What Blows Up First? Part 2: Japan
Of all the crazy financial stories of the past year, Japan's might be the craziest. To recap:
For two decades, successive Japanese governments have fought the deflationary effects of bursting real estate and stock bubbles with ever-larger public works programs. These prevented the collapse of the country's zombie banks and construction firms but didn't produce the kind of growth necessary to bring the zombies back to life. The sustained deficit spending did, however, produce a public debt that as a percentage of GDP dwarfs even those of the US and Europe.
So in 2013 incoming Prime Minister Shinzo Abe demanded that the Bank of Japan inject enough credit into the banking system to produce at least 2% inflation. The bank acquiesced and in the space of less than a year more than doubled the size of its balance sheet by buying bonds on the open market with newly-created currency.
Now here's where it gets strange. While this massive debt monetization program was ramping up, Abe and company began to worry about their ongoing deficits. So they raised the national sales tax to 10% in order to generate more revenue. But of course higher consumption taxes are deflationary, thus counteracting the Bank of Japan's inflationary debt monetization.
So the government then decided to aggressively increase public works and military spending, which means it will henceforth take in more money and spend nearly all of it, leaving the country with unsustainably-high deficits and a bigger, more intrusive government. In other words, a lot of effort has been expended to no real purpose, while the debt keeps mounting and government officials keep saying ever-more-senseless things to obscure the above facts. See this, from late December:
Japan unveiled a record budget for the next fiscal year, as Prime Minister Shinzo Abe boosts spending on social security, defense and public works while trying to contain the growth of the world's biggest debt burden.
Government ministers and the ruling coalition adopted the 95.88 trillion yen ($921 billion) budget proposal for the fiscal year starting April 1 at a meeting yesterday in Tokyo, Finance Minister Taro Aso told reporters. Japan will issue 41.25 trillion yen of new revenue bonds, Aso said, less than the 42.9 trillion yen earmarked in this year's initial budget.
Abe aims to pull the country out of a 15-year deflationary malaise and cope with the rising welfare costs of its aging population, while containing public debt that's more than twice the size of the economy. His government has pledged to halve the primary balance deficit by fiscal 2015 and achieve a surplus by fiscal 2020.
"The government needs to show that it's moving in the right direction on fiscal discipline but this budget lacks punch," said Yoshimasa Maruyama, chief economist at Itochu Corp. in Tokyo. "The government must cut spending to reach the planned target of a surplus in 2020."
The government "will simultaneously achieve the revitalization of the economy and fiscal consolidation," Abe said yesterday at the meeting of government ministers and the ruling coalition, adding that the budget draft will be submitted to Parliament in the new year for debate.
Japan's growth slowed for a second straight quarter in July-September, as the initial impulse of Abe's reflationary policies, dubbed Abenomics, started to fade. While an increase in the sales tax in April will boost revenue, enabling the government to check bond issuance, it is forecast to push the economy into contraction, adding headwinds to Abe's efforts to drive sustained recovery in the world's third-biggest economy.
Revenue from bond sales will pay for 43 percent of next year's budget, down from 46.3 percent this year, according to draft budget documents obtained yesterday by Bloomberg News from a government official. Debt-servicing costs -- including interest payments for outstanding bond issuance -- will rise to 23.3 trillion yen from 22.2 trillion yen this year, the documents show.
Japan's primary balance deficit will improve by 5.2 trillion yen next year, Aso said, with tax revenue estimated to rise to 50 trillion yen. This compares with 43 trillion yen estimated for this year's initial budget.
In addition to the sales-levy bump, higher company tax payments as corporate profits rise will also help lift revenue. The sales tax will be increased to 8 percent from the current 5 percent from April 1, and the government plans to increase it again to 10 percent in 2015.
Social security spending will rise to 30.5 trillion yen next fiscal year, compared with 29.1 trillion yen this year, the draft budget documents show. The increase comes as the nation's aging population boosts costs for welfare and pensions.
Public works spending will rise by 680 billion yen to 5.96 trillion yen, and the defense budget will rise by 130 billion yen to 4.88 trillion yen, according to the documents.
Real gross domestic product will grow 1.4% in the year starting in April, according to the documents, which show nominal GDP growing 3.3% to 500.4 trillion yen.
The above article tosses around a lot of alarming numbers. But the two that stand out are:
"Revenue from bond sales will pay for 43 percent of next year's budget, down from 46.3 percent this year..." This means that, far from reining in its excesses, the government will again borrow nearly half of its budget. This would be the equivalent of the US borrowing $1.5 trillion, something that would not be considered progress by most observers outside of the New York Times' editorial department.
"Debt-servicing costs -- including interest payments for outstanding bond issuance -- will rise to 23.3 trillion yen from 22.2 trillion yen this year..." That comes to about a fourth of Japan's federal budget, and is rising.
The dilemma is clear: Japan has to keep spending to satisfy its growing population of retirees, offset the effects of higher taxes and counter China's military build-up. And a big part of that spending has to be borrowed. But government debt of 220% of GDP and interest expense at 24% of the budget is already way too much, so the systemic implosion is just a matter of people figuring this out. And that could be triggered in 2014 by lots of things, including a slight uptick in interest rates that sends interest expense above the psychologically-important level of 25% of the budget, a confrontation with China over the islands they both claim, or a slowdown in a major export market like Europe.
The result: a sudden loss of confidence in the yen and/or the Nikkei that raises Japanese borrowing costs and forces the government to sell some of its Treasury bonds, thus exporting its crisis to the rest of the world.