Here’s a lesson from Japan about the threat of a US debt crisis

16-May-2018 Intellasia | Marketwatch | 6:00 AM Print This Post

A rapidly widening US budget deficit is stoking fears among some economists of a potential debt crisis. Investors might want to look to Japan before pushing the panic button, say analysts at Goldman Sachs.

Daan Struyven and David Mericle, economists at Goldman Sachs, said the example of Japan could prove instructive as the world’s third largest economy had not suffered a debt crisis, even though it arguably has the most public debt as a share of its GDP in the world. Japan’s government debt to GDP ratio sits at 236 percent in 2017, more than double that of the US, which stands at 108 percent, according to the International Monetary Fund.

“Japan’s experience confirms that a debt crisis is difficult to imagine in a country that issues debt in its own currency, has a flexible exchange rate, and controls its central bank,” wrote Struyven and Mericle. All three features are also shared by the US

That might suggest investors should drop their concerns that a debt crisis will afflict the US Deficit hawks, however, have pointed to a Federal Reserve set to hike several times in the next two years, stronger inflationary pressures and the twin stimulus of a lift to discretionary spending limits and trillion dollar tax cuts as reasons to be worried about US’s growing budget shortfalls.

Strategists at Credit Suisse forecast debt service costs to climb to 2.8 percent of GDP in 2028, from 1.4 percent in 2017.

Though the two economies share enough common ground to suggest the US debt load won’t be a problem, there are also key differences that could suggest the US burden could present a bigger challenge.

Unlike the US, Japan does not depend on the kindness of strangers, who are more sensitive to excessive budget deficits.

Deutsche Bank reported that close to 90 percent of Japan’s bonds in domestic hands, either by local residents or the Bank of Japan, while less than 60 percent of Treasurys are held by US individuals and financial institutions, according to the Treasury Department.

The home bias of Japanese investors has kept them from plowing their cash abroad even though yields overseas are much higher than at home. The yield for 10-year Japanese government bond TMBMKJP-10Y, +11.24 percent, or JGB, stands at 0.050 percent, according to Tradeweb data.

“Requiring the public to absorb a large supply of government debt can raise its interest rate. In Japan’s case, such pressures have been reduced by both the large JGB holdings of the Bank of Japan, a form of financial repression, and the limited share of JGBs held by foreign investors. The Fed also of course holds Treasurys, but a much smaller share of the total outstanding,” the Goldman strategists said.

Analysts say the Bank of Japan’s extraordinarily low interest rates and bond-buying operations have anchored its interest rates. Traders have struggled to profit from shorting Japan’s government paper, with such bets becoming known among market participants as a “widowmaker”.

In addition, the gulf between Japan’s moribund economy and relatively strong US growth also requires divergent paths in monetary policy.

While the US is already near its inflation target, the Bank of Japan is nowhere near hitting its own target, leading its governor Haruhiko Kuroda to ditch the forecast date for 2 percent inflation in April. The Fed has already raised six times since December 2015, allowing the 10-year Treasury yield TMUBMUSD10Y, +0.79 percent to climb to 2.988 percent, whereas Japan’s central bank hasn’t raised rates since 2007.

US “debt dynamics and debt servicing costs are on a worse trajectory over the next decade because of rising rates and a more negative primary balance,” said Struyven and Mericle.

Japan is reportedly aiming to reach a budget surplus by 2025, while US President Donald Trump in December signed into law a deficit-widening tax cut, marking a fiscal expansion of the type more often seen during economic slumps. Instead, the US is in ninth year of its expansion, the second longest since World War II.

That said, more robust economic growth has provided an advantage over Japan when it comes to keeping down government debt levels as a share of the economy.

The difference between the US growth rate and interest rates is much narrower than in Japan. In other words, the US economy grew fast enough to keep pace with the cost of servicing its debts, whereas Japanese economic growth fell behind those costs after the so-called Lost Decade in the 1990s when nominal interest rates had fallen to zero and could not be cut further.


Category: Japan

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