Five Things You Need To Know About Japan’s Debt Crisis

japan tsunami

The earthquake and tsunami that struck Japan (NYSE:EWJ) on Friday has caused tragic devastation to lives and property, but Japan may soon be over-whelmed by a debt crisis tsunami of epic proportions.

With crony deficit spending by the Japanese government having destroyed its economy over the last two decades; Japan now has a real national crisis that will force the government to engage in massive deficit spending.

There is a strong risk of a financial melt-down in the world’s most indebted nation.

After the credit-induced boom in the late 1980s, Japan’s high rate of growth stumbled and bank loan defaults sky-rocketed. Over the last twenty years, asset prices are down by 65% for the Nikkei stock index, 50% for residential real estate, and 70% for commercial real estate. The centrally planned Japanese government responded to this crisis of falling asset values with wave after wave of colossal deficit spending stimulus. Japan’s public debt rose from virtually nothing to 225% of gross domestic product, but the economy has remained stagnant.

Japan is sitting on central government debt approaching one quadrillion (one thousand trillion) Yen and central government revenues are approx ¥48 trillion. Their ratio of central government debt to revenue is a fatal 20x.

Both Japan and the USA need interest rates to stay low to fund their enormous deficits. According to J. Kyle Bass’ Hayman Capital, every 100 basis point change in the weighted-average cost of capital (interest rates) is roughly equal to 25% of Japan’s central government’s tax revenue.

Put another way, a 200 basis point move higher over time in Japan’s interest rates will increase their interest expense by more than ¥20 trillion. If Japan had to borrow at France’s rates (a AAA-rated member of the U.N. Security Council), the interest burden alone would bankrupt the island nation.

Japan has engaged in about the same level of 7% deficit spending as the US has averaged for the last two years, except Japan has sustained this level of spending for the last twenty years. Normally, heavy deficit spending quickly exhausts a nation’s internal markets to buy its own debt and the country is forced to auction bonds at higher and higher interest rates to outsiders; which also increases the costs of the debt and forces the nation to sell even more debt. At some point the country becomes so indebted that credit agencies downgrade the country’s quality rating to junk, foreigners refuse to buy new debt, and the country defaults. Japan has avoided this deficit financing end-game, because the nation has been able to finance 95% of its debt at home. Over the last year Greece with a third less and Ireland with less than half the debt to GDP ratio of Japan, imploded when foreigners refused to invest.

In the USA we’re not that far behind. According to Congressional Budget Office data, every one percentage point move in the weighted-average cost of capital at the end of the day will cost the US $142 billion annually in interest alone. A move back to 5% short rates will increase annual US interest expense by approx $700 billion annually vs. current US government revenues of $2.228 trillion.

As deficit spending has remained extraordinarily high for such a long period, Japan has maintained a 41% corporate tax rate; the highest in the world, 10% above the US and Europe and triple the fast growing Asian economies of Taiwan and Singapore. This has made Japan an unattractive location for private investment. The complete lack job security for young workers who can only find temporary employment has made life difficult for new families and caused the birth rate for Japanese women to be cut in half. Lower family formation has caused the household savings rate for the thrifty Japanese to fall from 5% at the end of the 1990’s to just above 2% currently.

Japan has maintained current-account surplus and has been sending more than 3% of its GDP abroad, providing more than $175 billion of funds this year for other countries to borrow. This paradox of a stunningly indebted nation financing the world is explained by a combination of high corporate saving and low levels of residential and non-residential fixed investment due to poor investment opportunities in Japan. That money is gone after this crisis. Millions of Japanese savers are about to start spending their savings on essentials, since they have lost their jobs and businesses due to the damage. Tokyo Electric Power Company will suffer losses of over $100 billion from its Fukushima Daiichi nuclear power plant melt-down and most of Japan’s northern corporate facilities that hug the eastern coastline have been destroyed or incapacitated. Japan averages one earthquake every four minutes, but Friday’s quake and tsunami were both the largest in the history of the country. Earthquake insurance in Japan is very expensive and only 10% of homeowners buy coverage. Therefore, the Japanese government will be on the hook for several hundred billion in infrastructure and reconstruction costs.

Many naive analysts are commenting about how this natural disaster will be good for the Japanese economy, because of the substantial rebuilding program. That might have been true if Japan was not already on the verge of a man-made debt disaster prior to this natural disaster. Standard & Poor’s credit rating service (NYSE:MHP) had just downgraded Japan’s sovereign debt to AA- in mid-January. The huge increase in the costs for welfare and unemployment payments, the economic disruption, the scale of the devastation, the lack of insurance and the minimum five years to rebuild the country may take Japan’s credit rating down to “junk bond” levels. The earthquake and tsunami that have devastated Japan came with quickly and violently. The debt crisis tsunami has been building for twenty years and may be much more devastating to the future of Japan (NYSE:EWJ).

This post originally appeared at Wall St. Cheat Sheet.

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