Japan's rising financing risks: James Saft

Thu Jan 26, 2012 1:17pm EST

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(Reuters) - Japan's financial profile is looking more and more like that of a retired person who spends more than he produces and who relies on investment income to fill the gap.

With the recent swing to a negative balance of trade, overseas investment income is now all that is keeping Japan from relying on foreigners to fund its current account deficit.

Relying on investments is a strategy that works for the elderly because eventually, well, they die, but for a country, much less one that is highly dependent on the good will of bond markets, this implies real and growing risk.

Japan recorded a 2.49 trillion yen ($32 billion) trade deficit for 2011, the first such in 31 years, as rising energy import costs combined with production shocks from last year's natural disaster and weak demand in Europe. December's trade balance showed the ninth straight seasonally adjusted monthly deficit, a worse run than in the wake of the failure of Lehman Brothers.

While demand for Japanese products might grow, depending on your view of global economic growth, what isn't going to change any time soon is Japan's need to import oil and natural gas to keep the lights on. Japan has cut back massively on nuclear power electricity production, which now accounts for only about 8.0 percent of supply, down from a third before the Fukushima disaster. At the same time the greying of Japan limits the scope for growth.

Endowed with few natural resources, Japan for decades relied on a strategy of exports, but a strong yen and competition from abroad have cut into its market share, leaving it vulnerable.

Years of high savings rates have left it with a huge overseas investment portfolio which now produces enough income to keep its current account positive despite its deteriorating trade figures.

That massive wealth is a bulwark, but unlike a well-off partially-retired doctor, Japan's government has been spending massively more than it takes in and making up the shortfall not from investment income but by borrowing money.

In the coming Japanese fiscal year, the country will for the fourth year in a row take in more revenues from selling bonds than from taxes and all other sources combined.

That has helped to take its net debt-to-GDP ratio above 130 percent last year, a number exceeded only by Greece among developed countries, according to IMF data.

FINANCING SQUEEZE?

It is not hard to look at things on that basis and conclude that Japan faces a real and growing risk of finding itself in an ugly financing squeeze. It is also hard to work out exactly how much stimulative spending Japan will need to help it overcome its demographic ills. It will be a long time until any baby boom, of which there is no sign, will goose growth.

Unlike Greece, or the U.S. for that matter, Japan has the advantage of being its own principal creditor, with nearly 95 percent of its government debt owned domestically. That means Japan can hold out for a long time, if its investor base, as they traditionally have, play along and if it can keep its foreign accounts in balance.

If for whatever reason Japan begins to run a current account deficit - essentially the tally of its trade and investment figures taken together - look out. Then regardless of who owns the stock of Japanese government debt, and even almost regardless of what they do with that stock, each marginal additional dollar of financing has to come from an overseas investor.

Those foreign investors could, as in Greece, start to demand more to buy Japanese debt, and with gross public debt twice the size of its economy the math gets ugly quickly.

At current very low interest rates - 10-year government bonds yield a paltry 1.0 percent - Japan has ample room for maneuver. Take that rate to 2.0 percent and Japan's annual interest bill doubles.

Other than demographically, Japan's situation compares favorably in many ways to the U.S. which has had a current account deficit for years and relies on foreign money for financing.

And unlike Greece, Japan has its own currency and its own central bank, leaving it with a nuclear option of money printing in response to a debt buyers' strike.

The threat of monetization is hardly one that will help keep domestic and international investors reassured.

To stave off crisis, Japan must increase exports, cut imports or earn more through its overseas investments. None of these options is easy or obvious over the medium term, especially given Japan's demographic headwinds.

No one, Japan least, wants to go there. Both a financing crisis and the likely official response imply huge political and financial system risk, with highly unpredictable results.

Japan likely can remain unsustainable longer than many of those now betting against it can stay solvent, but though that may be a long time, it is not forever.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on )

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