Japan has no problem with demand for its bonds – the Bank of Japan is buying plenty and there’s tons of demand via domestic savings – but it may be approaching a supply shock if Japanese politicians can’t figure out how to get deficit legislation passed.That’s the gist of a warning today from BofA Merrill Lynch strategist Brooks Thompson, who sent a note to clients this morning with the title: Did You Know Japan’s Fiscal Cliff is Right Around the Corner?
Here are Thompson’s thoughts on the conflict:
The current political stalemate has delayed legislation to finance the budget and Japan’s coffers are expected to run-out by end of November, which would lead to technical default. I don’t want to overly exaggerate, but I’d say this is a much more current and (somewhat) serious reality than the BOJ buying foreign bonds.
There are a lot of interests or inquiries regarding foreign bond buying by the BOJ, but I have not heard one inquiry about Japan being on the brink of default. We’re not talking about 3yrs, 5yrs or 10yrs from now, this could technically happen as early as December. Of course no one believes that Japanese politicians would actually allow the country to default, but just as the fiscal cliff in the U.S. is a reality, the political stalemate in Japan makes this unthinkable possibility a bit of a reality.
Thompson explains that Japan finances around 40 per cent of its annual budget by issuing new government debt. Every year, in Japan’s own version of the debt ceiling, the Japanese parliament has to vote on an extension of the laws that allow the Ministry of Finance to issue bonds.
If they don’t, Japan faces its own fiscal cliff. And Thompson says that if Japan can’t pass legislation approving additional bond sales by the end of November, when the government is expected to run out of cash, then the Ministry of Finance “may be forced to cancel the 2yr auction scheduled on Nov 27th and the 10yr auction on Dec 4th.”
So, what’s the issue holding up the Japanese government from passing legislation?
Japan currently has a caretaker government led by Prime Minister Yoshihiko Noda, and elections, which will dissolve the lower house of parliament – the one Noda’s DPJ party currently controls – are on the horizon.
Noda has been trying to put off the elections, but Deutsche Bank’s Makoto Yamashita thinks his hand may be forced over the bond issuance legislation pretty soon.
The DPJ needs to get the bill through parliament, but the main opposition party, the LDP, refuses to offer the votes needed to pass it until Noda schedules elections.
Yamashita wrote in a recent note to clients that Noda is the likely loser:
An election cannot be postponed indefinitely, however, and with certain fiscal expenditures (including tax grants to municipalities) already being delayed as a result of the government’s continued inability to enact deficit-covering bond legislation (a reflection of the fact that the upper house is controlled by the LDP and New Komeito), Noda may ultimately have no real option but to give in to the opposition’s demands by calling an early election.
This is what markets appear to be pricing in. Yields on Japanese government bonds have yet to rise significantly as November looms.
However, Bloomberg reporters Monami Yui, Hiroko Komiya, and Masaki Kondo noted today that the JGB market does appear to be getting a bit worried:
The bond market is signaling concern that Japanese lawmakers struggling to pass legislation to fund the budget will founder in their efforts to cut the world’s largest debt.
The extra yield that investors demand to hold 20-year government bonds instead of 10-year securities increased to 92 basis points yesterday, the most since July 1999, according to data compiled by Bloomberg. Longer bonds tend to be more sensitive to the market’s fiscal outlook. The equivalent German gap widened less than two basis points this month to 76.
In a separate note, BofA rates strategists Shogo Fujita and Shuichi Ohsaki offer a few potential scenarios for how the situation plays out in the Japanese parliament (click to enlarge):
Photo: BofA Merrill Lynch
Fujita and Ohsaki say the first scenario, or “Negotiated dissolution: Passage of legislation for JGB bond issuance, electoral reform, and a perhaps a compromised supplementary budget will be bartered for dissolving the Diet and holding a general elections,” appears most likely.
However, the strategists also emphasise the chaos in the Japanese political scene right now:
The problem is that under the current political landscape it is impossible to tell who is obstructing who. It appears at first glance that the LDP is obstructing the DPJ’s efforts to pass legislation, and if political wrangling winds up blocking budget implementation and causing a government shutdown, there is a possibility that the ruling party (DPJ) can pin the blame on the opposition (LDP) for not cooperating.
In that case, the DPJ could possibly pursue a strategy prior to the general election of tarnishing the LDP’s image. If both the ruling and opposition parties really want to see a constructive dissolution, their only choice is a negotiated dissolution. The more they fight, the greater the odds that a third political force will emerge.
And BofA’s Brooks Thompson cautions that the longer the delay in passing the bond issuance legislation, the worse the impact will be:
As Japan’s economy was already weakening, it got hit by the “China Boycott Shock” due to the territorial disputes. The delay in the “Deficit Bond” legislation will certainly be another shock or weight on an already weak economy. Perhaps not a 4% GDP impact as some warn with the U.S. fiscal cliff, but it could be a substantial especially if the delay is prolonged.
Nevertheless, with money quickly running out, we should soon have an answer.