Japan’s Financial Nemawashi Debt Powder Keg

SovereignMan’s Simon Black on Japan’s financial nemawashi powder keg (bold mine)

Japan is a land of irony and dichotomy. It is one of the most conservative cultures in the world, while simultaneously being one of the most perverted.

Business culture here is yet another thing that seems totally alien. Creativity and innovation are constrained by process and procedure. The individual is never celebrated, and dutiful compliance is everything.

In Japanese corporate culture, business meetings follow a strict agenda. New ideas, no matter how valuable, are simply not welcome.

They actually have a term here called nemawashi, which is a meeting before a meeting. The idea being that if you have an idea to present at a meeting, you need to discuss it first so that nobody’s caught off guard or embarrassed by not having a prepared response.

This is a cultural nuance that is completely lost on most Westerners. It stems from this mindset that everyone has an obligation to make sure that nobody else looks bad.

This carries over especially into Japan’s economic and financial situation. As a percentage of GDP the government here is carrying more debt than anyone else on the planet.

At one quadrillion yen, the debt level is so high that it now takes the government 43% of its central tax revenue just to pay interest this year.

The percentage of tax revenue to service the debt has been rising for years and is absurdly unsustainable. Yet large Japanese businesses have dutifully continued to hold Japanese government bonds as part of their obligation to make sure that the government doesn’t look bad.

It’s like a financial nemawashi, saving their counterparty from embarrassment.

This, however, is starting to change. Through its policy of aggressively seeking to create inflation, the government is now guaranteeing that anyone who holds Japanese government bonds will lose money.

This makes government bonds no longer an investment or a store of value, but a charity case. At best it’s just another tax.

Throughout history governments have often overestimated how much their citizens are willing to accept.

Japan has a beautiful stoic culture that has been able to endure tremendous suffering. That said, everyone has a breaking point.

And that’s when you see that there’s a big difference between love of country and love of government.

Bottom line—it’s already starting to unravel.

Every time I’m in Singapore now, as I was just last week, my banking contacts report exponential growth in Japanese customers. Businesses, entrepreneurs, and investors are all moving money out of Japan and into Singapore.

Even Japanese banks are aggressively expanding, following the money out of their own country.

This is precisely when capital controls end up being imposed—when a trickle of capital fleeing turns into a flood.

We’re seeing the same things right now in many places around the world, with most of the attention now focused on Greece and other parts of southern Europe.

However, as Japan has the third largest economy in the world and is the most woefully indebted, it’s really the one to watch.

When the powder keg goes off that sets the global financial system ablaze, it will most likely be in Japan where the match is lit.

In my March 3 post I pointed out that Japanese residents’ portfolio holdings of foreign currency assets has reached record highs. This are signs of intensifying capital flight. 

It’s also proof that the man in the street has been direly affected by the grand interventionist experiment called Abenomics of using of financial, economic and political nemawashi to save not only the face but of the interests of Japan’s ruling class and their allies. 

And as posted on February 24, a survey showed that a vast majority or 81% of the average Japanese questioning “where is the recovery?”. 

This is what Mr.Black has been talking about where the Japanese government’s national debt service have been devouring a large share of tax revenues.

The above budget estimates has been sourced from Japan’s Ministry of Finance under Japan’s fiscal condition as of January 2015

What’s truly remarkable has been that the budget has been premised on a very optimistic light. The Japanese government expects the burden of debt payment to get reduced from 51.46% and 46.54% in 2013 and 2014 to only 43% this year. This comes as tax revenues has been expected to grow 16.02% in 2014 and 9.4% in 2015.

Meanwhile government spending has been expected to grow 3.53% in and 4.7% in 2015.

The difference is that while government spending represents allocated spending, money that will be spent as part of the budget, tax revenues mainly depends on economic performance, and secondarily, administrative tax collection efforts

But remember the Japanese statistical economy fell into a technical recession in 2014. Granted that even if we consider the rebound during the last quarter where annualized gdp q-o-q jumped by 2.2%, that number is unlikely to raise the government’s projection of 16% tax revenue growth.

