Tremors…

For the Japanese, there is an inevitability about natural disasters. The country sits on the ring of fire, meaning it is in the most seismically active place on the planet. The proximity of its population to the coast makes it extremely vulnerable to tsunamis, as the Tohoku Earthquake last year demonstrated. And it sits in the path of the Pacific typhoon season. As countries go, there are few more in the path of Nature’s furies than Japan. For this reason, they are uniquely prepared for natural disasters, which means that despite not knowing the time or place of the next one, they are ready. It is, after all, inevitable. However, this prudence on the part of the government and the people does not extend to man-made catastrophes, one of which Japan is sleepwalking into at the moment.

Japan’s numbers make for scary reading. The country’s government is the most indebted in the world relative to GDP (nearly 240% by the end of the year), and second only to the US in absolute terms. This thirteen trillion dollar debt mountain has been steadily growing since the Japanese property bubble burst two decades ago, and shows no sign of slowing. Meanwhile, Japan’s demographics do not give much reassurance for its long-term growth. Already, it has one of the lowest birth rates and oldest populations in the world. It may already have passed the grey event horizon, and reached a point where the political power of the elderly, coupled with a traditional reverence for one’s seniors, makes meaningful reform of Japan’s welfare system impossible. At present the Japanese government’s expenses exceed their revenues by over half a trillion dollars

Two things sustain the Japanese government’s debt binge. The first is Japan’s current account surplus. Basically more money is entering the country than leaving it. This, coupled with the frugality of Japan’s citizens, who have one of the best savings ratios in the developed world, means that banks have lots to lend, driving down the rates borrowers must pay. Between banks awash with cash and citizens ever ready to invest in bonds, Japan has been able to avail of rock bottom yields. Were Japan borrowing at the same yields as most European countries, it would have gone bankrupt long ago. The sheer availabilty and cheapness of money blinds people to the reality that Japan’s debt is unsustainable. Like the Greeks, who took advantage of joining the euro to go on a borrowing binge, successive Japanese governments have essentially chosen to ignore the fact that sooner or later, all that money has to be paid back.

In some respects, Japan’s position is not as bad as the above suggests. Its aggregate debt levels (including personal and bank debt) are no worse than many developed countries. It still boasts an impressive manufacturing base, and as long as it can maintain a current account surplus and its citizens are willing to buy bonds, the cycle can continue. However, it is the sheer concentration of debt in the government sector that threatens to overwhelm the sector. This situation has been apparent for years, but two recent factors may bring Japan’s day of reckoning into view, both perversely related to the Tohoku Earthquake, and more specifically the meltdown at Fukushima I plant.

 

The Twilight of the Rising Sun

The first has been the gradual deterioration in Japan’s current account surplus. Over the past few years, Japan Inc. has watched upstart rivals from Korea and China, as well as resurgent firms in America and Europe, slowly eat away at its market share. Sony has found itself dethroned by Samsung and Apple in the electronics market. Meanwhile, Toyota’s reign as the world’s largest carmaker looks set to be short, with General Motors and Volkswagen seeking to unseat it. Slowly but surely, Japanese exports are being squeezed by competition from abroad

Meanwhile, the (metaphorical) fallout from Fukushima has been to turn the population off nuclear power. As of May 5th 2012, there are no active reactors in Japan. Prior to Fukushima, nearly a quarter of Japan’s electricity came from nuclear power. Even accounting for efficiency gains (Japanese workers are eschewing suits in order to avoid using air conditioning) the net result has been a big increase in the amount of electricity Japan generates from fossil fuels, almost all of which must be imported. A switch from nuclear to fossil fuels would drive up Japan’s energy imports by 7%, or approximately 180 million barrels of oil a year which at 2012 prices would cost at least $20bn more, equivalent to 0.3% of GDP. This, coupled with generally rising commodity prices around the world, means that Japan is now running a trade deficit. While it will be a few years before this becomes a current-account deficit, at this point the flow of hard currency into Japan is beginning to slow, and by the end of this decade, depending on a number of factors, may reverse.

The second factor is an erosion of trust by the Japanese people in their government. In 2009, for only the second time since 1955, voters ejected the Liberal Democratic Party from office. The traditional Japanese political structure, that of the LDP versus the Democratic Party of Japan in opposition, has been disappearing for years. Since Junichiro Koizumi, the last Prime Minister to last longer than a few months, there have been six PMs, four of whom were brought down without elections being held. At the same time, fringe parties appear to be gaining ground.

