We often like to mention Japan as a case to demonstrate that as long as a country has full control over the issuance of their currency, it is impossible for a country to run out of money. If that is too strong a case, at least it is much harder for such a country with full control over their currency to experience a debt crisis, like the peripheral Europe.
Every now and then, there are people in the market suggesting that yields on US Treasury or JGBs cannot stay low for much longer, and “there will be a looming debt crisis very soon”, says _________ [fill in the names yourself]. It turns out that they have indeed stayed low for a long time, especially JGBs.
The chart below from Goldman Sachs shows that 10-year JGB yield has been remarkably low and stable despite the fact that no one seems to think that the fiscal situation of Japan is sustainable.
Source: Goldman Sachs
So yields can stay low for a very long time even with gross government debt to GDP ratio above 200%, as in the case for Japan, but surely yields won’t stay low forever?
Of course it can’t stay low forever. Nothing will stay high or low forever in the market. The problem is the timing JGBs yields will finally rise, or perhaps more importantly, whether that will become a full blown debt crisis like we are seeing in Europe.
A paper by Takeo Hoshi and Takatoshi Ito suggests that perhaps it is near. Hoshi and Ito (2012) suggest that part of the reasons why JGBs yields are so low is because majority of JGBs are held by domestic investors. The chart below from Goldman Sachs illustrates the point.
Source: Goldman Sachs
But they believe it is going to change. They suggest that the amount of JGBs outstanding cannot be larger than the total domestic private sector financial assets, or else domestic investors will not be able to fully fund Japan’s budget deficit, and that day will come in about 10 years time. Likewise, Goldman Sachs suggests that domestic savings will not be able to fully fund Japan’s budget deficit by the end of this decade.
Source: Goldman Sachs
Hoshi and Ito (2012) suggest that from that yields can rise when private sector can’t fully fund government deficits.
We have some doubts.
Instead of thinking about Japan’s low bond yields being supported by domestic investors, we believe it is just a reflection of how slow the economy has been growing (if at all). As Japan has been in a deflationary spiral for a decade or two, so the Bank of Japan has to keep interest rate at zero. This is one of the reasons why US Treasury yields remain low as well, and because both governments (or central banks) have full control of currency issuance (unlike the euro area), it is impossible for these governments to run out of money, at least theoretically.
We also wonder if having domestic savers fully fund the budget deficit such a big deal. In fact, we find it interesting enough that while a lot of people are worried about rising JGBs yields because domestic investors will not buy enough of them, a lot of people are also worried about rising US Treasury yields because foreign investors will not buy enough of them. For the example of the US, which has a much larger proportion of US Treasury securities held by foreigners (like China), and that is because private sector net saving (saving less investment) and government savings were negative, which means that US has to run a trade/current account deficit, and the current account deficit must be offset by capital account surplus. Thus there is demand for US securities, including US Treasury. Should Japan’s private sector saving be unable to fully fund government budget deficit, we suspect that perhaps Japan will run a trade deficit, and that must be offset by capital inflow.
Perhaps Hoshi and Ito (2012) is right that yields can go higher when domestic investors are unable to fund budget deficit fully, but we doubt that would become a debt crisis, or it would be simply that Japanese Yen depreciating or something while nothing disastrous happens.
This article originally appeared here: Japan’s debt ceiling
Also sprach Analyst – World & China Economy, Global Finance, Real Estate
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