Friday, January 31, 2014

Why the Japanese Debt Doesn't Affect the Yen

There is a pretty dreadful argument going around that the Japanese Yen will go to zero like Zimbabwe's currency recently. The reason is the crippling Japanese government debt. Right now that debt is running at over 200% of GDP. The argument can certainly get attention and makes great headlines. But the facts fly in the face of this, at least in the short term.

Japan has struggled with deflation — not inflation — for more than a decade. Deflation is a dreadful situation that governments try to avoid at all costs. An infamous example of deflation was the Great Depression. Also, the puny rates on Japanese bonds shows that the market doesn't remotely believe in a bond default.

Japan recently summoned the political will to take drastic measures against deflation. This is called Abenomics. But removing deflation is like pushing a huge boulder up a hill. If you let up for just a bit, the gains are undone. But the Yen detractors say pushing inflation is difficult only now. Wait till they get inflation going, then it is game over. Inflation will go on forever. See figure below.

The detractors even know where is the hump in the figure. It will be the point when annual tax revenues cannot pay for the annual interest. They say we aren't at that hump only because the Japanese government can finance this debt with unusually low interest rates. And this rate will rise. I will spare you the details of why interest rates will rise. But based on this theory, people like Kyle Bass have setup funds that bet against the Yen, Japanese bond rates and the Japanese economy as a whole.

But I am very skeptical of this argument because the reality does not match the theory, at least in the short term.  It reminds me of people who believe in the efficient market theory. EMT all makes sense because as information and capital is more readily available, stocks should be less volatile. But crash after crash in the last two decades simply flies in the face of this argument.

At the extreme, why is the tipping point when the interest rate equals the tax revenue? Even when that happens, in theory the Bank of Japan can still print more money to pay the interest. Yes, it's a giant Ponzi scheme, but governments can do that with their own currency.  Also, the bond purchasers are overwhelming Japanese, so this is an internal issue of Japanese owing Japanese. If the debt is a problem, it will show up when the Japanese cannot fulfill their obligations to their old and needy. That's a very gradual process.

In the global markets, Japan bond holders won't dump their bonds for other country's bonds. The world wants Japanese goods, so demand for Yen is healthy. And even if there is a small amount of flight from the Yen, Japan has $1.3 trillion USD in foreign exchange. Nobody thinks there will be a run on the Yen. For evidence of this, simply look at what happened last week. When the world became pessimistic about emerging markets, investors converted their capital to Yen, causing the Yen to appreciate. This is market reality!

I believe a prolonged Yen decline will be caused by structural problems of the Japanese economy. The very things that Abenomics is trying to fix. The Japanese, with the dwindling population, must fix their inefficient industries, such as agriculture. When and if that happens, I think they will recover from prolonged deflation and their malaise. In the meantime, the markets think the Yen is a safe haven that is only matched in size and safety by the Euro and USD.

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