Japan's Abe risks a familiar debt debacle
While the talk has been about Japan joining the currency war and the subsequent threat to manufacturing economies and world growth, the real danger may be a European-style banking implosion.
The prospect of Japan igniting a currency war is one that has been much-discussed ever since it became clear Abe was going to coerce the BoJ into doubling its inflation target (it morphed today from a "goal" to a ‘’target’’) and committing to an open-ended program of purchasing financial assets. Abe has already announced a big new stimulus package.
There is no doubt the aggressive attempt by Japan to reflate an economy that has been deflating for the best part of a quarter of a century and the prospect of a new flood of cheap Japanese exports is causing concern in Europe, China, the rest of Asia and the US about the impact on their own manufacturers.
If they try to defend their shares of global trade in what is a difficult, low-grow global economic environment everyone will ultimately be losers from a new wave of protectionism. The yen had already fallen heavily against other major currencies, including the Australian dollar, as Abe’s intent became clear.
The Abe strategy, however, isn’t just a threat to global economic stability. He could end up shooting himself in the foot and doing a lot of damage to an already weakened Japanese economy. Indeed it is possible he could destroy the Japanese banking system.
Japan is the developed world’s most indebted nation. Its gross debt-to-GDP ratio is close to 250 per cent. It has been able to avoid the kind of sovereign debt panics experienced in Europe in recent times mainly because the overwhelming majority – just over 90 per cent – of that debt is held by Japanese individuals and financial institutions.
Japan’s banks are stuffed full of government debt yielding next to nothing, with their bond holdings representing multiples of their capital bases.
If the Abe plan is successful the BoJ and stimulus measures will kindle some modest inflation and, it is hoped, the combination of greater export competitiveness and inflationary expectations will finally trigger some growth.
The potential problem lies with all that debt and where it is held. Japan’s interest rates are close to zero and the BoJ buying ought to hold them there while the program is in place. If the Abe strategy works and inflation does pick up, however, that’s not good news for bonds, or for those who hold them.
The IMF has been public in expressing its concern that with government debt accounting for about 25 per cent of the assets within Japan’s banking system any increase in bond yields and consequent losses for government bondholders could not only raise the cost of servicing government debt to unmanageable levels but could blow holes in the balance sheets of the banks.
It is the same kind of position and the same kind of incestuous and circular relationships between sovereigns and banks that nearly blew the eurozone apart – but with much higher public debt levels and bank holdings of that debt.
If that were to transpire the consequences for Japan would be horrendous, but probably wouldn’t be confined to Japan.
Abe is walking a tightrope and taking the Japanese economy and financial system along with him on the journey. If the strategy fails – or is too ‘’successful’’ in rekindling inflation – it is improbable that the landing will be soft.