Investors like to worry. When you’ve got your money at risk it is natural to do so.
It is commonplace to read about the very high levels of Japanese state debt, with some querying how much longer it can carry on.
Japan has the highest level of state indebtedness of the main economies. Its gross state debt is 230% of its GDP, way above Greece and the other heavily indebted European countries. Japan continues to run a large state deficit, borrowing more each year to swell the gross totals. Despite this, the interest rates on the debt remain low or even negative, allowing the Japanese state to meet its regular interest payments easily.
One of the reasons the state debt has not undermined markets is the Bank of Japan is busily buying it up. The Bank now owns around 40% of the total state debt. As the Bank is an arm of the state it means the state owes the money to itself and solemnly pays itself interest. The effective state debt is therefore around 140% of GDP, not 230%. More importantly, the effective debt owed to other investors is falling despite the new borrowing being undertaken. Some think within a few years the debt not owned by the state will be down to around 100% of GDP, more in line with other highly borrowed advanced countries, with the Bank of Japan owning the majority of the gross total.
Most of the debt the state does not own is money owed to Japanese individuals and institutions. The state has the power to tax these same savers more should the need arise. This effectively gives the state the power to lower their very modest returns further, if necessary, helping the stability of the position.
Japan is in a very different positon to some Latin American countries who borrowed too much from foreigners
Like the other advanced countries undertaking quantitative easing (QE) programmes, Japan has not gone a step further and simply cancelled the debt it has bought in. Authorities fear this could undermine confidence, as it would suggest that what they are doing is simply creating new money to spend. All the time the new money created is used to buy up bonds which they then hold, there is a kind of veil over the policy of money creation which they think impresses the markets. Most QE programmes make a point of buying bonds in the secondary market, limiting themselves to second hand bonds. If they bought a new issue of bonds expressly to pay for current spending, then it would more clearly be creating money to spend. Buying second hand bonds does, however, allow a state to spend more than it would otherwise do by cutting the interest rate on the outstanding debt, and by crediting the interest on some of the debt back to the state, so it is an indirect version of the same thing. By these means Japan has cut her interest rates drastically and kept them down.
A country has more serious debt problems if the money is owed to foreigners, and much more serious if it is owed in foreign currencies. A sovereign country with its own currency and Central Bank can always create more money to meet obligations, or to keep the commercial banking system in funds so they can refinance debts. If the debts are owed abroad foreigners may cease to have full confidence in the debtor’s currency, creating pressures through the foreign exchange market. It can quickly become a crisis if the money is owed in foreign currency, as the more the national currency falls the more the country owes the foreigners in its own currency. It ends with emergency interest rate hikes and sometimes with capital controls. Japan has been running a balance of payments surplus, so this has not been an issue. All the time a country runs a payments surplus foreigners’ net claims on the economy are reducing, and the surplus country builds up more claims on overseas assets. A surplus country has to lend the surplus back to the debtor countries, or buy up their assets with the extra money it has earned.
Whilst we do not expect Japan to announce the cancellation of its debt any time soon, it is sensible to look at the net figure as well as the gross. All the time inflation remains low and the Japanese banks are reluctant to create their own credit, the Japanese authorities can keep on creating new money, buying up their own bonds, allowing the state to borrow more and more. One intermediate step between cancelling the debt and leaving it growing would be to refinance the state-owned debt as zero-coupon, ultra-long debt, or even zero-coupon debt with no repayment date. That could be a compromise on what to do next. Japan is in a very different positon to some Latin American countries who borrowed too much from foreigners, and ended up with currency crises and high interest rates to try and attract more capital. Japan’s unusual monetary policy has proved to be strangely stable so far, and can continue to be so all the time the Bank of Japan is willing to buy so many bonds with a determination to keep rates low, and all the time Japanese domestic investors believe in the system.
The above article by John Redwood, Charles Stanley’s Chief Global Strategist, was first published by Charles Stanley on 21st October 2016.