Japan - Land of Rising Debt

Every spring, our family has a tradition of visiting my hometown of Iowa City, where we spend quality time with friends and family. This past May, I was having dinner with a long-time friend. We discussed many topics, from our kids' activities to life in Iowa to economics and the markets. One topic that evening was the amount of debt governments worldwide have accumulated. He asked me a question I could not answer, and it’s bothered me ever since.

His question related to government debt levels of the United States vs. Japan. I mentioned the worrying growth of the United States government debt, which is now 122% of GDP (gross domestic product). This means we owe more (debt) than we bring in annual income (GDP). The higher this number goes, the more the market worries about a country's ability to service its debt, which could raise interest rates. The US debt to GDP ratio was a comfortable 32% in the early 1980s. Authors Carmen Reinhart and Kenneth Rogoff published a 2009 book entitled This Time is Different, arguing that once government debt to GDP gets above 90%, it negatively affects the entire economy's growth rate. A healthy economy should have low debt and consistent growth. I told my friend that night that Japan had a much larger debt to GDP ratio of 255%! (Figure 1). Japan has been above the “90% threshold” since 1995. This is where the question that I couldn’t answer came up. I am paraphrasing the question, but in essence, he asked if Japan has such a large amount of government debt and has for many years, why couldn’t the United States do the same?

Figure 1: Japanese Government Debt to GDP Ratio (1979 - 2024)

Source: TradingView

Japan’s Bubble Economy

Before we seek to answer my friend’s question, it’s worth explaining some of the history of Japan's economy. Japan is a large exporter of goods such as cars, electronics, machinery, etc. As a developing country post World War II, the Japanese government successfully implemented an investment-driven growth model. Michael Pettis describes the essence of this strategy in his book Trade Wars are Class Wars. He noted the government can accelerate economic growth by gathering resources from the private sector (citizens) to build infrastructure and manufacturing facilities. Household consumption would thus be suppressed in favor of manufacturing, companies, and the State. Sound familiar? China has used this playbook as well since the mid-1990s.

Due to attractive interest rates in the United States in the early 1980s, the US dollar rose in value. This helped Japanese manufacturing companies as their goods were attractive to foreigners due to the dollar being able to buy more and more goods as the dollar rose in value vs. the Yen. However, the US dollar was too strong as the decade wore on. Thus, a group of the largest five countries, the US, Japan, Germany, France, and the UK, met in 1985 and agreed to The Plaza Accord, where they would intervene in the foreign exchange markets to depreciate the dollar (Figure 2). The US dollar index fell from around 170 to 80 by 1995.

Figure 2: US Dollar Index

Source: Apollo

This was the beginning of the issues for Japan. A steadily rising currency hurt their exporters and, thus, economic growth. Their large companies began to look outside their heavily government-controlled banking system for loans, such as the Eurodollar system. Thus, the banks in Japan needed to expand their balance sheets and began to issue riskier loans, primarily in the real estate sector. The Japanese government also intervened in the market to limit the rise of the Yen vs. the dollar, lowered interest rates, and grew the money supply. This further enabled the bubble to inflate as banks were flush with reserves and low borrowing rates. Speculation in the stock and real estate markets, government intervention, and moral hazard were rampant. The bubble deflated in 1990, and Japan hasn’t been the same. The stock market peaked in 1990 and lost a third of its value within a year (Figure 3). It took the market 34 years to return to the peak 1990 levels when it eclipsed 39,000 again in 2024. Edward Chancellor noted in his book Devil Take the Hindmost:

“The Japanese economic system, with its emphasis on consensual values, was meant to be different from the freewheeling capitalism of the West. Japanese corporations remained subject to a high degree of bureaucratic intervention despite the global financial revolution. The bubble economy showed how the “fever” and “contagion” of speculation could infect even a tightly controlled economy, as long as its capital markets were relatively free”

Figure 3: Japanese Nikkei 225 Stock Index (1985 - 2024)

Source: TradingView

Since the Bubble Popped

Since the late 1990s, Japan has run a large government fiscal deficit, upwards of 5% annually, compounding the accumulation of government debt. As mentioned, the government debt to GDP rose from 70% in 1985 to 255% in 2024. Japan was the first major country to engage in large-scale “Quantitative Easing” or “QE” for short. This involves the Japanese Central Bank printing currency and buying government debt and other securities in the open market to suppress interest rates and increase bank reserves and the money supply (Figure 4). As of June 2024, the Bank of Japan held 53% of all outstanding Japanese government bonds. Their balance sheet now exceeds $5 trillion. Economic growth has been very low due to an aging population, a high savings rate, and banks unwilling to lend. This has kept inflation low, and there hasn’t been any government debt crisis. This was the point my friend was making. If Japan can do it, why can’t the United States?

