24 Jun 2016

Solving Japan's Financial Problems

Japan is in some ways the poster child for the developed world's current economic problems.  In 1989 it suffered the bursting of huge equity and property bubbles, the effects of which are still being felt by Japan today.  Rather than aggressively addressing the problems these crashes caused Japan's financial system, it was propped up by the government which as a result has ultimately absorbed an immense amount of debt.

The Japanese government currently spends 10 trillion Yen, or circa 16% of its tax revenue, to pay for the interest on its debt.  If interest rates were to rise by 2%, it would take 70% or more of total tax revenue just to pay the interest!  The Japanese government also needs to borrow more as it is currently running a budget deficit of 18 trillion Yen. 

This looks like a position from which the government cannot recover.  We offered a rather off-the-cuff solution in our January 2015 commentary, A few more left field themes.  However, we are beginning to think that some version of this might actually occur. 

Here is a "what-if' scenario that we have been posing to some of the economists that we get to meet:

The Bank of Japan currently holds 25% of the Japan government's debt.  What if it bought 80% of the government's debt, then wrote it off?


Source: Bloomberg, Bank of Japan

The theoretical answer should be "inflation" as this would be money printing in its purest form, but in a world where no one believes that inflation is possible it appears that this might be considered costless!  Desirable even! One might be concerned that it would trigger capital flight and currency crisis.  But why would this occur? 

Without the interest burden the government’s books would be closer to being balanced.  If capital markets were convinced that this was a one-off why would there be flight.  No one has lost money.  Any currency weakening would be highly beneficial to Japan's exporters, and might help stimulate some inflation, which Abe actually wants.

At Castle Point we are strong believers of aligning ourselves with the interests of the decision makers.   It appears to us that, while money printing continues to appear costless, governments will continue to print money whenever they fear a financial crisis might be looming. 

Ultimately money printing should be inflationary which, if left to run rampant, is highly destructive to an economy.  Even if the decision makers understand this, when it comes to choosing between economic turmoil now from default/deflation, or economic turmoil in some years' time from high inflation, we feel we know where most government officials might place their decision.   They may not even be in office by the time we see option 2.

When in doubt, print…