Japanese government bonds lost their stamp of premium quality in 2002. Early this year S&P took a second shot, with another downgrade to double A minus. The result? In last week’s turmoil the yield on Japan’s 10-year bond briefly dipped below 1 per cent. If Sidney Homer’s classic History of Interest Rates is any guide, this represents the lowest level of interest rates anywhere since Babylonian times.
Quick note: bond yield indicates quality – Junk bonds have high yield to attract buyers while investment grade bonds can afford to offer low yield
No less a person than Kaoru Yosano, minister of economic and fiscal affairs, warned in a Financial Times interview that “Japan faced a dreadful dream”. On the face of it the numbers appear to back him up. Japan’s net debt to gross domestic product ratio comfortably exceeds 100 per cent and primary deficits stretch out as far as the eye can see. Yet the markets themselves are saying something quite different – that the supply of Japanese government bonds, far from being excessive, is actually insufficient.
To call this a disconnect is putting it far too mildly. The markets and conventional opinion are on different planets.
Furthermore, Japan is no longer such an outlier. In Switzerland, too, bond yields have dropped to near-vanishing point, and Taiwan and Singapore are not far behind. All these countries enjoy current account surpluses and are therefore self-financing. However, even in spendthrift deficit countries such as the US and the UK the bond market vigilantes appear to have saddled up and left town.
Savvy investors such as Pimco’s Bill Gross had expected the end of the Federal Reserve’s “quantitative easing 2” bond binge to trigger a sharp sell-off. Instead bond prices have soared, sending yields to new lows. Despite S&P’s dire warnings, the US government is currently able to borrow on the most favourable terms in modern history.
The key point here is the deleveraging. When Japan’s bubble economy imploded in the early 1990s, the government net debt to GDP ratio was a negligible 15 per cent. Far from being a cause of Japan’s descent into stagnation, the build-up of public debt since then was the inevitable result. The private sector, traumatised by the bloodbath in stocks and real estate, embarked on a long process of reducing its indebtedness. But money paid back does not evaporate. It has to find another user, which, given the scale of the financial cold turkey being experienced by Japan’s companies and citizens alike, had to be the public sector. A sharp increase in saving by the private sector was matched by a sharp increase in government borrowing. The bond market was the conduit.
The lesson from Japan is that we know a lot less about debt dynamics than we think we do. There is no magic level of debt to GDP that will automatically trigger a fiscal crisis. After the collapse of a bubble of historical size, deleveraging by the private sector is likely to be substantial in scale and duration. One way or another it has to be accommodated. The only safe way to avoid a build-up in public debt is not to have the bubble in the first place.
Good words about insufficient knowledge about bond market in Japan and elsewhere. No silver bullet, no magic ratio or level, but reading between the lines for market conditions