On a day in March 2013, there was a presentation about Japan’s government debt. And, there took place a brief, but memorable, exchange of Q&A between the speaker and an audience.
Audience: “If tomorrow you got put in charge of Japan (the Ministry of Finance of Japan), what would you do?”
Speaker: “I’ll quit.”
(GGRPrivate, 2013: Youtube at 36:55)
The speaker was Kyle Bass, one of my favourite legendary hedge fund managers. What was behind his incisive response?
Back then, Japan’s ‘Gross Sovereign Debt to GDP Ratio’ was 234% (April 2013). And today it is updating its world record. Chart 1 compares the measure across different countries. In 2016, Japan owns the world top record of 237%. Chart 2 traces the historical evolution of the metric of Japan.
Simply put, the level of Japanese government debt is phenomenal.
Chart 3, the estimation work done by Junichi Yonezawa, traces Japan’s historical primary balance estimate, a measure of fiscal imbalance. (Yonezawa, 2016) It paints a picture: Japan has been having a chronic fiscal deficit since the mid-60s, except the period of its home-made bubble that extended roughly between 1987–1992.
Now, let’s translate this situation into a perspective of the government budget. Chart 4 shows the history of the central government’s tax revenue. What would be an impact of a hypothetical 100 basis point rise in interest rate (across all the maturity sectors) on the budget? With the debt outstanding amount of JPY 1,278.8 Trillion in 2016, we can roughly estimate the interest rate risk as follows:
- The Rise in Interest Cost: 100 basis point increase in interest rates would account for an additional JPY 12.8 Trillion (0.01×JPY 1,278.8 Trillion) interest cost.
- Japan’s tax revenue in 2016 was JPY 55.5 Tril.
- The interest impact on the budget would be 23% of its tax revenue (23% = 12.8 Tril/55.5 Tril).
Simply put, the hypothetical 100 basis point rise in interest rates (all across maturity sectors) could wipe out 23% of Japan’s annual tax revenue. It appears unmanageable. Of course, in reality, it takes some time for its existing bonds to be refinanced with new interest rates at different timings. So, the real impact would be different from this estimate. Despite its rugged simplified estimation, the estimate paints a picture how the normalisation of inflation, thus interest rates, could impair the government’s budget going forward.
Nevertheless, that is just the impact of interest rates. How about its principal repayment? Is it a matter of time for Japan to declare the state of insolvency? This is the backdrop of Kyle Bass’ incisive response in the Q&A.
Here is a list of some of points that Kyle Bass made.
- Interest rate risk: A rise in interest rates would further wipe out the tax revenue. Thus, the government’s ability to honour its debt would become questionable once interest rates start rising.
- Secular risk: Aging population will diminish Japan’s economic growth, thus, its government’s tax revenue.
- Inherent position: As a resource poor nation, Japan depends on imports for natural resource. Its currency depreciation, if material, would be critical for its survival.
- Madoff Analogy: No one can keep refinancing one’s debt forever. There should be a tipping point.
Today, despite Kyle Bass’ concern, Japan has managed to maintain its investment grade credit rating since then. It might be partly because the materialisation of the interest risk still seems a distant future. But, is there anything missing in the meticulous analysis of the brilliant analytical mind of our time? Or something wrong with rating agencies?
Before proceeding, I would like to set the mode of our mind regarding how we view the situation further. Now, just with these little evidences that we have seen through these four charts, we gained a picture that the government of Japan has been deeply in trouble. So, what’s relevant here is not to ask if Japan can meet requirements for the best practice in its sovereign debt management. It is simply because obviously the reality today tells us that they have breached such things already in the past. What’s relevant here is a mode of crisis prevention, or crisis management: how Japan is managing or is going to manage its situation to prevent the worst consequence, insolvency, from happening. Thus, it’s not going to be clean!
Well, setting our mind in a mode of crisis management, let’s go back to Kyle Bass’s arguments.
