Kyle Bass may be one of the best-known hedge-fund investors in the world. His bets against subprime made him wealthy, and as close as you can come to being a celebrity while managing a hedge fund.
These days, he is probably best known for his prediction that Japan is headed for a “bond crisis.”
The principle rationale for his thesis is demographic. Japan has an aging population with more people leaving the work force than entering. He predicts that soon they will have more people dis-saving than saving and begin accumulating a trade deficit with the rest of the world, breaking “the funding mechanism” that has supported low interest rates in Japan for decades.
“Their ability to fund themselves internally is coming to an end,” Bass wrote to investors in a letter last November.
This narrative of a country needing internal, private savings to fund its government spending and public-sector debt accumulation is familiar to a lot of people and has the ring of truth.
If the government cannot keep borrowing from its people, won’t it have to borrow from outsiders? When the country starts paying out more to the rest of the world than it takes in, doesn’t it become dependent on the credit of the rest of the world? And what if outsiders won't tolerate lending at near zero-rates against a public sector balance sheet with a “debt burden” as high as Japan’s?
That’s certainly the way it would work for a household. As revenues contract, the ability of a household to “fund” itself contracts as well. An aging household—that is, one in which grandpa and grandma retire—had better have some savings. If they are dependent on credit, they will soon find themselves paying exorbitant interest rates.
Sure, they could do a reverse mortgage, but eventually that too will run dry. When they run out of equity to mortgage, bankruptcy will loom.
Joe Weisenthal at Business Insider thinks that this resemblance is an illusion. Japan, he argues, is not going bust. Bass’ logic is “badly flawed,” he writes. As a result, the Japanese trade is “never going to pay off for him.”
Weisenthal makes a number of points in his argument. First of all, he says that the dependence of foreign creditors is an irrelevancy.
“There's no connection between rate sustainability and domestic/foreign borrowing,” Wesienthal writes.
The reason why is fascinating, because in order to get your mind around it you have to understand that for Japan, government debt accumulation is nothing like debt accumulation by private households, municipalities, corporations or even European governments. You have to step through the looking glass and apply Alice-in-Government-Land logic.
Foreign ownership of debt is not a function of the country going cap in hand all around the world, looking for investors to buy their bonds. It's a function of trade. When a country runs a trade deficit, it basically means it's spending more on goods from the rest of the world than the rest of the world is spending on goods from said country.
So it stands to reason that if Japan is buying a lot from the rest of the world, then there are a lot of yen floating around the world: More yen wind up in places like China, the Mideast, the US, Europe, etc.
What happens to those yen? Well, some will get spent on other things, but in the end, they'll all wind up in bank accounts somewhere, and somehow they'll find their way into a Japanese Government Bond, so that the holder of said yen might get some yield. Now theoretically if someone had a bunch of yen, they might prefer to buy German bonds or US bonds, and that's fine, but then there's another private holder of yen who has to make a decision about where they're going to place their currency. Eventually, that currency will find its way home, and the cycle is complete.
But if Japan doesn’t have to worry that high levels of debt will drive interest rates higher, what is going on in Europe?
The very question points toward its own answer. Japan has much higher levels of debt compared to its GDP than any European country. If that metric were what mattered, Japan would already be in a debt crisis.
Indeed, it would have preceded Greece into default and political mayhem. Greece, Italy, Spain, Ireland and Portugal all have more attractive “balance sheets” on this measure.
So obviously, something else is going on. Part of the answer is the currency union. As Weisenthal explains, Japan’s excess spending inevitably winds up as yen-denominated savings in Japanese government bonds. But when the government of Spain deficit-spends, there’s no guarantee that the euros wind up being used to buy Spanish government bonds. In fact, right now, much of the deficit funds of countries like Spain and Greece are being used to buy German bonds.
“This is the key idea that Bass is missing, and why his trade is never going to pay off. For a country that borrows in its own currency, government spending finances borrowing! If Japan spends 100 billion yen on something, that's 100 billion yen out there in the world that will eventually wind up in a financial institution, where ultimately 100 billion yen worth of JGB will be purchased,” Weisenthal writes.
In other words, Bass has the “funding mechanism” that supports Japanese government bonds backwards.
I’d argue that Weisenthal potentially misses one possible source of a crisis—a loss in global demand for yen.
For a country like Japan, there is no risk at all of interest rates rising—except in accordance with public policy. So long as the Bank of Japan desires rates to stay low, they will stay low. Even if all the foreigners with excess yen holdings decided to bury their yen in the ground, rates would stay low because Japan’s central bank can support rates at whatever level it wishes by simply buying the bonds at the target rate.
Wouldn’t this lead to inflation? It might—except that we’ve assumed in our example that excess yen aren’t coming back to Japan. If we do away with this assumption then the need for the central banks to buy bonds to support the price level goes away. The excess yen will support the desired rate levels by the mechanism Weisenthal describes.
But this doesn’t mean Japan is immune to a potential crisis. Japan has an aging population. If it were a closed economy, it could experience a crisis of not having enough goods and services available to the elderly who have left the workforce. A government that overspent into declining productivity would drive price inflation.
But this is unlikely. Japan is not a closed economy. It can import goods and services to meet the demand that surpasses what its country can produce.
The real source of a potential crisis would be the rest of the world deciding to stop accepting yen, in exchange for goods and services. In this case, a Japan unable to produce enough to supply its own population with the necessities of a comfortable life would experience a crisis.
This wouldn’t primarily be a monetary crisis or a crisis driven by a debt burden. It would be a crisis of real production. But it could drive interest rates higher. In order to convince the world to begin accepting Japanese currency again, the Bank of Japan might need to offer higher interest rates—spurring a demand for yen.
But it’s hard to see why the rest of the world would stop being willing to accept the currency of the third-largest economy in the world. The only scenario I can think of runs like this: Imagine a world in which we are running at maximum potential, making everything we possibly can. Imagine that global demand still exceeds this—meaning we are in a relative global supply crunch (the opposite situation of supply glut/demand slump that we fund ourselves in today).
In that case, producers of goods and services would choose who to sell to based on the desirability of the currency. So if Japan’s currency were at the bottom of the pile—that is, if everyone else’s currency was in greater demand—then you might get a Japanese currency rejection.
The only way I can see Japan’s currency getting to the bottom of the pile of currency is a massive contraction of Japanese productivity.
Japan would have to have far less stuff to offer the rest of the world for demand for yen to dry up entirely. That’s not impossible—but nothing in Japan’s demographic challenges indicates anything this extreme looms on the horizon. Certainly not in the next few months or years.
Note that it is absolutely essential that the world operate at the limits of its productive capacity for this to happen. If we are not at our productive limit, companies will expand to supply Japan goods. And if Japan still produces stuff the world wants, the demand for yen will remain.
Bass’s trade seems to depend on this unlikely currency collapse scenario. Which, perhaps ironically, makes Bass the most bullish guy on the planet. Supply will be outstripped by global demand. Productive countries will need to ration exports according to currency status.
So Weisenthal might be overstating things when he says there is no way the trade can pay off. There’s a way—it’s just really, really unlikely.
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