Thursday 21 September 2017

Deflation and the small investor can stir revolution in uneasy Japanese markets

James Saft

MARKETS are busy speculating on which country might follow Egypt on the revolutionary road, but watch out for the impact on a country where bellies are full and the chances of revolt are exactly nil: Japan.

The same inflation in food and energy which fanned discontent in Tunisia and Egypt could badly hit real wages and purchasing power among Japanese citizens, potentially undermining their willingness to hang on to the debt which the government desperately needs them to own.

That's right, deflation could actually ease in Japan and, that's right, its demise could help tip the country into the long-awaited financing crisis.

It is not the bond market vigilantes who are likely to precipitate a debt crisis in Japan, it is Mr and Mrs Watanabe, the archetypal small saver, who have patiently held Japanese government debt in huge amounts despite very low interest rates.

It is the existence of the Watanabes (domestic holdings of Japanese debt are about 94pc vs about 50pc in the US) who have allowed Japan to run its debt up to 196pc of GDP, trailing only Zimbabwe. By comparison, Greece's debt to GDP ratio is just 137pc.

With a massive and passive domestic lending base, Japan has never faced the interest rate squeeze which its long-term outlook justifies, and unlike the US, is far less vulnerable to sales by foreign investors or central banks.

For a country which is borrowing 50 cents of every dollar it spends, this is both a key support and a significant vulnerability.

But why have the Watanabes held on to their Japanese bonds, which are usually held through intermediaries such as via savings products? Partly it's a matter of culture and habit, but deflation has almost certainly played a mollifying role. Japanese domestic investors hold less than 5pc of the government bond market directly, but are much larger investors through accounts and instruments sold by financial institutions, the yield of which track government bond yields.

A paltry 1.2pc yield on a 10-year bond is a lot easier to swallow for retirees and investors if purchasing power appears to be rising as prices fall in a deflationary spiral.

If prices rise sharply they may demand more.

But that deflationary spiral, especially as it affects households, may be coming to an end courtesy of very loose US monetary policy and related strong emerging market demand.

Inflation in perishables, such as meat and fruit, hit 10.3pc in December, and overall food prices hit an all-time record, according to Japanese data.

Energy prices are moving upward as well, and are vulnerable to increasing shocks from the Middle East.

Overall, and not even depending on a falling yen, Japanese consumers look to be suffering a terms of trade shock, where their ability to command wages is left far behind by rising prices of the things they must buy.

Deflation has not been that terrible for Japanese households, at least to judge by their own reports: 63.9pc of people said they were content with their standard of living last year, as against 63.1pc in 1989.

Downgrade

Ratings agency Standard & Poor's downgraded Japan's sovereign credit rating last week to AA- from AA, citing the ageing population and expectations that government debt ratios would continue to rise.

Reaction was muted in bond markets, though the yen fell. The price to insure Japanese bonds against default over the next five years rose to about 0.85pc, near highs reached last summer during the European debt crisis.

To be sure, Japan is still in deflation and even with food and energy playing a heavy part of price measure, overall prices are likely to continue to fall.

Japan doubtless has much with which to protect itself in a bond sell-off; massive overseas assets, a positive current account balance and a cohesive and biddable financial sector.

The following scenario is one to watch -- domestic holders, stung by inflation, rapidly increase their holdings of overseas debt and other investments, cutting back on government bonds.

This drives yields up and the yen down, catching the eye of foreign investors who pile on, selling Japanese bonds aggressively.

Events take on a momentum of their own, and a year from now people are shaking their heads over how it was possible the Japan bond bubble lasted as long as it did.

If so, the damage globally will be profound, attention will focus on the US and its heavy debts, and quantitative easing, which helped to unleash the inflation, will prove to be a powerful tool best left in its box.

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