Japanese-recovery hopes could be misplaced

Many celebrities are defined by their addictions. Japan's recent history is defined by an addiction to public borrowing, government spending and money printing to resuscitate its moribund economy.

Second-time Prime Minister Shinzo Abe is seeking to increase growth through an additional US$120 billion of public spending and aggressive yen printing by the Bank of Japan (BoJ) to create inflation to reduce the debt to GDP ratio and devalue the yen.

In the post-war period, Japan enjoyed decades of strong economic growth -- around 9.5 per cent per annum between 1955 and 1970 and around 3.8 per cent per annum between 1971 and 1990. This growth was underpinned by a weak yen. In 1985, under the Plaza Accord, Japan was forced to allow the yen to appreciate sharply, resulting in a fall exports and growth.

Subsequent efforts to restore growth resulted in a credit-fuelled stock and real estate bubble, which collapsed in 1990s.

Since the collapse of the Japanese debt bubble in 1989-90, Japanese growth has been sluggish, averaging around 0.8 per cent per annum. Nominal gross domestic product (GDP) is roughly the same as 1992.

Following the collapse of the bubble, policy-makers tried a variety of economic stimulus programs. Japan's budget surplus of 2.4 per cent in 1991 has become a chronic large budget deficit. Japan now spends more than 200 yen for every 100 yen of tax revenue received.

Japanese government gross debt has risen to around 240 per cent of GDP. Net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 135 per cent.

The BoJ has tried unsuccessfully to increase inflation to reduce debt.

Japanese inflation has averaged minus 0.2 per cent in the 2000s, a decline from levels of 2.5 per cent in the 1980s and 1.2 per cent in the 1990s. The policies have failed to restore economic growth, trapping Japan in a period of economic stagnation.

Japan's large pool of savings, a large current account surplus and low interest rates allowed the build-up of government debt.

However, Japan's gross government debt will not be covered by domestic private-sector savings by around 2015, although net government debt will not reach this limit until after 2020. Even before this point is reached, the declining savings rate and increasing drawing on savings by aging households will reduce inflows into Japanese government bonds (JGBs), making domestic funding of the deficit more difficult.

Japan's large portfolio of foreign assets (around US$4 trillion including US$1 trillion U.S. Treasury) will cushion the effects for a time. But even if net income from foreign assets (interest payments, profits and dividends) stays constant, Japan's overall current account may move into deficit as soon as 2015.

As the drawdown on financial assets to finance retirement accelerates, Japan will initially run down its overseas investments.

Unless public finances improve, Japan ultimately will be forced to finance its budget deficit by borrowing overseas.

Where the marginal buyers of JGBs are foreign investors rather than domestic Japanese investors, interest rates may increase, perhaps significantly.

Even at current low interest rates, Japan spends around 25 to 30 per cent of its tax revenues on interest payments.

At higher borrowing costs, Japan's interest payments will be an unsustainable proportion of tax receipts.

Prime Minster Shinzo's policies will provide a short-term lift in economic activity, but is unlikely to create a sustainable recovery.

It will compound the ongoing problem of large budget deficits and government debt levels. The policies do not address the core problems.

Spending on social security accounts and interest expense now totals a major part of government spending.

Increasing health and aged-care costs are expected by 2025 to be around 10 to 12 per cent of GDP. An aging population and shrinking workforce will continue to drive slower growth and lower tax revenues.

Given its large domestic savings and also the ability of the BoJ to further monetize its debt, the status quo can be maintained for a little longer.

But eventually, Japan's toxic combination of weak economic performance, large budget deficits, high and increasing levels of government debt, declining household savings and looming current account deficits may prove unsustainable. Ultimately, Japan may have no option other than a de facto domestic default to reduce its debt to more manageable levels.

Faith in the new LDP government's new 'old' policies may prove a triumph of hope over experience.

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money

Republished from the Winnipeg Free Press print edition February 11, 2013 B6