Will debt derail Abenomics?

For a long time Japan was able to service its growing government debt burden by keeping interest rates low. Success of its Abenomics policy would stop this game in its tracks.

It seems to me that one of the automatic, if not always intended, consequences of Abenomics is to force up Japan’s current account surplus, and in fact to force it up substantially. This will have to do at least in part with deciding how to manage the country’s enormous government debt burden, which easily exceeds 200 per cent of the country’s GDP.

If I am right, this should create two concerns. First, in a world struggling with insufficient demand and excess capacity, and in which the growth strategies of too many countries implicitly involve a significant increase in exports relative to imports, a major increase in Japan’s current account surplus could easily derail growth recovery elsewhere. The US, for example, has to worry that policies aimed at increasing domestic demand don’t simply result in rising debt as US demand bleeds out through the current account, while both China and Europe need strong external sectors to make their own difficult domestic adjustments less painful.

Second, it is not obvious that the world will be able to absorb a significant increase in the Japanese exports, and if Abenomics implicitly forces up the Japanese savings rate relative to investment (which is all that we mean when we say that economic policies force up current account surpluses), these policies can resolve themselves either in the form of high growth and soaring exports, or much lower growth and slowing imports. The former implies that Abenomics will be successful, while the latter that it will fail. It is not obvious, in other words, that Abenomics can succeed in a world of weak demand, and its failure is likely to make Japan’s domestic imbalances worse, not better.

It may seem a little quixotic to worry about a surging Japanese current account surplus just now when in fact Japan’s external balance has declined substantially and is surprising analysts on the downside. According to an article in the Financial Times this month:

“Japan’s current account balance plummeted by nearly two-thirds in August from a year ago, surprising forecasters that had assumed it would grow nearly a fifth. The current account is a broad measure of trade. A fall indicates Japan is receiving less income from overseas investments, despite help from the falling yen.

“The current account surplus fell nearly 64 per cent in August, versus forecasts expecting an 18 per cent gain. The unadjusted balance in the month was ¥161.5 billion, against forecasts at ¥520 billion and down from ¥577.3 billion in July. Within the data, trade of goods and services was in deficit of more than ¥1 trillion for a second consecutive month, while income fell to ¥1.253 trillion from ¥1.794 trillion a month before.”

My concern, however, is unlikely to be played out over the next few quarters but rather over the next few years as Abenomics is implemented, and so Japan’s external position in the immediate future doesn’t matter. What matters, I think, is that in order to generate growth Tokyo is planning to implement polices aimed at raising both inflation and real GDP, and these policies are likely to force up the national savings rate relative to investment.

What is more, to the extent that these policies are successful in generating higher nominal GDP growth, they create a problem for Tokyo in how it decides to set domestic interest rates. Japan has never really resolved the overinvestment orgy of the 1980s. Instead of writing down bad debt it effectively transferred much of it to the government balance sheet, and now this huge debt burden is itself becoming, I think, a constraint on the success of policies designed by Tokyo to spur growth.

…But there is more, perhaps much more. Japan is struggling with an enormous debt burden, and perhaps this explains why Tokyo is so eager to engage in policies that force up the Japanese savings rate. As long as more than 100 per cent of Japanese borrowing is funded by domestic savings (if Japan runs a current account surplus is must be a net exporter, not importer, of capital), it doesn’t have to rely on fickle foreigners, who might not be satisfied with coupons close to zero, to fund its enormous debt burden.

But the debt burden creates its own very dangerous source of trade instability. … Even if the real interest rate in Japan declines, debt servicing is likely to be much more difficult as the nominal rate rises. Japan might be paying a lower real rate, but it is also implicitly paying down principle, instead of capitalising it. Tokyo would need a significant increase in revenues, or a significant decrease in expenditures, to cover the cost.

So what would force Japan to raise its nominal interest rate? In principle the nominal interest rate should be more or less in line with the nominal GDP growth rate. If it is higher, growth generated by investing capital is disproportionately retained by net savers (including mainly the household sector). There is, in other words, a hidden transfer of resources from net borrowers to net savers.

If the nominal lending rate is lower than the nominal GDP growth rate, as is the case in China today and Japan during the 1980s, the opposite occurs. There is a hidden transfer from net savers to net borrowers, and because net savers are mainly the household sector, this will put downward pressure on the household share of income even as it gooses investment growth. This hidden transfer has been at the heart of the rapid economic growth that typically occurs in financially repressed economies during the earlier stages, and is also at the heart of the investment misallocation process that typically occurs during the later stages. We have seen this very clearly in China.

Will Tokyo raise interest rates?

Japan is trying to generate both positive inflation and real GDP growth, so that it is trying urgently to raise the growth rate of nominal GDP. What happens if and when it is successful? For example let us assume that Japan’s GDP is able to grow nominally by 4-5 per cent a year – what will happen to the nominal Japanese interest rate?

Tokyo can either raise interest rates in line with nominal GDP growth rates or it can keep them repressed. In the former case, debt-servicing costs would soar, ultimately to 8 per cent of GDP or more. This would create a problem for Tokyo in its ability to service its tremendous debt burden. It would need a primary surplus of around 8 per cent of GDP just to keep debt levels constant, and it is hard to imagine how such a huge surplus would be consistent with nominal GDP growth rates of 4-5 per cent.

If it were to raise income taxes it would create a huge burden for the household sector and almost certainly force up the national savings rate by forcing down the household share of GDP. Remember that during the 1980s Japan, like China today, generated rapid growth in part through financial repression, and one of the consequences of that rapid growth was an extraordinarily high savings rate along with a huge current account surplus, both of which were ultimately unsustainable. Japan has spent much of the past twenty years rebalancing GDP back in favour of the household sector, and to reverse this process may provide relief in the short term, but it is hard to see how it can be helpful in the medium term.

On the other hand if, in order to make its debt burden manageable Tokyo represses interest rates to well below the nominal GDP growth rate, it is effectively transferring a significant share of GDP from the household sector to the government in the form of the hidden financial repression tax. This is what Japan was doing in the 1980s, with all of the now-obvious consequences.

Japan’s enormous debt burden was manageable as long as GDP growth rates were close to zero because this allowed both for the country to rebalance its economy and for Tokyo to make the negligible debt servicing payments even as it was effectively capitalising part of its debt servicing cost. If Japan starts to grow, however, it can no longer do so. Unless it is willing to privatise assets and pay down the debt, or to impose very heavy taxes of the business sector, one way or the other it will either face serious debt constraints or it will begin to rebalance the economy once again away from consumption.

As this happens Japan’s saving rate will inexorably creep up, and unless investment can grow just as consistently, Japan will require ever larger current account surpluses in order to resolve the excess of its production over its domestic demand. If it has trouble running large current account surpluses, as I expect in a world struggling with too much capacity and too little demand, Abenomics is likely to fail in the medium term.

Perhaps all I am saying with this analysis is that debt matters, even if it is possible to pretend for many years that it doesn’t (and this pretense was made possible by the implicit capitalisation of debt-servicing costs). Japan never really wrote down all or even most of its investment misallocation of the 1980s and simply rolled it forward in the form of rising government debt. For a long time it was able to service this growing debt burden by keeping interest rates very low as a response to very slow growth and by effectively capitalising interest payments, but if Abenomics is “successful”, ironically, it will no longer be able to play this game. Unless Japan moves quickly to pay down debt, perhaps by privatising government assets, Abenomics, in that case, will be derailed by its own success.

Michael Pettis is a senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets, where a longer version of this article first appeared.

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