With the new Greek restructuring deal agreed, the question is whether fears about the sovereign debt crisis will abate or will the markets simply start looking elsewhere for other troubled waters?
In this regard, Japan increasingly looks like the real stand out. A variety of famous investors have come to the conclusion over the past two decades that Japan was on the verge of a major sovereign debt crisis, only to retreat quietly after it becomes clear that domestic deflationary pressures and strong domestic bond demand are continuing to keep Japanese bond yields remarkably low.
Japan has somehow managed to creep by with its problems untouched, or as some of us have described it, seemingly enjoying a “happy depression”. But the fact is that Japan’s outstanding debt to gross domestic product stands at a whopping 230 per cent and makes Greece’s latest 120 per cent by 2020 target seem like a picnic by comparison.
Late last year I repeatedly found myself asking Japanese investors why they were joining the rush to sell 10-year Italian bonds at seven per cent yields when their own 10-year bond yielded one per cent. With the exchange rate against the euro below Y100, shouldn’t they in fact be doing the opposite? Even though Italian yields are now back down to 5.5 per cent and the exchange rate has risen above Y106, it still strikes me as odd that Japanese investors are ignoring such an attractive relative investment.
Some of the investors I spoke to replied that Japan has external surpluses whereas Italy, like the rest of Club Med Europe, has external deficits. They could have said this then, but the argument weakened after Japan reported its first full calendar year trade deficit for decades. Moreover, given high energy prices and the fall in Japan’s industrial competitiveness, such deficits could well persist. It would raise the possibility that Japan’s days as an inveterate current account surplus country are coming to an end.
From a global perspective, this is not a bad thing as it is another sign along of global rebalancing. But it raises the thorny question as to who is going to be the marginal buyer for Japanese bonds? Unless the yen is going to get much weaker and 10-year yields much higher, it seems exceptionally unlikely that there will be international investors.
So what should Japanese policymakers do to avoid a crisis? They need to do two things. In the medium term, Japan has to find a creative strategy to deliver a reduction in its long term debt. It must control public spending better, adapt its tax system, and combine this with a plan to raise its pitiful real growth potential. If the government is not going to encourage mass immigration, it will also need to introduce dramatic service sector reform. Strong productivity gains are essential if the growth rate is to rise beyond that implied by the country’s weak demographic profile. These issues are not dissimilar to those previously ignored by many of the Club Med countries. Now, forced by the crisis, the likes of Greece and Portugal are finally trying to make reforms.
In the nearer term, Japan simply has to announce a Swiss National Bank-style commitment to halting further yen appreciation. The currency’s strength is compounding Japan’s competitiveness problems as many of its leading multinationals struggle to cope with challenges from overseas rivals. Due to Japan’s persistent low inflation, some models suggests that the yen is close to a reasonable level. Other models that adjust for productivity rates suggest something closer to an exchange rate of Y110 against the dollar and Y130 against the euro would be more sensible. This would put it in a better position to deal with the mounting long term challenges. Without that, it looks as though Japan’s “happy depression” of the past 20 years is set to become less happy and more depressed.
The writer is chairman of the asset management division of Goldman Sachs and its former chief economist