How long can Japan sustain its Mount Fuji of debt?

The Japanese economy continues to defy gravity despite a Mount Fuji of debt that has no parallel in Western countries, and the worst problem of demographics among all the world’s rich nations. Japan’s net debt-to-GDP ratio is about 135%, even higher than the Southern European nations when they plunged into crisis. Meanwhile, the World Bank’s figures show one of the world’s lowest fertility rates of 1.39 births per woman, leading to rapid population decline.

The Japanese economy continues to defy gravity despite a Mount Fuji of debt that has no parallel in Western countries, and the worst problem of demographics among all the world’s rich nations. Japan’s net debt-to-GDP ratio is about 135%, even higher than the Southern European nations when they plunged into crisis. Meanwhile, the World Bank’s figures show one of the world’s lowest fertility rates of 1.39 births per woman, leading to rapid population decline. Rising health and pension costs will inevitably pile more pressure onto the indebted state.

[quote] “The combination of these two elements – enormous debt and the demographic time bomb – are totally unsustainable,” said Jean-Pierre Lehmann, a professor at IMD business school and leading expert on Japan, where he lived for many years before becoming Founding Director of the European Institute of Japanese Studies (EIJS) at the Stockholm School of Economics. “There are various possible scenarios from here. The Prime Minister Shinzo Abe is hoping for recovery, which seems increasingly elusive, then there’s the catastrophic crash scenario, which is possible. Finally, there’s the underdevelopment scenario of a long period of decline, which I think is the most likely.” [/quote]

Lehmann says the signs of long-term social deterioration are already there. “I visit Japan a lot and I see more homelessness and poverty than ever before,” he said. “I expect the country’s standard of living to keep on deteriorating, along with the quality of public services and infrastructure.”

The world’s third-biggest economy is teetering on the brink of disaster. The most recent quarterly results showed shrinkage in Japan’s economy by an annualized 6.8% from April through June. Although the Bank of Japan has predicted a rebound in the next quarter, many economists are even more pessimistic than Jean-Pierre Lehmann. They predict a crash for Japan with dire consequences for the global economy.  

Kyle Bass, the founder of Hayman Capital Management, says the next major global crash will be in Japan. Bass’s track record makes him worth listening to. He made hundreds of millions of dollars for his clients by predicting the subprime mortgage meltdown. He says Japan’s bond bubble is so large that once it starts to implode the fear will be contagious.

The distinguished Japanese economist Takeo Hoshi, at Stanford University, published a paper recently in the Economic Policy journal to explain how Japan could avert catastrophe. Hoshi argues that either tax increases of 13%, or budget cuts at the same rate, would ensure stability. Otherwise, he agrees with Professor Lehmann that Japan will face a decline in living standards, as well as inflation and public services cutbacks.

[quote] “Japan is at an economic crossroads. The current fiscal approach – in which its fiscal stimulus precedes any credible plan for fiscal consolidation – runs a serious risk of losing credibility in the world market,” Hoshi said. “Japan has been spending liberally without much success in restoring economic growth.” [/quote]

Japan is unique in that its government bonds continue to enjoy low and stable interest rates despite the fact it has the highest debt-to-gross domestic product ratio among advanced countries. “The most plausible explanation for such an apparent anomaly is that the bonds are predominantly held by the Japanese residents, who are willing to absorb increasing amount of Japanese government bonds (JGB) without requiring high yields,” said Hoshi.

Japanese people hold about 90% of the Government’s debt, yet the yield on the 10-year bond is less than 1%, he says. So, bondholders are making very little money and yet they are willing to hold. This conservative mindset is at the root of Japan’s mysterious economy.

But even if the Japanese people continue to invest savings in government bonds, it would not prevent the country from falling off the fiscal cliff, according to Hoshi. Japan’s looming demographic time bomb will lead inexorably to decline unless the Government acts swiftly.

The demographic issues are worse in Japan than anywhere else. Japan’s population fell by a record 244,000 last year. Already more than 20% of the population are aged 65 and over. Meanwhile, the annual fertility rate of 1.39 babies per woman spells trouble. The Japanese Government estimates that if trends continue, Japan’s population will shrink from its current size of 127 million to 87 million by 2060. Of those 87 million, as many as 40% could be 65 or older.

“Demographics are a concern all over Europe, but Japan has the problem in spades,” said Professor Lehmann. “The Abe government is taking measures to encourage people to have more children, but it will take 20 years to have any impact, assuming it succeeds at all.

