The End Game for Japan?

by Ambrose Evans-Pritchard
May 16, 2016

Lake Como, Italy. Japan is heading for a full-blown solvency crisis as the country runs out of local investors and may ultimately be forced to inflate away its debt in a desperate end-game, one of the world’s most influential economists has warned.

Olivier Blanchard, former chief economist at the International Monetary Fund, said zero interest rates have disguised the underlying danger posed by Japan’s public debt, likely to reach 250% of GDP this year and spiraling upwards on an unsustainable trajectory.

Speaking Monday (4/11) at the Ambrosetti Forum of world policy-makers on Lake Como, he said, “To our surprise, Japanese retirees have been willing to hold government debt at zero rates, but the marginal investor will soon not be a Japanese retiree.”

Prof. Blanchard said the Japanese treasury will have to tap foreign funds to plug the gap and this will prove far more costly, threatening to bring the long-feared funding crisis to a head.

“If and when US hedge funds become the marginal Japanese debt, they are going to ask for a substantial spread,” he told me.

Analysts say this would transform the country’s debt dynamics and kill the illusion of solvency, possibly in a sudden, non-linear fashion.

Prof. Blanchard, now at the Peterson Institute in Washington, said the Bank of Japan will come under mounting political pressure to fund the budget directly, at which point the country risks lurching from deflation to an inflationary denouement.

“One day the BoJ may well get a call from the finance ministry saying please think about us – it is a life or death question – and keep rates at zero for a bit longer,” he said.  “The risk of fiscal dominance, leading eventually to high inflation, is definitely present.”

Arguably, this is already starting to happen. The BoJ is  soaking up the entire budget deficit under Governor Haruhiko Kuroda as  he pursues quantitative easing a l’outrance (to the limit).

The central bank owned 34.5% of the Japanese government bond market as of February, and this is expected to reach 50% by 2017.

Japanese officials admit privately that a key purpose of ‘Abenomics’ is to soak up the debt and avert a funding crisis as the big pension funds and life insurers retreat from the market. The other unstated goal is to raise nominal GDP growth to 5% in order to ‘bend down’ the trajectory of the debt ratio, a task easier said than done.

Prof. Blanchard did not elaborate on the implications of Japan’s woes for the global financial system, but they would surely be dramatic. Japan is still the world’s third largest economy by far. It is also the global laboratory for an ageing crisis that the rest of us will face to varying degrees.

Once markets begin to suspect that Tokyo is deliberately engineering an escape from its $10 trillion public debt trap by means of an inflationary ‘stealth default’, matters could spin out of control quickly.

It might lead to an abrupt reappraisal of sovereign debt risk in other parts of the world, especially in Europe with its own Japanese pathologies of low-growth and bad demographics.

Prof. Blanchard said the risk for the eurozone is the election of populist “rogue governments” that let rip with spending in defiance of Brussels. “Investors would have serious thoughts about buying their sovereign bonds,” he said.

The European Central Bank would be legally prohibited from activating its back-stop mechanism (OMT) to prevent yields soaring since these governments would not be in compliance with EU rules. “Some of them have very high debt and presumably would have to default,” he said.

He refused to single out candidates. One of them is clearly Portugal, where a Socialist government backed by Communists and the Left Bloc has already been in a fiscal fight with Brussels. Last year’s deficit was 4.2% of GDP, far from the original target of 2.7%.

Portugal’s public debt is 129% of GDP, near the danger line for a country with no lender of last resort. Spreads on its 10-year bond yields have jumped to 325 basis points over German Bunds.

Spain is also pushing its luck on fiscal policy. Italy faces a banking crisis and its anemic economic recovery is losing speed. Rome has cut its growth forecast to 1.2% this year, too little to make a dent on a debt ratio still stuck at 132.7% of GDP.

The worry is what will happen in the next global downturn – or when the effects of cheap oil and quantitative easing fade – given that public finances are already so stretched.

One thing he is not worried about is running out of monetary ammunition. “There is an argument that QE actually becomes more effective, the more you use it,” he said.

As a central bank buys more bonds, the more it has to pay to convince the last hold-outs to sell their holdings. “The effect on the price plausibly becomes stronger and stronger,” he said.

Prof. Blanchard said the authorities should stick to plain vanilla QE rather than experimenting with “exotic stuff.”  He waved aside talk of ‘helicopter money’ with contempt, calling it nothing more than a fiscal expansion by other means. It makes little difference whether spending is paid for with money or bonds when interest rates are zero.

He said negative interest rates – or NIRP – have complex side-effects and damage the banks, which can’t pass on the rates to depositors. “Banks are already in enough trouble without adding this one,” he said.

Professor Blanchard refuses to join the apocalyptic chorus on Brexit but advises the British people to enter these uncharted waters with open eyes. Divorce will not be a short shock followed by swift recovery.

“The cost of Britain exiting the EU will not be seamless, and the uncertainty will last for a very long time afterwards.  Firms deciding whether to locate plant in the UK or in the Continent will wait. Investment will drop,” he said.

But the sky will not fall for the Gilts market. “Will financing be more difficult after Brexit? Will investors see the British government as more risky? I don’t think so,” he said.

Prof. Blanchard has been one of the world’s top theoretical economists over the last quarter century and might have won the Nobel Prize by now if he had not been cajoled into IMF service by his fellow Frenchman, Dominique Strauss-Kahn.

He transformed the IMF into a brain-trust of progressive ‘Keynesian’ thinking – or strictly speaking the MIT school of New Keynesian and Neoclassical Synthesis – much to the fury of Berlin. A leaked document from the German finance ministry said the institution should be renamed the ‘Inflation Maximizing Fund’.

Professor Blanchard has had the last laugh on that joke. Seven years after the Lehman crisis the eurozone is in outright deflation and yields on 10-year German Bunds are trading at an historic low 0.11%.  Touché.

 

— Ambrose Evans-Pritchard is the International Business Editor of the London Telegraph. This article is republished with permission of To The Point News.