becomes dependent on global savings to fund its deficit and either the currency weakens or interest rates rise.”

Adding to its woes is the fact that almost $3.2 trillion worth of Japanese Government Bonds (JGBs) are due to mature in 2012, and if interest rates rise due to a lack of demand Japan could quickly find itself in a PIIG-style funding crisis. A rise in rates to just 3% would consume all of Japan’s annual tax revenue.

Given this backdrop I expect the Bank of Japan (BoJ) to step in and monetise a good portion of this maturing debt. This is especially likely given their new 1% inflation target.

In February the Bank of Japan (BoJ) expanded its asset-purchase programme to 65 trillion yen ($832 billon) from 55 trillion yen, in an attempt to support growth and drive down the value of the yen. The BoJ’s strategy has little chance of spurring real growth; however it is now starting to have an effect on the yen. Since 3 February the Japanese Yen has fallen almost 6% against the US Dollar.

Those wishing to join the likes of Hugh Hendry and Gary Shilling in profiting from the bursting of Japan’s gigantic debt bubble could look at shorting the Japanese Yen.

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