In 2009, the Japanese government’s average debt cost was (at most) 3% away from a rate that would force it to pay interest out of newly issued debt (think: a household paying credit card interest with new credit cards). Today that metric is at best the same and possibly worse. In short, Japan’s fiscal condition is vulnerable to rapid deterioration. This much is clear.
Even so; some argue that the likelihood of such a deterioration is small since Japan “funds itself”. Well, here we’ll look at sectoral balances around the globe to find out why this presumption is incorrect. By the end of this piece you’ll understand why the Japanese government is increasingly reliant on external funding and how Japan’s situation compares with major countries around the world.
Imagine for a second that you and I are the only people in the world. In this scenario your income is my expenditure and your expenditure is my income. It’s a pretty simple concept, but it allows for some nice analysis when applied to the real economy.
You can divide the economy into three sectors:
- The Private Sector
- The Public Sector
- The External (or Foreign) Sector
By the same principle by which our net balances summed to 0 above (i.e. your income was my expense etc.), the income less expenditure of the private, public and external sectors must sum to zero.
You can also think of it like this:
GDP is the sum total of consumption, investment, government spending and net exports (C + I + G + X – M). But equally well it ultimately comes down to the sum of consumption, savings and taxation (C + S + T).
So if you equate these two formulations you get:
C + I + G + X – M = C + S + T
Which means you can cancel out consumption from both sides to get:
I + G + X – M = S + T
Rearranging this you can get the following:
(T-G) + (M-X) + (S-I) = 0
Or, put differently: the government sector balance plus the external sector balance plus the private-sector balance equal zero.
Many have (rightly) observed that Japanese investors are willing to finance the government at low rates of interest (especially when compared to the external sector). They view CPI deflation as “real” yield, they don’t have any other options (equity and property prices have been falling for 20 years) and many consider it an act of patriotism.
So, they say, since Japan has a current account surplus, which translates to corporate profits that are ultimately used to purchase new government bonds, on a net basis the external sector doesn’t have to fund the deficit. That is; Japan can self-fund.
Here’s why that presumption is incorrect. Below we have a chart plotting the government, external and private sector balances for major countries around the world. Squares represent government sector balances, circles represent external sector balances and triangles represent private sector balances.
Now, Japan’s deficit was in the 9-10% range for the four quarters ending in Q3 2012. Its external balance (the current account balance with the sign inversed) was some negative 1-2%. In the first instance this shows that corporate profits from international trade are well short of a number that would fund the deficit by itself. But that’s not all. The external sector balance has been moving into positive territory lately (i.e. when the external sector takes more income than it spends). In fact, recent data showed back-to-back monthly current account deficits. If this trend continues then the Japanese government will be (net) reliant on external funding
As you can see below, Japan had the fourth worst fiscal deficit during the year ending in Q3 2012. The present shift in the external balance is significant. Especially since this is a country that is used to having its bonds bought and held internally.
External investors have many options competing for their capital. They do not consider Japanese CPI deflation to be “real” yield. And needless to say they are oblivious to notions of Japanese patriotism. It seems that the possibility of traversing the Keynesian endpoint is more than an outside chance when it comes to Japan.