At some point in his presentation, Bass compared the Japanese government debt situation to Bernard Madoff’s Ponzi scheme. In hindsight, this analogy is proven to be misleading. He was missing a fundamental difference between the government of Japan and Bernard Madoff: the government of Japan is the sole issuer of the local currency which is the only currency denominating its sovereign debt; Bernard Madoff had no ability to issue any currency and had to receive other people’s money to pay back his existing debt. How did this difference play out?
Now, we are about to view Japanese government’s debt magic, ‘monetisation.’ Importantly, this can be done — although some conditions apply — because we are in fiat money regime of the post-modernity.
What is monetisation?
In the government debt context, in a plain sentence, when the government borrows money from its central bank rather than from investors, it’s called ‘monetisation’ of the government debt.
Here is an example of government debt monetisation’s process:
- Step 1) the government of Japan issues new Japanese Government Bonds (JGB) to fund the repayment of its legacy debts;
- Step 2) the central bank, Bank of Japan (BoJ), issues the local currency on behalf of the government in order to purchase the newly issued JGB. At this stage BoJ’s fundamental raison d’etre, political independence, is compromised.
- Step 3) the government receives the proceeds from BoJ and repays to the creditors of its legacy debts at the maturity;
- Step 4) the creditors receive the principal repayment. And the repaid fund circulates into the economy;
- Step 5) going forward, the newly issued debts do not necessarily need to be repaid to the central bank. It would be a matter of a political as well as an economic decision whether to repay the monetised portion of its debts to BoJ. Or, the monetised debt might remain on the balance sheet forever.
In a way, it’s indeed a ‘Debt Magic’ that only a currency-issuing government can conduct. Unfortunately, we, households, do not have this option. (Well, these days, some might attempt to issue crypto-tokens, which might not be used in a general setting, though.)
It sounds very convenient for the government of Japan. Nevertheless, there is a catch: monetisation has an inflationary implication.
As we see in the monetisation process above, at the maturity of the government’s legacy debt, monetisation by its design only injects new currency into the system without absorbing the same amount of currency out of the system — since the newly issued debt is bought by the central bank with the newly issued money, but not by investors with existing currency in the system. In other words, monetisation has an inflationary implication, with other conditions constant. If it causes inflation, it would have a flavour of monetary impairment in the sense that it impairs the purchasing power of money. And the spiciness of the flavour would depend on the resulting inflation impact — to be discussed later.
In hindsight, it is no secret that Japan has been conducting the ‘Debt Magic’ for some years. The government has increased its pace since 2013. Chart 1 presented above reveals the recent evolution of monetisation.
According to Chart 1, in 2016 Japan’s cumulative monetisation has reached 33% of its total government debt, which is equivalent of 77% of its GDP. In other words, the government’s debt liability to parties excluding its central bank is reduced to 160% (= 237% — 77%) by monetisation.
Here, we have two questions about ‘monetisation’:
- Can other countries also conduct monetisation? If Japan is OK, why not other countries?
- What risks can monetisation cause? Can Japan continue its monetisation forever?
Monetisation: Conditions apply!
Well, not all countries possess sovereign discretion over debt monetisation. Why? It is because some conditions apply for this super deal. Japan meets the following two conditions that some other countries might not meet:
- Condition 1) A national government issues its own currency;
- Condition 2) All sovereign debt that the national government issues is only denominated in its own national currency.
Any country violating either of these two conditions would find it hard to maintain full sovereign discretion over monetary policy, fiscal policy, and monetisation. Here are two examples of those countries that do not meet these conditions:
- Eurozone countries: Spain, Portugal, Italy and other Eurozone states cannot issue own currency. ECB, a supra-sovereign institution, issues EURO for the member countries. Once the condition 1 is breached, the condition 2 is automatically breached. Thus, no single Eurozone nation can issue its own debt denominated in its own domestically issued currency. None of them has sovereign discretion to monetise its own debt. Simply put, their monetary policy is monopolised by ECB. In other words, Eurozone countries, sort of voluntarily, abandoned their sovereignty over their government debt monetisation.