Distrust of politicians has been further exacerbated by Fukushima, and the perceived bungling of the government’s response. Support for outsider parties is on the increase. This is evidenced by the increasing popularity of Toru Hashimoto, the Mayor of Osaka, Japan’s second city. According to the New York Times, as of January 2012 Hashimoto is now the most popular politician in the country, and while his support base is still concentrated in Osaka and its environs, these represent a huge swathe of the Japanese electorate.

The upshot of this is that the second plank of Japanese borrowing, the willingness of citizens to buy bonds, may be disappearing too. Simultaneous with this is Japan’s demographic nightmare, which nobody seems to have a solution to. Already the population is falling. The percentage of the population over 65 has doubled in the past two decades, with nearly a quarter of Japan’s citizens falling into this category. Japan has so far managed to deliver an excellent healthcare system and keep costs in check, but as the elderly form an ever-increasing share of the population, this will come under strain. At the other end of the spectrum, fertility levels are well below replacement rates (Japanese women now manage an average of less than 1.3 children, versus the 2.1 needed to ensure population stability in a developed country), and immigration simply doesn’t happen. While the government is taking steps to improve the situation, it is almost certainly too late.

An ageing population poses two problems. The first is on the government’s finances. Pensioners, by definition, are net recipients of welfare, usually from the government’s purse. No matter what efforts are made to keep healthcare costs in check, an ageing population coupled with more complicated treatments and increasing incidences of chronic ailments means that health expenditure is in an upwards-only cycle.

The second, perhaps more worrying issue is how an ageing population will affect demand for Japanese bonds. Much of Japan’s vaunted savings are as a result of people setting money by for retirement. As the demographic squeeze tightens, pensioners will draw on their savings. This coupled with a narrowing current-account surplus, is going to reduce the pool from which Japanese governments find their money. What then?

 

Banzai!

Some projections now have Japan running a current account deficit from 2015 onwards.For a few years thereafter, the government will still probably be able to finance its debt from existing private savings. However, a point will eventually be reached where the Japanese people won’t be saving enough in government bonds, and Japan will have to look for sources of finance abroad.

From here events move quickly. Foreign creditors can loan on the open market and are not tied to Japan by notions of patriotism. This means that they will demand a higher return on money advanced to the Japanese government than domestic creditors currently do. Given that the Japanese government already spends a quarter of its revenues on servicing debts issued at rock-bottom rates, any uptick in bond yields will impact heavily on Japan’s balance sheet. This brings forward the day when Japan’s debt is simply too big, and the country defaults, with all the catastrophic consequences therein. Japan’s vast asset pool abroad, it’s trillions in foreign-exchange reserves and its thrifty population may help put off the day of reckoning, but without serious policy changes, they can run, but they can’t hide.

Herein lieth the rub. Japan’s governments, as has been suggested above, are sclerotic, factionalised, and incapable of seeing the woods for the trees. Both major parties are riven by factions and feuds. In a country almost devoid of cultivable land, a powerful agricultural lobby ensures farmers enjoy the most generous subsidies on the planet. Every year Japan goes to extreme diplomatic lengths to protect a whaling industry that would have long ago succumbed to the vagaries of the free market without government support. The hurdles blocking major infrastructural projects are such that it is generally cheaper to build airports on artificial islands rather than on land. A bicameral system where both houses have effective vetoes means that, with a lower house controlled by the DPJ and an upper where neither has a majority, partisan politics is rife. The LDP is systematically blocking as many reform bills as possible in the hope of forcing a general election and ushering in Japan’s eighth Prime minister in six years, and it is hard to see the DPJ being any more cooperative in opposition. Meanwhile, disillusionment with politics looks set to create an increasingly fragmented set of parties, which will only increase the amount of vested interests in the system. This makes a crash program of austerity, with all the social unrest and economic upheaval therein, a political impossibility. Even if meaningful reform were possible, the core issue of demographics stills hangs over Japan.

So what next? Even assuming a generous set of assumptions (2018 before Japan starts running a current account deficit, ten more years to run down savings, and the government keeping the budget in primary balance, or running a small primary surplus), Japan would still have to renegotiate terms with its creditors around 2030. And that is the optimistic assumption. More pessimistically, this could happen a decade earlier. Even the usual outlets for a country in this situation (devaluation, or more unconventionally, inflation targeting) look inadequate for a problem on this scale, and in any case merely kick the can a few years down the road for an older, poorer Japan to deal with.

