Fig 1: Ratio of Old Aged Population to Working Age Population
Both a declining population and an increasing ratio of old aged people to working age people implies that Japan's savings pool will soon decline, removing one of the fundamental supports to the yen and reducing downward pressure on yields as demand for Japanese Government Bonds (JGBs) fall. Micro evidence already suggests that the aged in Japan are saving less once retired and in fact Japan's household saving rate has actually been in steady decline since 1985. It stood at only 2.2 per cent by the end of 2007 and the IMF estimate that the saving rate will decline further. Even if the household saving rate holds steady at 2.2 per cent, simulations project that public debt will exceed household financial assets by 2015.
Fig 2: Japan’s Household Saving Rate
The consequences
With Japan's domestic absorptive capacity for debt likely to decline over the medium term, the country will inevitably become more reliant on foreign investors. However, how tempted will foreign investors be in helping finance the Japanese government when its fiscal finances are the most stretched within the G20, the yen is far from cheap and the compensation for doing so is so low (10 year JGBs yield just 1.2 per cent)? Alternatively, the central bank could once more switch on the printing presses.
Either way, surely the yen must weaken and yields must rise? The problem is that both could trigger a damaging chain reaction. A weakening yen could cause Japanese households to shift their financial assets abroad; putting further downward pressure on the currency as well as upward pressure on yields.
The majority of Japan's government debt is short dated. The consequence of this is that Japan's debt servicing burden is highly sensitive to yields and the country is very much exposed to a funding crisis. Approximately 18 per cent of tax revenues are already used to pay interest on the national debt , and this is despite interest rates being at rock bottom levels.
Fig 5: Japan’s Debt Maturity Profile
Little room for maneuver
Unfortunately it is very difficult to quickly alter a country's fiscal position and Japan’s starting position is particularly bad. Its primary budget deficit (ie deficit excluding interest payments) is forecast to be around 8 per cent in 2011 . This compares with Greece at 5.3 per cent. To give an indication as to the scale of the fiscal adjustment required, it is calculated that the country would need to run a primary budget surplus of 4.5 per cent over the next 20 years just to stabilise the country's public debt to GDP ratio at 2007 levels. It is not even as though Japan had low levels of debt in 2007; the ratio already stood at 167 per cent.
Whilst a declining population means that the strain on government expenditure decreases, this is mostly offset by the onerous demographic changes that the country will experience as its spending commitment per person will increase - the result of higher age related expenditure. Further, it also means that the tax base from which revenue can be raised will also decline. In other words, Japan has built up a national debt pile at close the peak of its population which it will then have to address from a shrinking tax base.
Strong GDP growth would be helpful for Japan; however a declining population means that it is difficult to see where GDP growth will come from. Although an aging population could potentially be positive for GDP as retirees increase consumption, it is also potentially inflationary. In the absence of extraordinary productivity gains the economy could struggle to satisfy any increased demand from what would be a declining production base. This could also lead to deterioration in the country's external balance as imports increase in order to satisfy this extra demand that cannot be met from domestic production, further undermining the currency's perceived strength.
One also has to question whether the expansionary fiscal policy that Japan has embarked on for so long has had long lasting damaging effects on the economy's productive potential and the functioning of its private markets.
Only time will tell
Some would argue that it is more appropriate to look at the whole situation from a net public debt perspective. To this I would make the following points.
Firstly, the numbers are still alarming, with net public debt projected to reach 140 per cent by 2014.
Secondly, I would point out that both the gross and net public debt figures published don't include off-balance sheet liabilities such as increased future social security and healthcare related costs which could well be substantial.
Thirdly, gross public debt is also the figure that dictates the country's interest expense and thus the affordability and sustainability of the fiscal situation. Whilst the net public debt figure is much smaller, many of the financial assets held indirectly by the government is JGBs through its government agencies and pension funds.
At the very least I find it difficult to form a bullish case for Japanese bonds or the yen.
The views expressed are those of Midas Capital Partners at the time of writing, are subject to change without notice and do not constitute investment advice. This article is directed at investment professionals only and should not be relied upon by private investors.
Whilst Midas Capital Partners has used all reasonable efforts to ensure the accuracy of the information contained in this article, we can not guarantee the reliability, completeness or accuracy of such information.