- Argentina issues a significant portion of foreign-currency denominated sovereign debt, although it issues its own currency: the country violates the condition 2, while meeting the condition 1. Thereby, for Argentina, currency risk is embedded in its sovereign debt management. The presence of foreign-currency denominated sovereign debt makes it impossible for such countries to meet the following three objectives at the same time: sovereign debt management (currency risk management), sovereign discretion over monetary policy, and sovereign discretion over fiscal policy. This point is discussed in one of my earlier contents: Perplexing Sovereign Debt to GDP Ratio (Suginoo, 2018).
On the other hand, thanks to meeting these two conditions, Japan can maintain its sovereign discretion over monetary and fiscal policies as well as monetisation of its debts.
Repeatedly, Chart 3 paints a picture: Japan has been having a chronic fiscal deficit since 1965, except for the period of its home-made bubble that extends roughly between 1987–1992. And Japan’s monetisation is a postdrome of its ongoing chronic fiscal deficit.
Overall, Japan, meeting these two necessary conditions, demonstrated the following notion.
- To avoid economic stagnation, a currency-issuing country can expand fiscal spending at its discretion by issuing its local-currency denominated government debt, while refraining from issuing foreign-currency-denominated debt.
The notion sounds familiar. Actually, it is one of notions that Modern Monetary Theory (MMT) advocates. In this sense, Japan’s fiscal history demonstrated a case for the MMT’s claim. So far, so good. Nevertheless, it is just a product of a historical accident, but not a product of any theoretical experiment. In that sense, Japan’s past does not necessarily guarantee its future in the conduct of monetisation. It raises a question whether these two conditions guarantee the safety of Japan`s monetisation toward the future; whether there is any other condition that would further apply for a successful ‘Debt Magic’ going forward.
Risk associated with Monetisation
Now, keeping in mind some of Kyle Bass’ points aforementioned, let’s explore risks associated with the ‘Debt Magic,’ government debt monetisation.
Here, as a precaution, I am not intending to draw any sort of likely forecast. Instead, I am going to talk about risks, potential adverse events, associated with government debt monetisation.
Interest Rates’ Impact on Budget:
Rising inflation would call for the central bank’s policy rate hike. Repeatedly, at the current level of Japan’s sovereign debt, a 100 bps increase in interest rate would wipe out 23% of its tax revenue.
As interest rate rises, the government not only needs to borrow money to refinance legacy debts with long-term bonds but also might need to fund with short term notes the increased interest payments outflow attached to newly issued debts. If we assume refinance without monetisation, the net increase in the new borrowing will compound with interest rate going forward. This is going to further exacerbate the government budget.
Without monetisation, insolvency would be a very imminent issue at the current level of its sovereign debt, should interest rates rise. Then, would monetisation solve all the relevant problems?
Mutually Reinforcing Dynamics between Monetisation and Inflation
What would it be like with monetisation? Needless to say, by definition, monetisation would help the government reduce the debt, thus improve the government budgeting. On the other hand, monetisation has an inflationary implication by its design.
Although the tightening monetary policy intends to contain inflation, if monetisation’s inflationary impact exceeds the monetary policy’s tightening impact on inflation, it could lead to a further rise in inflation, thus, interest rate. So, here we have a mutually reinforcing loop:
- inflation calls for the policy rate hike;
- a rise in interest rates calls for more need for monetisation;
- more monetisation has more inflationary implication. Then, it returns to the first line.
If this mutually reinforcing feed-in/feedback loop came into being, the resulting inflationary impact could impair the purchasing power of money — with this conditional statement, I am not telling you that this will happen necessarily. The magnitude of its impact would significantly depend on the given state of the economy — especially, lending activities and the given state of inflation.
Counter-arguments vs Secular Reversal:
Of course, it remains a big question whether this mutually reinforcing dynamic between monetisation and inflation comes into being. I can imagine a variety of counter-arguments such as:
- Inflation is not necessarily a monetary phenomenon as its cause, although its effects inevitably have monetary implications: as a historical evidence, QE failed to restore inflation. So, monetisation might not necessarily lead to material inflation.
- Innovation is yielding a downward pressure on price. Thus, inflation would be less likely problematic.
- Japan’s economy will remain weak due to its secular demographic change. Thus, there is no risk of rising inflation.
