Is ‘Abeggedon’ approaching?

Time to short the yen again? It’s tempting to wonder as none other than Mr. Yen, aka Eisuke Sakakibara, says the currency will strengthen to 100 by year-end.

A one-time Finance Ministry big shot, Sakakibara has long been a walking, talking (too much, actually) contrarian indicator. One quick example: During a panel I moderated in May 2010, I asked Sakakibara if the Bank of Japan might raise interest rates within five years. He laughed out loud, flailed his arms in the air and dismissed the idea as “just stupid!” His conclusion: “Of course the BOJ will be raising rates by then! Everyone knows that!”

Not so much. Six years on, the BOJ is pushing rates further into negative territory — and under great pressure to keep going. The yen Prime Minister Shinzo Abe has been working to devalue for more than three years is skyrocketing — up 10 percent so far this year. That spells doom not just for Toyota’s profit and the broader Nikkei, but Abenomics.

But what about Japan’s bond market? This, too, is an everyone-knows-that topic. Japan’s $10 trillion debt monster has long been the world’s most obvious, most dangerous and least understood asset bubble. How can a rigid economy with a shrinking population, negligible growth, minuscule immigration, flat wages, dismal productivity and waning competitiveness ever pay off its debt? It can’t without huge reforms, as everyone who’s ever studied economics knows.

No one, perhaps, better than Olivier Blanchard, former chief economist at the International Monetary Fund. His tenure as the IMF’s top economist from 2008 to 2015 was an unusually active one from a debt-crisis standpoint, including the subprime loan mess that nearly toppled Wall Street. While Sakakibara tells Bloomberg a yen rally versus the dollar is “no problem” for the economy, Blanchard is eying a much bigger issue: whether the “endgame” is nearing for Japanese government bond stability.

Thing is, Japan wouldn’t face long-term solvency questions if Mr. Yen did less talking in the 1990s when he oversaw international affairs at the Finance Ministry. When he retired in 1999, the BBC said Sakakibara was “to the world’s currency markets what Alan Greenspan is to interest rates — the key player whom everyone listens to.” If only Sakakibara and his boss, the late Kiichi Miyazawa, did more to modernize the economy and less to paper cracks with excess borrowing, yen intervention and bailouts for irresponsible bankers, the Abenomics program now flaming out wouldn’t have been needed.

Nor would Tokyo be stuck with the trillions of dollars of additional debt amassed since then. Because of the inaction of Finance Ministry officials during Sakakibara’s day, the BOJ has become more ATM machine than central bank. And that’s just what worries economists like Blanchard. The BOJ’s zero-rate policies, unquenchable hunger for JGBs and role as central enabler for timid politicians masks the ticking time bomb at the core of the world’s third-biggest economy. Debt is almost 2½ times greater than annual output, and growing.

Japan Inc. defied the laws of financial gravity by creating a pyramid scheme. In the decades following World War II, it became customary to pile savings into JGBs. Public debt became the asset of choice for banks, insurance companies, pension funds, endowments, universities, the postal savings system, government institutions, companies and retirees, while foreign ownership was limited to reduce risk. It’s mutually assured destruction: if yields surge, everyone gets hurt. And so the BOJ and Finance Ministry work closely to control the bond market. The BOJ, says Tobias Harris of Teneo Intelligence, is increasingly inclined to introduce new stimulus measures again, perhaps later this month.

The question is whether that sense of loyalty is breaking down, particularly with the BOJ pushing rates negative. Japan, for example, is experiencing a bull market in demand for ¥10,000 bills and household safes as consumers wonder about bank solvency, as they did back in Sakakibara’s Finance Ministry days. The BOJ is printing an extra 180 million ¥10,000 bills this fiscal year, a sign that negative rates are backfiring spectacularly.

This loyalty question worries Blanchard, too. That might force Japan to tap foreign investors to pick up the slack as domestic ones age or lose trust in the BOJ. “To our surprise, Japanese retirees have been willing to hold government debt at zero rates, but the marginal investor will soon not be a Japanese retiree,” Blanchard told the Telegraph. “If and when U.S. hedge funds become the marginal Japanese debt, they are going to ask for a substantial spread.”

Japan would do all it can to avoid that scenario. Tokyo holds two trump cards that peers lack. One, roughly 90 percent of JGBs are in domestic hands, reducing capital-flight risks. Two, an Armageddon put option: domestic debt forgiveness on a massive scale. This suggestion will seem fanciful to Westerners, but Japanese culture favors the collective over the individual. In 1998, millions of Koreans voluntarily donated gold and other family treasures to shore up the national balance sheet amid the Asian crisis. Faced with a humiliating default and worried about losing more ground to China, many Japanese might agree to a collective haircut on JGBs for the good of the motherland.

BOJ Gov. Haruhiko Kuroda faces another tricky problem: he’s running out of marketable securities to buy. As I’ve written before, the BOJ’s slow pace in introducing another dose of quantitative easing is as much a “how” question as a “why” one. Even now, the BOJ’s purchases (officially about $700 billion annually) are more than twice net government issuance — or “double monetization” of the deficit, as Morgan Stanley’s Robert Feldman calls it. If few domestic investors are selling JGBs, the BOJ must look for other assets to hoard.

Funny, Japan was so reluctant to nationalize banks back in Sakakibara’s Finance Ministry days. The BOJ is now doing it indirectly by nationalizing the JGBs that dominate bank balance sheets. It makes you wonder how the BOJ could ever taper, like the Federal Reserve, never mind find an exit strategy. Nothing is more important to Tokyo in the long run than preserving calm in the world’s frothiest bond market. As such, Kuroda is just as stuck in Tokyo’s pyramid scheme as anyone.

At the moment, the focus is on Abenomics preservation. Odds are, Sakakibara is wrong yet again about the yen. Yes, long-yen positions are now the highest since before Abe entered the scene in late 2012. But intervention risks are rising just as fast as the currency. The closer the yen gets to the 100 mark, the closer the last of the foreigners who are most bullish on Abenomics flee to avoid “Abegeddon.”

William Pesek
Barron’s Asia
Apr 14, 2016