There are, of course, externalities. Japan could strike oil in its waters. The birth rate could pick up. Technological advances could shift the ways economies operate, as in the 1990s. The problem is that this is a dangerous gamble. Take the above three possibilities. In hydrocarbon terms, Japan is well-trodden ground. Private industry and the government have spent decades searching for substantial oil reserves, to no effect. The 1990s may have transformed Western economies, but in Japan they are remembered as a lost decade. As for the birth rate, there would have to be a massive change, and even this would have negative short-term consequences, as it would worsen Japan’s dependency ratio. In fact, the only quick solution to the demographic problem is massive inward migration, which shows no signs of happening on nearly the scale (up to a million immigrants a year, by one estimate) necessary to stabilise the dependency ratio at current levels.

The sad reality is that, on current evidence, Japan seems an insoluble case. And even 2020 could be optimistic. As mentioned before, Japan spends a quarter of its budget on servicing its debt. As a result, any constriction in Japan’s ability to borrow would cause it to default. This means that bonds issued up to ten years before D-Day might not be repaid in full. As this becomes more apparent, investors may be less happy about buying Japanese debt, which creates a vicious cycle, as Japan must pay a higher premium, thereby worsening its core position. Eventually a tipping point would be reached where Japanese bond yields would climb rapidly, precipitating a default. The usual avenues of rescue would be useless. Were the full reserves of every sovereign wealth fund and central bank on the planet along with those of the IMF and ESM deployed, they would still be inadequate to cover Japan’s debt.

 

Conclusion: The Emperor has no Clothes On

Reality may at last be intruding on the thoughts of policymakers in Japan. A slow stream of credit downgrades, coupled with anaemic growth of the past two decades is perhaps getting through. The current government is taking steps to raise additional revenue (of which there is plenty, Japan is one of the most lightly taxed countries on the planet). The problem is that it may be a case of too little, too late. The same evidence that spurred the Japanese government to action is available to everyone. Japan may find itself borrowing on a more normal market, with all the consequences outlined above. With an economy built on an illusion, the last thing that Japan needs is a sudden revelation.

Japan still has many strengths. Its companies still, as pointed out above, own trillions of foreign assets. Its workforce is among the most productive on the planet, and its firms among the most innovative. Its carmakers and electronics industry are still world leaders. In addition, from an external perspective, the consequences of a default would impinge on the rest of the world less than might be expected, as most of the money is owed to internal creditors. Unfortunately, there is quite simply no way that a thirteen-trillion dollar crash can be pleasant.

Maybe this is all overly pessimistic. Japan is, after all, famously resilient. But it is hard to look beyond the numbers. Already Japan’s big four banks are seeking to diversify their operations abroad, and Japanese citizens are increasingly buying property elsewhere in Asia. Tremors, perhaps. But the Japanese know to be wary of tremors. They can be the herald of an earthquake.

By gregbowler

How bad could it get ? Implications of an Irish No vote in the EU Fiscal compact treaty

On May 31st, the country votes on whether to ratify the European Fiscal Compact. The likelihood is that we will ratify it, but failing that, what next?.

The first thing is, all this talk about how the treaty is bad for the social fabric of the country is irrelevant. Talk of social upheaval won’t wash with our creditors. Secondly, while there is a principled argument that governments should have the right to run deficits in certain circumstances, this facility has been grossly abused by Europe.  Traditionally, governments borrowed for a number of reasons. They might be at war, investing in infrastructure, or more recently trying to break out of a flat economic cycle. In each case this was front-loading spending from future accounts, and creditors could assume that they would be repaid at some point when the country got its books back in order. The debt mountains amassed by European governments in the past few decades have nothing to do with extraordinary circumstances. Deficits are now being used to finance current spending, even in the good years. France hasn’t balanced the books since the oil shocks in the 1970s. Greece’s and Italy’s public debts were over 100% of GDP even before the crisis hit. Clearly, governments have done a poor job balancing the books, and in the eurozone, all parties have a responsibility to each other not to be overly profligate.

However, most people vote on bread and butter issues, so the real question is: what are the consequences of acceptance or rejection of the treaty? Both sides accept that a Yes vote will mean further cuts to government spending. However, both sides offer wildly divergent views on what a No vote will mean. A number of consequences are possible:

  1. The EU fronts us the money anyway.

Optimists hope that business will continue as usual. The EU will continue to give us the money we need, and a Europe-wide backlash against austerity will mean that by the time our current bailout program ends in 2013, the troika will be willing to advance further cash. This is, to put it mildly, a dangerous assumption.

