“X-day” sounds like, but is not the title of a Japanese B movie in which a giant lizard destroys Tokyo suburbs. Godzilla is tame by comparison. The damages inflicted to Japan on X-day, with ripple effects for the rest of the world, could be many times more severe than the monster's wildest rampage.
X-day is the day on which market participants will refuse to buy Japanese government bonds (JGB). I think, this day is approaching fast. While barely discussed elsewhere around the globe, Japanese politicians — in the government and in the opposition — are preparing for it. Before we examine the consequences of such an event and how to react to it, we need to understand why it could occur in the first place.
The year 2012 (1945 + 67) will be first in which members of the postwar baby-boom generation enter mandatory retirement in Japan. Henceforward for roughly two decades, both the overall Japanese population and that in the working age bracket will significantly decline. This will have severe consequences.
Due to aging, Japanese households will increasingly disperse — spend — their savings. A declining private savings rate has been observed in Japan since the mid-1990s. Without a change in demographic dynamics, something, which is very unlikely, the Japanese household savings rate will continue its downward trend and become negative within the next two to three years. At the same time, with greater numbers of people in retirement, government expenditures will significantly increase. Hence Japanese private savings (both households and private companies), which so far have absorbed the huge Japanese public deficits, will decline below the financing needs of the government.
Current Japanese government debt stands at roughly 230% of GDP, or almost a quadrillion (one thousand trillions or a million billions) Japanese yen. To grasp this number better: Japanese government debt is almost equivalent to the US gross domestic product. Over the years many analysts have been puzzled at how the Japanese government was able to pay extremely low interest rates on a debt of this size. The answer, plain and simply, was that there was a domestic demand for a “safe” asset from Japanese households saving for their retirement. This demand is now significantly declining and the Japanese government will need to find other investors than its own population to purchase its debt.
International investors, however, are unwilling to buy debt bearing a higher credit risk than that of the US, the UK or Germany (Japan was recently downgraded from Standard & Poor’s from AA to AA-), while at the same time offering much lower yields than AAA sovereign debt. Proposing higher interests rates is not an option either.
If Japan today were to pay the same interest rates as Germany, its revenues would not suffice, and Japan would pile up even more debt to meet coupon outflows. We would be in a classic Ponzi- or Madoff-scheme. More explicitly: Japan would be broke.
In my view, on X-day the only solution which could work — there is no guarantee — would be a monetization of the debt, i.e., the Bank of Japan would need to buy the lion’s share of newly emitted JGBs. This would massively fuel Japanese inflation, and the value of the Japanese yen would crumble.
Hence I venture this bold forecast: After two decades of deflation, starting on X-day, Japan could be paradoxically the first developed country where inflation rises out of control.
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