I would not contend against these views. However, what we are dealing with are risks associated with a secular turning point of interest rates. To emphasise the difficulty of forecasting a secular reversal point, here is a quote of Kyle Bass:
“Black-Scholes model dramatically misprices risks at a secular turning point. It’s analogous to driving a racing car with a rear-view mirror. It is a beautiful thing, if you are trying to run a hedge portfolio and look at these kinds of risks.“ (Kyle Bass: GGRPrivate, 2013, YouTube @21:50)
A brilliant analogy. In a sense, some counter arguments shaped based on ‘a rear-view mirror’ would fail to anticipate forthcoming secular changes. This is the reason why we would need to check a long-term historical chart once in a while in order to contemplate on a secular turning point.
Chart 5 shows the 10 year Japanese government bond yields. How does it look like to you? Are we close to a secular turning point?
Probably, it is still impossible for anyone to spot exactly the next turning point. That said, it would be fair to say: our current position at near zero line indicates that we are very likely in the range of a secular reversal zone in terms of the yield level. Of course, in terms of timing, we cannot obtain sufficient relevant information from this chart to spot the next secular reversal point.
Here are some additional relevant issues in contemplating the timing of the forthcoming secular reversal:
- The US Federal Reserve Bank is normalising its policy interest rate. In this context, there are two concerns: How US monetary policy penetrates into Japan’s monetary reality; How it affects the long end of Japan’s swap curve;
- The current trend of protectionism-oriented international affair might cause a material supply disruption in some sector in the global supply chain. This can cause global supply-driven inflation. Then, Japan would not be free from the global inflationary pressure.
- A massive pile of banks’ reserve: At the entry of QE an increase in banks’ reserve was made without affecting the private sector’s lending activities since the government directly purchased risk assets from non-banks. (McLeay, Radia, & Ryland, 2014) Because of this mechanism of QE together with stagnated demand conditions, the increased banks’ reserve has been ineffective to restore inflation level as well as economic growth in the past. Nevertheless, going forward, the banks’ reserve still sets the upper limit of the private sector’s lending activities. At the current unprecedented level of banks’ reserve, once the economic trend makes its turn, money supply, thus inflation, might surge.
- If stagflation unfolds, the future interest cost would rise, while the government would face the needs to expand fiscal spending. How would monetary policy and fiscal policy share their roles to optimise their impact? Can they contain inflation while averting economic recession?
Again, any of these risks does not necessarily need to unfold. Nevertheless, once the secular cycle of interest rates makes its turn and a rising interest rate cycle starts shaping itself, the risk might materialise at a progressively accelerated pace so that no policy can catch up to contain it. If that happened, at the current level of Japan’s sovereign debt, monetisation could materially impair the purchasing power of JPY, thus, the public confidence in the local currency. It would put the entire resource-poor Japan’s society in jeopardy. In this sense, in my view, Kyle Bass’ warning about JGB would remain very relevant going forward; even though the genius possibly missed out the development of monetisation in his analysis.
Implications of Monetisation Risk
As we saw in Chart 3, Japan’s monetisation is a postdrome of its long-standing chronic fiscal spending. In this backdrop, it is important to incorporate the context of its chronic fiscal imbalance into our risk assessment on Japan’s monetisation. Here, I want to talk about the following two implications:
- The Public Confidence in its Own Currency:
- Declining Competency and Aging Population:
Let’s take a look at them one by one.
The Public Confidence in its Own Currency:
Probably, two primary implications arising from the overuse of monetisation would be inflation and a deterioration of the public confidence in the local currency.