[quote] “The Government has promised to close the gap by boosting immigration to 200,000 people a year, but there is deep-rooted resistance in this profoundly chauvinistic nation. There are very few foreigners – around 2% of the population – and they are mainly working in the ‘3D jobs’ – the dirty, dangerous and dull ones.” [/quote]

Even supposing immigration reaches the target of 200,000 a year, Japan’s low birth rate would still cause rapid population decline. If the birth rate stays as it is, Japan would need to admit 650,000 immigrants per year starting in 2015 to stabilize population levels.

Lehmann contrasted the Japanese resistance to outsiders with American openness. [quote] “In the US, they welcome the best minds from all over the world. That’s how they maintain their pre-eminent position. Even in Europe, there are more non-Japanese Asians in senior positions in the UK, Germany and France, than in Japan. And on Japanese university campuses you hardly see any faces of different colours. In the UK, you will regularly see Asian newsreaders, but an Indian newsreader speaking Japanese would cause a mass switch-off in Japan. Societies range along a spectrum from open to closed and Japan is at the very closed end.” [/quote]

For decades, the Japanese economy has defied logic, Hoffmann says. He refers to the famous quotation of economist Simon Kuznets that there are four kinds of economies – “developed, underdeveloped, Japan, and Argentina”. But Japan cannot defy economic logic forever, he says.

The root of the problem lies in a transformation that occurred to the deeply conservative Japanese psyche in the 1980s. When the Japanese were catching up with the West during the 1960s and 1970s, they were flexible in their approach, realizing that they had to emulate more advanced countries. But once the Japanese economy began to be praised as a model for the West in the 1980s, they became arrogant and complacent.

[quote] “They went from humility to hubris,” said Lehmann. “During their period of economic dominance they used to speak about the ‘advanced country disease’ of the Western nations. In other words, they thought that we were arrogant because we assumed we would always be top dogs. At the time, they confidently predicted that Japan’s economy would overtake the US in size by 2004,” he added. [/quote]

But Japan herself started to suffer from ‘advanced country disease’ from the 1980s onwards. “When the Japanese economy started tanking in the 1990s, instead of reforming and adapting, there was a long period of denial when they claimed their model was still working if we just tweaked it here and there. They didn’t recognize that the world had changed. The Japanese were extremely advanced in electronics, but nowhere in IT and they missed that boat. They also totally underestimated the rise of China. They were arrogantly dismissive of the rise of China in the same way the West had once arrogantly dismissed Japan.”

The Japanese economy still has strengths in traditional manufacturing, especially in the automotive, office equipment and camera sectors. But in many respects it has failed to move on. “Anyone suggesting back in the 1990s that Samsung would overtake Sony would have been locked up in madhouse. But the Japanese electronics giants have not been as innovative,” he said.

Neither has Japan developed a globally successful financial sector, such as London’s, which has long sustained the UK economy. “In the 1980s, Japan had some of the biggest banks in the world by assets, but they failed totally. Even Nomura, which acquired parts of Lehmann brothers, has not made any global impact at all,” he said.

Japan has proved its resilience many times in the past. It reformed twice in the mid 19th century and rose in the face of Western imperialism to be a global powerhouse. Later, it emerged from the ashes after World War II. “Within 15 years we were talking about the Japanese economic miracle and at the time of the Tokyo Olympics in 1964 Japan was already very successful. By 1967, it had overtaken Germany in terms of GDP.”

But there is a feeling that Japan cannot keep pulling off these miraculous feats of recovery. Long-term structural weaknesses have not been addressed. One issue is the appallingly low level of English, the lingua franca of the business world. Japan lies behind only North Korea in Asia’s English language league table.

The once vaunted Japanese education system is also failing to produce innovative thinkers. [quote] “There’s still an emphasis on rote learning. It’s one major reason why they have such a conformist and conservative culture. There’s a Japanese saying that the ‘nail which sticks out will be hammered down’. That describes their schools and universities.” [/quote]

Meanwhile, labour laws need addressing. Japan has tried to encourage more flexibility in the workplace, but it remains almost impossible to remove under-performing permanent employees. “The Hitachis and Toshibas have around 40% of their workforces on permanent employment contracts. These employees in their 40s and 50s will be totally unsackable for another 20 years.”

For all these reasons, Lehmann feels recovery is unlikely. “In 1991, when there was a slump, I predicted Japan would bounce back because it always has done, but now I think those days are over. Back then, external forces were to blame for decline. Now the problems are mainly internal,” he said.