MOODY'S: Home truths for Japan
Moody's unwelcome downgrading of Japan's debt may prod the government into finding a lasting solution to its economic woes, say Paul Abrahams and Gillian Tett.
Moody's downgrade was a warning to the government that its attempt to spend its way out of recession might fail, but worse, that it could damage both the Japanese economy and global markets.
The danger is that the huge volume of additional net Japanese government bond issues - by one estimate ¥52,000bn ($436bn) will be issued this year and next - could prick the bubble in bond prices that has appeared to defy economic logic this year. Such a correction would have calamitous consequences for Japan's already troubled banks, which are big holders of bonds, and could send shock waves through the world's financial markets.
The possibility of a crash in Japanese bonds may appear perverse, given that they seem so strong that the government can sell them cheaply. Last night, despite Moody's warning, the yield on the 203rd 10-year benchmark bond closed at 0.86 per cent, almost unchanged. That is not far from its world record low that was reached earlier this year despite the deterioration in government finances. By traditional measures, that would indicate the market believes the Japanese government is not only the most creditworthy in the world, but the most creditworthy in the history of the world.
But this yield is deceptive because the Japanese government bond market is distorted by official intervention. Last year, government institutions such as the Trust Fund Bureau and the Bank of Japan bought 78 per cent of net supply, leaving only 22 per cent to private investors. Tim Bond, director of interest rate strategy at Barclays Capital, argues that this is essentially a conjuring trick that allowed almost all of last year's increase in government debt to be financed by the government itself.
Until now Japanese policymakers have tackled their economic crisis by throwing money at the problem. Nomura Securities estimates that since 1992 the government has announced packages worth an amazing ¥85,000bn ($714bn), even before the latest ¥24,000bn offering. Not only is the government injecting huge sums into infrastructure projects and the banking system, but most recently it has indicated it wants to start providing support to troubled industrial groups such as Nissan, the automotive company. The assumption has been that the government will continue implementing ever larger stimulus schemes until there is a recovery. That assumption may no longer be valid.
The problem is a growing imbalance in the supply and demand of government debt. The central government must finance its extra requirements largely by issuing bonds. This is partly because recession has badly dented tax revenues - in the six months to September they fell year-on-year by 11 per cent - and partly because it is unwilling to print money in huge quantities. That leaves the government with no alternative but to issue debt.
By any standards the prospective issuance figures look alarming. The government's initial budget plans for fiscal 1998, for example, envisaged ¥64,000bn of total bond issuance, or net issuance of around ¥22,000bn after redemptions. Kiichi Miyazawa, finance minister, hinted this week that an additional ¥10,000bn to ¥15,000bn of issues would be made this year.
For 1998, the total amount appears manageable. But the government is also committed to making net issues of ¥26,000bn next year. And if, as expected, it pushed some 1998 issues into 1999, then total bond issuance next year could rise to some 35 per of general account revenues, argues Nomura Research. This would be the highest figure on record - and push the budget deficit to the startling level of 10 per cent of gross domestic product. It is already higher than Italy and the US.
And this is happening just as investors' appetite for bonds may be waning. The same economic logic which led to the Moody's downgrade is also triggering an unusual rebellion in parts of the government itself. Most investors assume that the Ministry of Finance's Trust Fund Bureau can be bullied into buying any spare government bonds by using money from the state-owned postal savings system. Indeed, it has already absorbed some ¥13,000bn of the issuance this year, while the Post Office itself has bought ¥5,000bn.
But the bureau and the Post Office are now privately warning the government they it cannot be relied on to absorb the additional bonds. About 45 per cent of Post Office deposits are likely to be withdrawn in 2000 and 2001 because high-yielding 10-year accounts created around 1990 are due to mature.
Demand for Japanese government bonds from other investors, such as life insurance companies, is also likely to decline because they are becoming more sensitive to risk and return. "We can't ignore things like Moody's any more," confesses a portfolio manager at one of Japan's largest brokers. Nor can they ignore the difference in the yield on long-term Japanese bonds (0.8 per cent) and US treasuries (5.5 per cent). The danger is that Japanese investors, tempted by such returns, could take their money overseas on a huge scale, shrinking the domestic savings pool, threatening the country's foreign exchange reserves and putting upward pressure on domestic interest rates at a time of deep recession.
The implications are extremely serious. The debt ratings of some of Japan's strongest companies, such as Toyota and NTT, were automatically downgraded yesterday because companies cannot have a higher rating than their country's sovereign debt. Many of Japan's industrial companies are in no position to endure an increase in their cost of borrowing.
As for the financial system, a bond crash would be disastrous. Goldman Sachs estimates that the bond weighting in banks' portfolios rose to 26 per cent by 1994, the last year for which there are data. Analysts believe the proportion has increased since then. Even a small correction would hurt bank profits badly - and the banks are in dreadful shape as it is.
For the moment the risks of a bond market crash remain a medium-term threat, rather than an immediate one. As Standard & Poor's, another US rating agency, argues, Japan has massive foreign exchange reserves ($205bn) and is the world's largest creditor nation. It also points out that on a narrow definition of net debt, Japan, with 40 per cent of gross domestic product, is below the German level and comparable to the US and UK, which all have top-notch ratings (though a wider definition gives a much more alarming figure). Few analysts are predicting an imminent correction and massive capital flight.
All the same, the difference between Japan and rest of Asia during the region's economic crisis has been that Japan has had endless supplies of money. Moody's unwelcome announcement yesterday is one of the first signs that in fact funds may not be unlimited. If that forces the government to abandon its approach so far - largely that of muddling through with ever-larger fiscal promises - then Moody's "insult" would have done the country a service.
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