Japan is the Next Shoe to Drop

The fiscal cliff has been getting most of the media attention these days.  And when not fretting over U.S. political gridlock, investors have turned their attention to Europe.

But the real crisis brewing—and the one that no one seems to notice—is in Japan.  The land of the rising sun is a ticking time bomb, and when it finally blows up it will make all the talk of Eurozone disintegration seem petty by comparison.

Japan is the most heavily-indebted nation in the world with government debts of over 220% of GDP and a gaping budget deficit of nearly 10% of GDP.

To put that in perspective, Greece, Spain and Italy—the European countries most viewed as being at risk of default—have debts equivalent to 160%, 68% and 120% of their respective GDPs.  The United States recently tripped over the 100% mark, but for all of the (completely justified) fretting about out-of-control debt in America, Japan’s debts are more than twice as big.

Once the statistics are released, we will most likely get confirmation that Japan spent a good part of 2012 in recession.  And already, the Japanese government is planning a 1 trillion yen ($12.3 billion) stimulus package to jolt the economy back into growth.

Seriously?  Japan has racked up the biggest debts in modern history trying to stimulate a dead economy, yet it has still been in and out of recession for the better part of the past two decades.  It’s hard to see that extra trillion yen making much of a difference at this point.

I know, I know.  Japan is different.  Unlike America and Europe, most of its debts are held by its own population, so there is little risk of international bond vigilantes punishing the country the same way they’ve punished Europe’s problem children.  Plus, you know the Japanese.  They are conservative and save a high percentage of their income.

If your money manager or financial advisor has told you this, pick up the phone right now and fire him.

I say this in complete seriousness.  Anyone who says something that phenomenally stupid should not be allowed to manage money professionally.  Yet there appear to be plenty of them out there, because the Japanese yen has been pushed sharply higher in recent years by investors who are delusional enough to consider the country a safe haven.

Think I’m being too harsh?

Let’s look at some very simple demographic math.  Those high savings rates we all heard so much about last decade were a product of Japan’s high-income earners in their 40s, 50s and early 60s socking away money for a retirement they knew was quickly approaching.

Well, it came.  Japan is the oldest country in the world with the highest percentage of its population beyond retirement age (roughly a quarter of the population).  And as Japan’s Post-WWII generation drops out of the workforce, they are starting to dip into those savings they spent the last three decades accumulating.  Japan’s savings rate is now just 2% and falling—a far cry from the 44% savings rate it recorded in 1990.  If it has not dipped into negative territory already, rest assured that it will soon. (The OECD estimates that Japan’s savings rate will be 1.9% next year; that may prove to be far too optimisitic.)

Figure 1: Japan Household Savings Rate (2012 and 2013 Forecasted)

2006	2007	2008	2009	2010	2011	2012	2013
1.1	0.9	0.4	2.4	2.1	2.9	1.9	1.9

Source: OECD

The legions of Mrs. Watanabes that Japan has depended on to buy its government debt are no longer saving and investing.  They are living off of their past savings and, given how low interest rates are, are probably going to be selling a good chunk of those bonds in the years ahead to make ends meet.

What then?  What do you expect will happen to Japanese government yields when the Japanese have to turn to the international bond markets for the first time?

They could turn to the Bank of Japan, of course.  And in fact, that is exactly what Shinzo Abe, the probable winner of Japan’s December election, is advocating.  Abe has called for “unlimited” bond buying, and not just in the secondary markets.  He wants the Bank to lend money to the government directly.

We have the pieces in place for a hyperinflationary meltdown.  This may sound impossible given that Japan has had on again / off again deflation for the past two decades, but it is hard to see any other outcome.  As Japan’s borrowing costs inevitably rise, it will have to fund more and more of its budget via the central bank.  And from that point, the path to hyperinflation becomes a slippery slope.

Investors will eventually lose their faith in the Japanese yen.  It is a little shocking to me that they haven’t already.  And when they do, the value of the yen will plummet and the prices that Japan pays for imported products and materials will soar…and will necessitate more money printing.

In Endgame, John Mauldin called Japan a “bug in search of a windshield,” and it’s an apt metaphor.  It’s just a question of when it will splat and what the particular windshield will be.

For now, it’s a waiting game.  When investor sentiment finally turns on Japan, I see it creating an incredible short opportunity in Japanese assets.  If you missed the opportunity in 2008 to short subprime lenders and banks, fear not.  You’ll almost certainly be able to make a bundle shorting the yen, Japanese bonds, and Japanese stocks.

In the meantime, keep an eye on Japanese interest rates.  When you see them starting to rise, you might want to start setting yourself up for the short opportunity of a lifetime.

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