As an aside, Japan has three ways of looking at the statistical GDP. The GDP annual growth rate still shows Japan in a recession.

Importantly as I recently pointed out, the 4Q bounce was all about statistical growth and not real economic growth

Mediocre investment activities, consumption boost from BoJ’s devaluation, and a big boost from government spending means Japan’s 4Q GDP represents no less than a government statistical pump—or growth only in statistics.

Another important factor, bond dependency ratio or the use of bond financing as % of revenues. Since taxes have been insufficient to finance government expenditures, the government has become almost entirely dependent on bond financing. 

Yet due to rosy expectations on tax revenue growth, the Japanese government projects this bond ratio to fall from 46.3% in 2013 to 38.3% this year. I don’t think this target will be met. Not with the current data. Japan’s nemawashi finance looks very much like Ponzi financing—debt in debt out.

Some mainstream experts recently cheered that wage inflation has appeared. Unfortunately, wage inflation has been lower than the CPI. 

From Bloomberg-Japan Times: Increases in the cost of living outpaced annual earnings that rose for the first time in four years in 2014 as the Abe administration sought to reflate the economy. Average earnings climbed 0.8 percent last year while pay, adjusted for inflation, fell 2.5 percent, the labor ministry said Wednesday. Base wages excluding overtime and bonuses were unchanged in 2014, ending eight years of decline, preliminary data showed. Earnings that trail inflation crimp the spending power of households, undermining the sustainability of price gains. Prime Minister Shinzo Abe and the Bank of Japan are pumping unprecedented stimulus into the economy in an effort to end two decades of stagnation.

Adding to the Japan’s woes, last week Japan’s government announced unemployment rate last January increased to 3.6%.

So despite the money pumping and fiscal stimulus what the economy has shown has been sustained stagnation where fiscal imbalances signify a hole which the Japanese government keeps digging deeper.

Japan is in a debt TRAP. Japan can hardly grow out of its way from the current debt levels. Also, the Japanese government's policies have become an impediment to real economic growth. Instead of promoting the incentives for productive agents to flourish, distortion from interventions only foists uncertainty, e.g. devaluation distorts pricing system. 

So the government's aim has now been about showbiz, manipulating markets to show buoyancy.

Yet these policies will accelerate Japan's path to a credit event.

If inflation does go up, due to G-R-O-W-T-H, this would mean “guaranteeing that anyone who holds Japanese government bonds will lose money” then interest rate will spike and expose the fragility of the government’s mountain of debt.

On the other hand, if stagnation persist, or if Japan's financial bubble goes bust, those colossal debt levels will eventually be seen by the markets as susceptible to credit events.

Either way, the future of Japan’s debt is either default or a debt jubilee. It’s a question of when not an if.

For now the BoJ’s policies has monetized much of the government spending. (chart from Zero Hedge)

The BoJ’s monetization process comes with future consequences. As I recently wrote:

According to Japan Macro Advisors: In terms of the BoJ's market share in the JGB market, it renewed its new peak. In January 2015, the BoJ owned 25.6% of the JGB market, measured in value, and 20.9% measured in aggregate duration risk. We expect BoJ's market share will exceed 30% by the end of 2015, and approach 40% by the end of 2016.

So by siphoning liquidity out of the JGB markets, the ramifications of BoJ’s actions has been to increase volatility. Such volatility has emerged in the form of reduced demand for JGBs that has spiked yields. Current events may signify as the unintended long term consequences from the BoJs inflationary policies.

The recent spike by yields of 10 year JGBs has been pushed back by the BoJ’s assurances of more easing.

But it appears that this has not been enough (chart from investing.com as of yesterday’s close). The yields are back testing the recent highs.

Japan’s Nikkei trades at 15 year high. Such milestone highs have not come in the favor of locals as households have been net sellers. It’s only foreigners and domestic institutions whom are being rewarded from the political redistribution.

But record stocks come in the face of record imbalances at the precipice.

Again Simon Black

When the powder keg goes off that sets the global financial system ablaze, it will most likely be in Japan where the match is lit.

Japan may just be one of the matches.