Japan Is the Next Greece

27. Feb. 2010

We've seen headlines all over asking who is the next Greece? Will Greece take the rest of the PIGS (Spain, Portugal, and Ireland) with it? This may very well happen, but if we are talking about sovereign risk, one should definitely keep an eye out for Japan.

ContrarianEdge has an interesting research piece on Japan. The Japanse budget deficit is growin;

As we know, governments issue debt to fill the budget gaps. Japan's government debt has tripled since the mid-90s and nearly doubled in the last decade:

Since the bubble burst in Japan's stock and real estate markets, Japan's GDP has been stagnant for almost two decades. To spur growth, the Japanese central bank has kept rates low, cut taxes, increased spending and issued debt. This strategy has not been effective to date, as GDP has not reached its previous high. The graph below is clearly "pre-crisis" as Japanese GDP fell over -4% in 2008 and around -1% in 2009.

Japan's debt-to-GDP ratio is the highest among major economies at ~190%. It is fair to note that unlike countries such as Greece and even the United States, only around 10% of Japanese government bonds are held by foreign investors. This should provide some cushion from the events that we have seen in Greece and the eurozone in recent weeks, right? However, the savings rates in Japan have been trending downward. Demographically, Japan is aging and projections have the population shrinking. This is not good for savings or for financing government deficits.

In the past, Japan has been able to contain its debt picture because the interest payments and supply/demand of debt was sustainable. Now Japan faces a future in which this is definitely in question. Government debt sustainability is on course for decline due to demographic factors, which includes secular deterioration in the domestic savings/investment balance. Debt levels continue to rise substantially at the same time that demand for debt in Japan will fall. That is not a good or sustainable formula.

Japan seems to be at the beginning of a debt trap. As its government debt sustainability declines, Japan will be forced to sell its debt load to outside investors, thus requiring it to compete with rates in international markets which are higher. This will drive up rates which will drive up interest expense, which of course further deteriorates sustainability. As expense climbs, the printing press revs up, depreciating the currency. Another option is for the Bank of Japan to intensify a QE program, balloon its balance sheet by purchasing debt.

Either option signals long term weakness in the yen. Frankly put, the yen is toast.
[Seeking Alpha]