## Thursday, April 24, 2014

### Japan's government debt: up

(A version of this piece will appear on Morningstar Advisor, my employer's bi-monthly magazine.)

By standard criteria Japan is in worse fiscal shape than Greece. The Japanese government hasn’t balanced a budget since 1992, and runs one of the highest deficits on earth. The stock of debt is eight times as high as annual tax revenue. Would the bank give you another loan if you owed eight years’ worth of income? The familiar ratio of debt to GDP has risen in 20 years from 80% to 243%, the highest level in the world. How did public finances get so rotten?

The road to ruin
Debt dynamics depend on five things which, properly arranged, get you GIDDY: growth (g), inflation (i), debt (D), deficit (d), and yield (y). A short equation describes the relationship:
D[t] = D[t-1] * (1 + y - g - i) + d[t]
The formula says that this year’s debt-to-GDP ratio, D[t], is equal to last year’s, D[t-1], multiplied by the term (1 + y - g - i), plus this year’s deficit d[t].
The apparent causes of Japan’s debt explosion, then, are three. First, despite ground-low interest rates, economic growth plus inflation were even lower, so the term (y – g – i) was positive for most of the last two decades. The implicit interest rate has averaged 1.9% since 1993. Real GDP has increased a mere 0.9% a year, while the GDP deflator (a broad measure of prices) has fallen 1% per year. Deflation more than erased the gain in real output.
Second, the larger the debt balance, the harder it is to pay it off, as any credit card holder knows. That’s because debt itself, D, is multiplied by the term (1 + y – g – i). Even a small positive difference between the interest rate and nominal growth makes a significant impact, once debt gets as high as Japan’s.
And third is the primary fiscal deficit, d. If expenses exceed revenues the government must finance the gap by borrowing, which adds to debt. Japan has averaged a fiscal gap of 5.4% of GDP over two decades.
Aging weighs down public finances
At a deeper level the debt problem has a demographic root: Japan’s population is aging and shrinking, fast.
Demographics touch on each of the five determinants of debt. The connection between deficit and age structure is the easiest to see. Aging widens the pool of pensioners while it shrinks the number of taxpayers. In Japan Social Security payments have almost tripled since 1990, and now eat up 40% of tax receipts. Seniors go more to the doctor, too, and Japan provides universal healthcare.
Then there’s economic growth. The working-age population gets 1% smaller every year. To achieve, then, even a modest output growth rate of 2%, output per worker must rise by 2.9% a year. No advanced economy has sustained that pace of productivity gain in the last 20 years. Most countries, including Japan, have been in the 1% to 2% range since the 1990s.
Deflation is linked to demographics as well. As former Bank of Japan governor Masaaki Shirakawa says in a recent speech: “Over the decade of the 2000s, the population growth rate and inflation correlate positively across 24 advanced economies.  That finding shows a sharp contrast with the recently waning correlation between money growth and inflation.” Shirakawa then says that aging is undermining real demand growth, which falls behind   potential output growth, fuelling deflation.
An army of pensioners, I might add, will probably fight inflation. Life is great when you’re on a fixed income and prices decline, which is what seniors in Japan have come to expect.
Finally, aging puts pressure on interest rates. The baby-boom generation is selling its bond holdings to provide income for retirement. That raises bond yields, adds to the government’s interest bill, and accelerates the growth of debt.
Where is, then, Japan headed? To estimate the ratio of debt to GDP in, say, 2020, I roll forward the formula above and plug in projections for the five drivers of debt over the next seven years. Under those forecasts the debt ratio rises relatively little, from 243% to 257% (see the table).
Changing assumptions produces striking results. In a sunnier world of robust growth and inflation, deficits half what they’ve been since 2009, and a borrowing cost even lower than today’s, debt shrinks to 218%. Under less favorable, but more credible, conditions the debt ratio hits 297%. The odds are that debt will keep rising.
Projections of Japan’s government debt
 Assumptions Optimistic Baseline Pessimistic Debt / GDP in 2020 (%) 218 257 297 Debt / GDP in 2013 (%) 243 243 243 GDP growth in 2013-20 (%) 1.5 0.9 0.5 Inflation in 2013-20 (%) 2.1 1.1 0.1 Primary deficit in 2013-20 (%) 3.4 4.4 5.4 Implicit int. rate 2013-20 (%) 0.5 1.0 1.5
Source: IMF; author’s calculations.
Interest rates are key
Key to the outlook, and most uncertain, are interest rates. Yields have stayed low due to steady demand for bonds from domestic buyers. The Japanese private sector produces large cash surpluses, which get recycled into Japanese government bonds (JGBs) via the banks. Commercial banks have been more than happy to invest in sovereign debt, as loan demand is sluggish. Where else would they find an investment with a real return of 2.5% and no capital requirements?
Financial repression has played a role too. The Ministry of Finance has used its clout to force pension funds and insurance companies to buy public debt. The Japan Post Group, which includes a massive bank and a major insurance company, is owned by the state, and thus another reliable buyer.
Thanks to this loyal domestic demand, the government with the highest debt in the world pays the lowest borrowing costs.
The private sector, however, cannot absorb public deficits forever. An aging population means the household saving rate is falling. Soonish it will turn negative. Corporations still produce excess savings, but not enough to cover the public financing needs. If firms kept buying JGBs eventually all of Japan’s private wealth would be held in government bonds. What would happen then?
A recent paper by professors Takeo Hoshi and Takatoshi Ito answers this question. They argue that, once domestic savers are tapped out, Tokyo must borrow abroad. Foreigners are presumably less willing to accept ultra-low yields, so the interest expense will surge.
Today the Ministry of Finance spends over half of tax revenues on interest payments, even though the implicit borrowing rate is below 1%. Just a modest increase to 2%, then, would put interest charges above tax receipts—what Hyman Minsky called “Ponzi finance.” The markets would deem the government insolvent, and default would follow. Under every simulation run by Hoshi and Ito, bankruptcy would come by 2023.
Japan’s policymakers are aware of this possibility, which is perhaps why they’ve turned to the central bank. After winning the November 2012 election, prime minister Abe appointed a new head of the Bank of Japan (BoJ). Under governor Kuroda the BoJ announced that it would buy 7.5 trillion yen of bonds a month, or 70% of all new issuance. These purchases have anchored yields. With a boundless balance sheet, the central bank can keep financing the government forever, in theory. In practice, as centuries’ worth of sovereign debt crises show, monetization of the deficits can lead to hyperinflation.
Mr. Abe is betting he can dodge both default and hyperinflation. If he can keep funding the deficit with long-term bonds at tiny interest rates; if moderate inflation keeps chipping away at the pile of debt; and if deficits decline somehow, despite population aging, the government might contain the swell of debt. That’s a lot of ifs, and they will take years to work. The question is: Will markets bear with Japan that long?
Leaders in other aging countries might draw a message of hope. Japan proves that it’s possible to combine slow growth with persistent deflation, soaring public debt, and cheap borrowing, all while avoiding unpopular fiscal decisions, for decades. Most prime ministers, who have a four-year calendar, will take the gamble.