Figure 4: Annual Purchases of Japanese Government Bonds (Excluding T-bills)

Source: Chien, Cole, Lustig (2023)

Financial Repression - Hedge Fund Style

Government financial repression takes many forms. The main one is keeping the interest rates on government debt below inflation, which allows a government to “inflate away” its debt. Other forms of financial repression include capital controls, where a government limits the ability to move money in and out of the country, and state-controlled banking systems.

Japan has engineered a special kind of financial repression, which is the answer to the question of this article. Essentially, they’ve leveraged their central bank’s balance sheet like a hedge fund and entered into a carry trade, all at the detriment of their citizens, who have been given low deposit rates. First, let’s discuss the Bank of Japan’s balance sheet to understand its actions. Below is a chart of the Bank of Japan's balance sheet as of the end of 2023. On the asset side, they hold gold, deposits, loans, bonds, bills, and about 11% of stocks. The government's liabilities are paper currency in circulation, bank reserves (bank deposits for citizens), and loans.

Figure 5: Bank of Japan Balance Sheet

Source: Chien, Cole, Lustig (2023)

Figure 6 below shows the same numbers as a percentage of GDP. The “duration” of their assets is “longer” than most central bank balance sheets. In this sense, duration means their investments or assets are riskier, such as equities (stocks), which typically have a duration of around 15-20 years. The longer the duration of an asset, the riskier and potentially the higher the return. As seen below, they’ve heavily increased their investment in equities, 56% of which are in un-hedged foreign securities, mainly in the United States, benefiting from the “yen carry trade.” The government's liabilities are paper currency in circulation, bank reserves, and loans. These are very “short-term” in duration. Thus, they borrow short-term from their citizens, paying very low interest rates and using those assets to purchase longer-duration assets such as long-term government bonds and stocks. Thus, they earn a spread on this activity.

Figure 6: Consolidated Government Balance Sheet

Source: Chien, Cole, Lustig (2023)

Conclusion

The authors of the paper What About Japan? estimate that this “hedge-fund” like spread has earned 2.12% annually from 1997-2023. Voila! No sovereign debt crisis! As long as they can continue leveraging the banking system’s assets and earn a positive “carry,” all is well!

Figure 7: Rates of Returns on Consolidated Balance Sheet

Source: Chien, Cole, Lustig (2023)

Not so fast. What can go wrong? Any incremental increase in the real rate of interest they pay on deposits and government bonds will quickly erode their returns. Further, foreign currency movements can also exacerbate their leveraged balance sheet. Is the United States destined for a similar future? I think the answer to this question is a solid no! Our economy is much more diverse, and many citizens actively invest in various markets. Our government central bank is also not legally allowed to hold private company stock or debt. The Federal Reserve is also an independent institution free from the government. So, a similar fate does not await the United States. This is not to say we have a government debt problem. However, our way out of our debt problem may look much different than Japan's.

Turning back to Japan. This can’t go on forever. At some point, faith in their fiat currency, the Japanese Yen, will erode, interest rates will rise, and they will inevitably default. If this occurs, it may set off a global sovereign debt crisis. I certainly hope not, but it’s a risk that must be taken seriously. The real losers in the Japanese economic system are their people, especially younger Japanese, who can’t afford to buy financial assets such as homes and stocks. These people are forced to keep their assets in low-yielding bank accounts. Further, their currency is continually debased year after year, especially versus gold. I leave you with the value of Yen in gold, the ultimate store of value.

Figure 8: Gold/JPY Inverted (2006 - 2024)

Source: TradingView

References

• Chien, Cole, Lustig, (2023). What about Japan? Stanford University Graduate School of Business https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4620159
• Rogoff, Reinhart. (2009). This Time is Different: Eight Centuries of Financial Folly [Print]. Princeton University Press.
• Klein, M. C., & Pettis, M. (2020). Trade wars are class wars: How rising inequality distorts the global economy and threatens international peace. [Print]. Yale University Press. https://www.amazon.com/Trade-Wars-Are-Class-International/dp/0300244177
• Chancellor. (2000). Devil Take the Hindmost: A history of financial speculation [Print]. Plume.
• Slok, T. (2024). No Plaza Accord Today. Apollo.

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