Japan – positioning for the end game by Titan Investment Partners

Last week, in what should have been an expected announcement and not all too surprising, Japan in fact shocked the world when announcing the latest number from its national debt. It seems 16 digits are now needed to express Japan’s debt and which stands at 1,008,600,000,000,000 Yen – that’s right, a quadrillion yen! We are all going to need a bigger calculator going forward when dealing with Japan.

At current exchange rates, the number translates to €7.85 trillion, $10.47 trillion, or in good ol’ pounds – £6.75 trillion. It represents a staggering 230pc of GDP and is more than five times bigger than the actual British economy. In fact, it is bigger than the economies of Germany, Britain, France, and Spain combined!

While the absolute numbers may seem shocking to investors, it seems that the rating agencies prefer to ignore them, similar to what they did with mortgage securities in the run upto the financial crisis… Unbelievably, many agencies still attribute the country with a sovereign rating as high as AA-. Yields on 10-year government bonds still remain at a low rate of 0.76%. The million, no quadrillion dollar question is – does the current rate reflect the risks deriving from a country which is spending a massive portion of its government revenues in interest payments?

Japan needs a plan, and a credible one at that to control its public finances. But, the current Abenesyan, which is an extreme form of Keynesian policy that is presently being undertaken is, in the eyes of many, in particular one Kyle Bass, now leading the country to a point of no return.

Monetary policy has been ineffective for more than a decade now – a decade in which the central bank has repeatedly tried to inflate prices artificially but has, in the process, just increased its total assets from 70 billion yen in 2000 to the current 197 trillion. Fiscal policy also hasn’t succeeded and is in fact the main culprit that has contributed to the huge load of debt the country now runs.

Japan has, so far, been able to avoid a fully fledged debt crisis because the vast majority of its debt is held domestically and interest rates are low but, if rates rise, something that Abenomics will, if it is successful, inevitability result in as inflation returns, things may change very quickly. Were the markets to lose faith in Japan’s ability to service its debt, even though the holders of it are largely its own people, then we could be staring down one of the biggest debt crisis ever seen on the planet as Japan is the third largest world economy. Capital flight would make the Lehman’s crisis look like a Japanese tea party!

Shinzo Abe will, somehow, need to address Japan’s fiscal problem and decide whether to increase consumption taxes or not. If he doesn’t do anything, ratings agencies will start downgrading the country’s debt quality. Even if most debt is held domestically, interest rates will rise and as debt expires it will be ever more costly for the government to refinance debt. It has been estimated that for each one-percentage point increase in interest rates, big banks would incur mark-to-market costs (read losses) equivalent to 10% of tier one capital. At the same time, higher interest rates would swallow government revenues to a point where it would be impossible to repay interest, let alone the principal on the debt pile itself. In contrast, if Abe tries to increase taxes instead, then just say ciao to growth… Past history also shows that under such circumstances, debt to GDP tends to increase. The picture doesn’t look good to many.

Japan seems to be in a lose-lose situation as it may in fact be too late for the country to solve its debt problem. The only route seemingly left to go down now is for the central bank to keep buying government debt at the current rate (sound familiar?). If things derail and interest rates rise anyway, then the BOJ may buy even more debt, something like 100% of all government new issues and eventually all the debt that other institutions want to get rid off. This way it is possible to keep the interest rate low, with a massive cash injection. Off course, this is banana republic economics and the yen would collapse. But, if the yen collapsed, miraculously the Govt debt burden would have been inflated away. Of course, Japan’s people will be left to pick up the pieces and as a major oil importer, we are not sure what that would do to the economy… Inflation would spiral higher and higher beyond the point of no return. What’s Japanese for “Weimar Republic”…?

How do you benefit/profit from such a scenario? Well it may seem odd to suggest buying the stock market in the face of such an outlook but if you have monitored other banana republic economies which descend into hyper inflation, you’ll know that the nominal index level of its stock market, like everything else, rises dramatically in yen terms. Usefully, when spread betting on the Nikkei, the yen hedge is actually embedded in the price when dealing in sterling.

At Titan, we plan to reposition ourselves for the “Japanese scenario” over coming months, having kept out of the market this last few months following our prediction of a sharp collapse (see here – http://www.spreadbetmagazine.com/blog/the-japanese-bubble-reaches-new-technical-extremes.html). If you want to join us on this trade, click the banner below for more details on our Global Macro Fund.

R Jennings, CFA. Titan Investment Partners.