Markets Insight
March 20, 2013 11:25 am
Markets Insight: Japan sets course for hyperinflation
Not many things keep me awake at night, but recent developments in Asia are a cause for concern. The increasingly destabilising policies being implemented by Japan have the potential to ignite a global financial conflagration with consequences even more severe than the recent crisis.
Japanese authorities have embarked on a precarious policy of depreciating the yen, raising domestic inflation to 2 per cent, and running larger fiscal deficits in an attempt to end decades of chronic stagnation. This policy cocktail, designed to increase domestic spending while improving export competitiveness, threatens to rekindle uncertainty and upheaval across the globe.
Rising domestic inflation would result in negative real returns for Japanese government bonds (JGBs), while the depreciation of the yen would further discourage foreign investment. This could lead to capital outflows as global investors seek to escape the certainty of negative real returns on yen-denominated assets. Even Japanese equities, which should perform well under the new policy, would fail to attract hard currency investment as investors would hedge their yen exposure.
None of these factors would have been a problem 10 years ago, when Japan amassed large annual increases in domestic savings. But since then, the ratio of retirees to the working age population has increased and Japan no longer generates enough domestic savings to finance the deficits proposed by Prime Minister Shinzo Abe. Within the next few years, Japan’s domestic savings will likely turn negative due to the protracted period of dis-saving caused by the country’s ageing population.
So who will finance Mr Abe’s fiscal stimulus programme? With a 2 per cent inflation target and the need to expand the money supply, the Bank of Japan will be a willing buyer, at least for a while. As the BoJ reaches its inflation target, monetary policy will need to be normalised. This would reduce or eliminate central bank purchases of JGBs. As the BoJ steps aside, interest rates would begin to rise in order to attract private sector capital.
The current size of Japan’s public debt is approximately 230 per cent of GDP, with total interest expense on JGBs representing about 40 per cent of government receipts. Were interest rates to increase by 300 basis points over the next five years, which is in line with Mr Abe’s stated objective of bringing inflation from -1 per cent to 2 per cent, interest expense would expand to approximately 80 per cent of present total government revenues, with the prospect that this ratio could continue to rise.
What does this mean for the rest of the world? With the BoJ out of the market, and no incremental domestic savings, Japan will be dependent on foreign capital to finance its shortfall. Without that infusion of capital, interest rates could continue to rise, thus increasing deficits and exacerbating the nation’s fiscal crisis. Japan would then find itself in the dubious position of having to restructure its debt or continue to run the printing press to buy more bonds, driving inflation higher and dramatically devaluing the yen. These grim policy options would destabilise not just the Asian region, but the global economy.
The probability of this catastrophic series of events may appear remote, but the severity of their potential consequences demands attention. This global margin call on Japan would lead to a protracted period of capital flight. Investors then would focus on others vulnerable to similar risk factors as Japan; specifically, nations or regions unable to finance national deficits with domestic savings or foreign capital, and that are dependent on the central bank to purchase bonds.
Disturbingly, the leading candidates to follow Japan into the crosshairs include the US, UK and western Europe. Just as contagion spread across the countries of Europe in 2008, contagion from Japan could easily spread from Asia to other regions.
History suggests that the long-term monetisation of public debt by central banks is a formula for hyperinflation. Price increases that result from the rapid expansion of the money supply can cause an insidious cycle that requires the creation of ever-larger amounts of new money to fund government activities. This can also lead to a crisis of confidence due to the erosion of faith in a nation’s currency as a store of future value.
The world’s third-largest economy may be setting the stage for a global inflationary spiral, perhaps beyond anything previously experienced. As Japan seeks to deal with the longer-term consequences of its current policy, it could easily slide down the slippery slope that leads to hyperinflation. Troublingly, the rest of the industrialised world is at risk of going down with it.
Scott Minerd is chief investment officer at Guggenheim Partners
Japanese authorities have embarked on a precarious policy of depreciating the yen, raising domestic inflation to 2 per cent, and running larger fiscal deficits in an attempt to end decades of chronic stagnation. This policy cocktail, designed to increase domestic spending while improving export competitiveness, threatens to rekindle uncertainty and upheaval across the globe.
Rising domestic inflation would result in negative real returns for Japanese government bonds (JGBs), while the depreciation of the yen would further discourage foreign investment. This could lead to capital outflows as global investors seek to escape the certainty of negative real returns on yen-denominated assets. Even Japanese equities, which should perform well under the new policy, would fail to attract hard currency investment as investors would hedge their yen exposure.
None of these factors would have been a problem 10 years ago, when Japan amassed large annual increases in domestic savings. But since then, the ratio of retirees to the working age population has increased and Japan no longer generates enough domestic savings to finance the deficits proposed by Prime Minister Shinzo Abe. Within the next few years, Japan’s domestic savings will likely turn negative due to the protracted period of dis-saving caused by the country’s ageing population.
So who will finance Mr Abe’s fiscal stimulus programme? With a 2 per cent inflation target and the need to expand the money supply, the Bank of Japan will be a willing buyer, at least for a while. As the BoJ reaches its inflation target, monetary policy will need to be normalised. This would reduce or eliminate central bank purchases of JGBs. As the BoJ steps aside, interest rates would begin to rise in order to attract private sector capital.
The current size of Japan’s public debt is approximately 230 per cent of GDP, with total interest expense on JGBs representing about 40 per cent of government receipts. Were interest rates to increase by 300 basis points over the next five years, which is in line with Mr Abe’s stated objective of bringing inflation from -1 per cent to 2 per cent, interest expense would expand to approximately 80 per cent of present total government revenues, with the prospect that this ratio could continue to rise.
What does this mean for the rest of the world? With the BoJ out of the market, and no incremental domestic savings, Japan will be dependent on foreign capital to finance its shortfall. Without that infusion of capital, interest rates could continue to rise, thus increasing deficits and exacerbating the nation’s fiscal crisis. Japan would then find itself in the dubious position of having to restructure its debt or continue to run the printing press to buy more bonds, driving inflation higher and dramatically devaluing the yen. These grim policy options would destabilise not just the Asian region, but the global economy.
The probability of this catastrophic series of events may appear remote, but the severity of their potential consequences demands attention. This global margin call on Japan would lead to a protracted period of capital flight. Investors then would focus on others vulnerable to similar risk factors as Japan; specifically, nations or regions unable to finance national deficits with domestic savings or foreign capital, and that are dependent on the central bank to purchase bonds.
Disturbingly, the leading candidates to follow Japan into the crosshairs include the US, UK and western Europe. Just as contagion spread across the countries of Europe in 2008, contagion from Japan could easily spread from Asia to other regions.
History suggests that the long-term monetisation of public debt by central banks is a formula for hyperinflation. Price increases that result from the rapid expansion of the money supply can cause an insidious cycle that requires the creation of ever-larger amounts of new money to fund government activities. This can also lead to a crisis of confidence due to the erosion of faith in a nation’s currency as a store of future value.
The world’s third-largest economy may be setting the stage for a global inflationary spiral, perhaps beyond anything previously experienced. As Japan seeks to deal with the longer-term consequences of its current policy, it could easily slide down the slippery slope that leads to hyperinflation. Troublingly, the rest of the industrialised world is at risk of going down with it.
Scott Minerd is chief investment officer at Guggenheim Partners
Copyright The Financial Times Limited 2013
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