It has been argued that we are somehow integral to the euro, that the EU simply cannot afford to cut us loose. Two things would seem to contradict this. The first one is the treatment Greece has received following polls suggesting that radical leftists SYRIZA would get into government. SYRIZA has campaigned on much the same platform as the No camp in Ireland, namely that the costs of kicking Greece out of the euro exceed the costs of subsidising Greece’s defiance, so walking away from the bailout would not prevent further funding. However, no sooner did SYRIZA look like winning a plurality than the prospect of a Greek exit from the single currency began to discussed openly by other European leaders. Essentially, Europe sent a very public message out that Greece’s solvency and membership of the euro were contingent upon its acceptance of the bailout conditions.

Talk of a democratic mandate to end austerity is just that, talk. SYRIZA, despite its promises, is not the master of Greece’s destiny, nor was the previous government forcing austerity on the Greek people out of malice. The reality is that Europe’s weakest economies are dependent on money from the stronger ones, and the notion that people can simply vote away the laws of economics is nonsensical. As a result, the only way that Greece could exit austerity in the near future is through the consent of its creditors, and the EU becoming a full-fledged transfer union.

For northern European countries, the logic is simple. Any exception creates a precedent. Allow the Greeks to get away with flouting their bailout conditions, and it would be politically impossible to force austerity on Spain, Italy, Portugal or Ireland. Each country, having seen how Greece’s blackmail worked, would follow suit. While the bill from funding Greece might be bearable, the cost of funding the whole of Europe south of the Alps would not be. Just as politics have forced Francois Holland to adopt a defiant tone on austerity, so too Angela Merkel cannot be seen to back down. Any transfer union would have to have Germany as the paymaster, so what Merkel says, goes. Even former SYRIZA leader Alekos Alvanos admits that SYRIZA cannot keep Greece in the euro and that this should be made clear to the electorate.

The fact is that, while the EU has to respect our right to reject the treaty, we have to respect their right not to advance us any further money if we do so. The backlash against austerity evidenced by the election of Francois Hollande in France and the CDU’s defeat in Nordrein-Westphalia is not an act of European solidarity. Rather, it is a backlash against austerity in those countries. Voters elected Hollande on a mandate to reverse cuts in France, not to advance money to Greece or Ireland. We cannot expect them to give us additional cash to fund our deficit without guarantees that we will balance the books at some point.

  1. We get alternative sources of finance.

Of course, if we reject the Treaty, we won’t have to deal with the consequences immediately. Our current bailout covers the next fifteen months, so we probably have some breathing space (emphasis on “probably”, see below). The imperative, in these supposed fifteen months, is to find someone else to give us money. The most obvious candidates are the IMF and the open market.

The IMF is, at best, a maybe. They’ve invested an awful lot in us, so they may be inclined to throw good money after bad. However, they have repeatedly said that bailing out Europe will only be done in concert with the EU, so it would be a difficult about-face for them to do. In any case, the IMF’s conditions for future aid would hardly be less stringent than the EU’s, so this isn’t going to put the brake on austerity anytime soon.

As for the open market, this is unlikely. While in recent months our bond yields have crept down to more bearable levels, this is largely a consequence of having European backing. If we reject the Treaty, the risk associated with our bonds shoots up, as do the yields, Unless we are prepared to pay double-digit rates of interest on our debt, this is unsustainable. In any case, investors will demand as much if not more strenuous efforts to bring our budget into balance.

There is a final alternative, which is to find another sugar daddy. It hasn’t got a lot of play, but it would in theory be possible to try and persuade one of the Middle Eastern sovereign wealth funds, or China or Russia, to invest in our bonds. However, were this to happen, there would likely be political strings attached, and in any case they would demand guarantees of repayment.

  1. We balance the books

Assuming that we cannot borrow, only one option stands between us and bankruptcy in 2013. We need to bring our budget into immediate balance. This would require a correction of over ten billion euro in one year, far more than any previous budget. The deflationary aspect of this would knock our economy flat, and if we’re voting against the treaty as a blow against austerity, it hardly helps if we need the most austere budget in our history as a result. The situation may never arise, however, because…

  1. We leave the euro

If we vote No, the fear that we may be unable to repay our debt come 2013 will create knock on effects. Irish banks are heavily exposed to government debt, so the fear that we may be insolvent next year could trigger a bank run. In this situation, the Irish government would be called upon to stand behind its 2008 guarantee of depositors, which we can no longer afford to do. The result would be a disorderly default and probable exit from the euro.

For some in the No camp, this would be no bad thing. The large-scale devaluation that would accompany a return to the punt would lower our labour costs, thereby (ceteris paribus) making us a more attractive investment option. The problem with this is that it focuses exclusively on one narrow aspect of a euro exit, and not the bigger picture.