- Extreme inflation would result in depreciation of the local currency, thus, can impair the public confidence in the currency. Currency depreciation can be positive for export, given that Japan’s export still finds its demand abroad: this condition would be subject to a discussion. From its import sector’s perspective, the resource poor nation, especially under the post-Fukushima context, would suffer from rising prices on imported natural resources. Uncontrollable inflation itself is an evil. (Negative)
- Repeatedly, a rising interest rate would increase the future cost of the government’s funding. Recall: based on 2016 data, a 100 bps increase in interest rates can wipe out 23% of the tax revenue of Japan. (Negative)
- Inflation would reduce the real value of the legacy debts denominated in the local currency. (Positive)
- An acute decline in the purchasing power of money would make it difficult for the government of Japan to attract domestic investors as well as foreign investors; thus it would make it difficult to issue its sovereign debt in its own currency; (Negative)
- Whether Japan can extend monetisation of debt, knowing that it has inflationary implication, would be questionable under a highly inflationary environment. Should the mutually reinforcing loop between monetisation and inflation kick in, the public confidence in the local currency may be at risk. (Negative)
The third item above suggests that inflation does present a favourable impact for Japan by reducing the real value of its debt. Nevertheless, the overall effect of extreme inflation could ruin the public confidence in its local currency, thus, it would be negative for Japan’s entire economy. Also causing a spike in the future funding cost, material inflation would be a real threat to Japan’s sovereign debt management. And there is no guarantee that Japan would be free from extreme inflation before Japan manages to reduce its debt level to an immaterial level.
Declining Competency and Aging Population:
Japan’s chronic fiscal imbalance is a sign of its structural inefficiency, which in the long-run would impair its competency relative to its competitors. Especially, the neighbouring countries in Asia are rapidly industrialising their economies. Japan, as a resource poor nation, needs to transform its economic structure to redefine its new competency. Its chronic fiscal spending has deterred the process of its structural reform.
In addition, Japan is going through its aging demographic challenge as well.
Given these secular forces in our mind, here are two contrasting possible prospects:
- monetisation is just a symptom of Japan’s long-term gradual structural decay. Thus, the underlying decay would progress and only impair the public confidence in its own local currency in the long-term unless the structural reform is addressed.
- Or, on the contrary, a series of monetisation could save Japan out of its current secular stagnation.
It would depend on both the willingness and the ability of the government in delivering structural reform. Let’s see!
Monetisation Implication for the government of Japan
The current low range of inflation rate in Japan might be just the calm before the storm. What would be the implication of the interest rate risk for the government? While interest rate remains low, the government of Japan should accelerate monetisation to reduce as much as possible the debt liabilities to parties other than the central bank. Otherwise, it can expose itself to the risk of drastic credit downgrading.
As a possibility, the government of Japan may be successful in managing the yield level of JGB and saving the funding cost, should inflationary environment emerge. As a historical example, US managed the yield of its war finance during the WWII. Although the war itself was inflationary, the US government managed the yield curve of its war-financing bonds. In the midst of the WWII when the credit of the private sector becomes uncertain, US Treasury exploited the risk-free status of its bonds, by guaranteeing the absolute credibility of its debt servicing ability and willingness. This historical episode might offer a possibility that the government of Japan might explore in its own new context.
As of today, at a low range of interest rate, there seems to be no material insolvency risk in JGB. Thus, for now, Japan deserves an investment grade.
Toward the future, how will it play out? Once called a rising sun, would Japan descend to a setting sun in the face of rising interest rates? Or, can Japan restore its position with a massive ‘Debt Magic” before the secular interest rate cycle takes its turn? Nobody knows as of today. What a thrilling ‘Monetary Kabuki play’! Now, it’s on live at the open-air reality.
- GGRPrivate. (2013, 4 7). Kyle Bass — Coming Crisis in Japan. Retrieved 11 4, 2018, from YouTube: https://www.youtube.com/watch?v=7kFcDKBpdII
- McLeay, M., Radia, A., & Thomas, R. (2014). Money creation in the modern economy. Quarterly Bulletin — Bank of England, 4–27. Retrieved from Bank of England: https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf
- Suginoo, M. (2018, 10 26). Perplexing Sovereign Debt to GDP Ratio: Between 237% (2017) Japan and 59% (2018) Argentina, which is more risk? Retrieved from monetarywonderland.com: https://www.monetarywonderland.com/perplexing-sovereign-debt-to-gdp-ratio.html
- Yonezawa, J. (2016, 10). 国債発行５０年の総決算ープライマリー・バランス分析決定版. Retrieved from POLICY RESEARCH INSTITUTE, Ministry Of Finance, JAPAN: https://www.mof.go.jp/pri/research/discussion_paper/ron285.pdf