Japan approaching a tipping point

On Tuesday, the Bank of Japan (BoJ) released its first statement for 2013 and the first since Prime Minister Shinzo Abe took power in December.

Two things to note about the release:
1. “Price Stability Target”… read 2% inflation “target” replacing a “goal” of 1%
2. The policy announcement was made jointly with the Government

While both of these points mark a shift in policy, neither are surprising. It has been our expectation for some time that inflationary policy would be pursued as the most politically palatable, allowing for a weaker Yen for exporters and putting the BoJ front and centre as the buyer of Japanese Government Bonds (JGBs).

The inflation target will be sought through an “open-ended asset purchasing method” (i.e. to purchase assets without setting any termination date) under the Asset Purchase Program (APP).

A large part of the APP will be in JGBs, allowing the Government to push ahead with its planned fiscal stimulus. While this is all very interesting, in reality little has changed here, rather a tweaking of an existing policy. We do however expect the BoJ will expand this program, increasing both the magnitude and speed at which it purchases JGBs but not before the Governor of the BoJ is replaced in April 2013.

What is most interesting, is the fact that the BoJ has yielded to pressure from the Abe Government by pursuing an inflation target through monetary easing and done it in a joint press conference for all the world to see. In our view, this formally marks the point where the BoJ loses its independence and the integrity of the currency comes into question.

Be careful what you wish for
Should the Government and the BoJ be successful in achieving this inflation target, we expect that the Nikkei would ontinue to perform well and the Yen to weaken further. But what for JGBs? Until recently, Japan’s domestic banks have been willing buyers of JGBs taking up 45% of bond issuance. Who buys a 10 year bond with a 0.8% yield from the most indebted Government in the world you ask?

The answer, no one in their right mind, but given the deflationary environment in Japan coupled with low credit demand, Japanese banks have sought to park excess deposits in JGBs, earning a neat yield while getting points from regulators toward their capital adequacy requirements. We find it hard to imagine banks holding bonds that yield 0.8% or less in an environment where inflation is at 2% (i.e. a 1.2% loss in real terms).

The other major buyer of JGBs, the Pension & Life Insurance sector (25% of issuance), have already begun to sell down their holdings. As the Japanese population ages, a greater number of citizens begin to draw on pension reserves and Government benefits. This leaves the BoJ to fill the void buying up unwanted Government debt.

Implicit in the agreement between the Government and the BoJ is that the BoJ will continue to monetise Government debt to facilitate future fiscal deficits and allow the rollover of existing debt. In addition, it will do what it can to keep JGB rates stable.

There is no doubt that the BoJ will be successful in keeping rates stable for a time but as the old adage goes, what is unsustainable will not be sustained. While the weak Yen policy will be supportive for Japanese exporters, the inflationary effects will not be so welcome.

Japan is a large importer of food, energy and raw materials and the logical flow on effects of inflation in financial asset markets will further diminish the attractiveness of JGBs. While the narrative seems circular it is more of a death spiral….Central Bank prints money to finance Government debt; inflationary flow on effects cause domestic banks to sell bond holdings in search of more attractive yields which in turn requires further Central Bank action (printing) to soak up excess supply.

Given the sovereign debt picture, raising rates to curb inflation will not be an option for the BoJ. That which was once considered extraordinary monetary policy action has become the new norm.

As highlighted in the chart above, Yen and JGB yields are highly correlated and while JGB rates have only moved modestly, we anticipate a shift higher in the near term. We expect recent Yen weakness to continue and see little in the way to stop a move to 120 and beyond in USDJPY. This is unlikely to win Japan any friends. We are already hearing noises from Korean exporters in response to Japan’s weak Yen policy, just imagine the cacophony with USDJPY at 120!

The consequences of this policy will reach beyond Japan’s domestic economy. We anticipate JGB yields to follow USDJPY higher, it’s at this point that the scenario gets particularly unpleasant for the Japanese Government. Issuing new debt and rolling over existing debt would become very difficult with even a modest increase in bond yields. This is the endgame.

Summary
· Japan’s debt-to-GDP is estimated at 230% in excess of 1 quadrillion Yen (USD12 trillion +).
· Nearly 50% of the Japanese budget is currently consumed servicing this debt.
· The new Government and the BoJ are now actively pursuing debt monetisation and a weak Yen policy.
· This will be broadly positive for the Nikkei and negative for the Yen and Japanese Government Bonds.
· As the Yen depreciates and JGB yields increase, Japan’s debt position will rapidly become unsustainable.

So far the Japan scenario is playing out much as we had anticipated, albeit at a faster pace than even we expected. We see this move as just the start of what will likely play out over the months and years ahead and the Apeiron team will endeavour to keep you updated as further important events unfold.