Consider what happens the day we default and return to the punt. The first thing is we can write off our financial system. Our banks have tens of billions of euro worth of exposure to Irish bonds, and can ill afford another write-down in their assets. Even a relatively minor default would destroy our banks. One of the conditions of accepting the bailout was that the troika became the most senior creditor. In other words, they get paid back first in a default, meaning the bulk of the impact would fall on the other creditors, namely our banks, destroying billions of assets in one go. Meanwhile, with the 2008 guarantee now worthless, savers would rush to withdraw cash from the banks and ship it out of the country. In order to preserve any liquidity in the country the government would have to impose capital controls.

Here at least our task is easier than Greece’s would be, particularly if we got British cooperation in sealing off the island to prevent people moving money out of it. However, capital controls would be such a flagrant violation of the EU’s rules on freedom of movement that we might actually be forced out of the EU altogether, destroying whatever advantages we have to foreign investors and grossly outweighing the cheaper operating environment that devaluation would bring about. Even if this wasn’t the case, we would likely face significant sanctions from Brussels.

Meanwhile, we suddenly have to face a hard currency shortage. While it is true that we have a positive current account balance, in certain areas we are dangerously dependent on imports. The most obvious of these is energy. Our electrical grid is overwhelmingly dependent on imported coal, oil and gas, all of which has to be paid with hard currency. It is unlikely that the ESB and Bord Gais’s suppliers will accept punts for payments originally drafted in euro, meaning that the Central Bank’s two billion of foreign reserves would have to be used to finance energy imports. In order to eke out as much utility as possible from this, we can expect both petrol rationing and rolling blackouts. Meanwhile there would be a crash program to reopen our domestic coal sources in Arigna, Wolfhill and Castlecomer, as well as increase peat production. While this would plug some of the gap, it also means we write off any chance of meeting our emissions commitments under the Kyoto Protocol. Other assets such as the Corrib Gas Field or the shale gas under Lough Allen are years from being ready to produce.

Meanwhile, the government would be forced to impose export controls on food. A plunging punt would dramatically increase the nominal revenues to be made by farmers on exports. Irish consumers would be priced out of the market. In order to avoid food shortages, the government would have to take steps to stop produce leaving Ireland. Conversely, their desperation for hard currency might encourage them to make these controls laxer than needs be.

We can, in all likelihood, kiss our reputation as an attractive investment destination goodbye for a few years. Any foreign investors who held assets in Irish banks will have had their fingers badly burned. Our lack of foreign reserves will create a supply chain crisis, constricting our ability to produce the finished goods which constitute most of our exports. The plunging value of the punt will lead to rapid inflation, stoking wage demands from workers who’ve seen the purchasing power of their wages collapse. It is worth remembering that a devaluation of a currency by 25% is the monetary equivalent of a 25% pay cut, which few people would countenance. Meanwhile, we’re going to be in the EU’s bad books, possibly looking at an exit from the single market. Suddenly all our advantages have evaporated.

This isn’t the end of our problems. Defaults are rarely a clean rupture. More than a decade later, Argentina still finds itself on the receiving end of lawsuits from creditors who took a hit in its default. If our country showed any sign of recovery, our burned creditors will swoop in the hope of recovering some of their losses. As a small open economy, the last thing we can afford to do is have outstanding judgements against the country. Meanwhile, there will be a huge morass of contractual disputes, as parties try to settle contracts originally signed for payment in euro. Divorce, as people know, is never as straightforward or amicable as marriage.

Finally, of course, there’s still the question of how to balance the books. Defaulting locks us out the debt market for the foreseeable future. A plunging currency will lead to spiralling inflation, fuelling public demands for wage and welfare hikes. It is likely that the current government would not be able to survive, meaning a more extreme coalition, most likely led by Sinn Fein, would come to power. Faced with a huge budget gap, two options would remain. Either tough it out with austerity measures beyond our wildest fears, or print money to close the gap. Should we plump for the latter, hyperinflation would be an almost certain consequence, which with a new currency would be catastrophic. It is likely that, in this situation, the euro would remain a de facto currency, and the black market would proliferate.

There are sound grounds of principle to oppose the Fiscal Compact. It constrains future governments from dealing with unforeseen eventualities, and stands square in the face of Keynesian macroeconomics. It may well prove unworkable in the long run, and get torn up. But, in the meantime, from an economic standpoint, No simply isn’t an option. To vote No is to gamble on a complete collapse of the treaty, and the consequences of being wrong are immeasurable.

By gregbowler