From Penang with bile: JGB wrongheadedness – Not default but reflation

Greetings from Penang – A UNESCO site with shopping malls.

If you love small, old, dark hotels lacking facilities and overpriced on the basis of historical curiosity value, then you should consider coming here, otherwise you must stay away.

I cannot read Japanese today – my head is full of Chinese, which short-circuits the Japanese for a while. So I have been reading general stuff on the Internet, and noticed an elevation in interest in the “Japanese bond bubble” bursting.

Here are some things to consider in regard to this:

1. Is it a bubble when people are not particularly interested in the underlying asset?

I may be banging on a semantic drum here, but…

There is no mania for Japanese bonds. There is over-stuffing of mattresses, due to a perception of nowhere to invest, despite 3 and 4% yields on offer in cheap stocks.

 

Let’s remember that a mania is usually characterized by:

a. Great interest amounts the general (uninformed) public

b. Promoters of new forms of tulip derivatives, questionable IPOs, and other opportunity-seeking actors skinning investors

c. Unethical practices and bending/ breaking rules through actual deception

d. The use of leverage to enhance returns

e. A hyperbolic arc of accelerating prices which participants feel that they must ride or be shut out of forever

f. Widespread belief in a fundamental and permanent change in attractiveness of an asset class

Now, you can wrangle with these to make the case of JGBs being in a bubble (e.g. You could say the government is ’leveraging’ it’s performance) but that’s a stretch. Out of all of the above, I think you can only say (f) is consistent with today’s JGB market, but that can be explained by complacency rather than enthusiasm.

 

2. What has really been happening is this:

The private sector became over-levered in the 1980s – to such an obscene level that you cannot even imagine.  The Japanese banking system was bigger, at one point, than that of the US.

Then it started deleveraging slowly, paying down debt, shrinking credit, increasing deposits, and reducing demand for loans. At the same time, the Japanese government borrowed the savings and started spending them to increase activity in the economy. If it did not do this, the process would have been much more painful (but quicker).

Now, the deleveraging is basically over, and the corporate sector is flush with cash.  Except that this cash is stored in banks, which turn around and put it into government bonds.

So the shortest possible recent financial history of Japan in a sentence might be: The corporate sector borrowed too much, and the government took on the debt. Shorter still: big debt swap.

The irony is that, while it is obvious that the debt cannot be paid back and must be reflated, this was the plan all along, although the deflationary depression was not.

Yes, inflating away the debt was the plan of the men in gray suits who ran Japan in the 1980s, just as they relied on inflation to clear away the bad debt of the two post-war boom-bust cycles before it.

The trouble came after 1985, when he Plaza accord forced the yen up from 240/$ to 150/$ in less than a year, causing a recession and forcing the BoJ to be ultra-easy when it should have been just the opposite (same same but different as the Greenspan put), launching stocks and land prices beyond the stratosphere and somewhere into the orbit of Neptune.

The problem was, you see, not only the size of the indebtedness of all kinds of companies investing in projects of questionable prospects (hello, China circa 2013), but, of course, also the dire situation of the banking system (Japanese banks were unique in being allowed to count share price gains as capital – can you imagine?), which could have exploded worse than the US in 2008, but didn’t thanks to the heavy hand of government – bankers needed written permission from a government bureaucrat to even fart, “credit ratings” were not used or even comprehended because everyone knew that they could not refuse another institution a loan without consulting the government first. Ironically, nowadays it is S&P who doesn’t get it – they have downgraded Japanese debt but no-one is listening, and the Japanese government told them that they are retards (which they are).

So, thanks to institutional inertia and gray-suited committees of 20 company men needing to get anything done, there was no run on the bank.

 

3. But, the people shorting JGBs now in expectation of another Geek event have got it wrong in four important ways

a. You can’t have a panic when decision is by Japanese committee

Imagine the 20 or 30 of the dullest, most conservative people you have ever seen, put them in a room, and get them to discuss whether to panic sell their biggest asset – which will drive the price of it down and cause a crisis. Now imagine several such committees reporting back and forth to one another, the bureaucracy, and some more committees and sub-committees for good measure – this is the socialist reality of Japan, folks – not the capitalism red in tooth and claw as assumed by some people.

The foreign and other small holders are too small to count, really, because:

 

b. This is too big to fail

A JGB crisis would bring down the entire Japanese banking system. This cannot be allowed to happen. This risk is well-known and has been referenced in government documents, some of which are in English. If there is a threat of this kind of situation, it will be a national emergency (because any significant fall in JGBs will mean bankruptcy for the government), causing them to take what they will inevitably call “stabilization measures” – buying the bejesus out of the paper in question. This will allow orderly exit from that market and real reflation of the economy as originally intended by QE.

 

c. Japan has its own currency – unlike Greece

If Greece had the ability to mint Euros (or, if its debt was denominated in drachmas), do you think it would be in its current situation? If you don’t get the question, please stand at the back of the class.

 

d. Japan makes stuff that people want

Japan right now has a trade deficit, but it has so much in foreign reserves that it doesn’t matter. Plus, the deficit will probably turn to surplus once the nuke plants are back online. Even if that doesn’t happen, the decline in the yen will increase the volume of stuff sold overseas, leading to a surplus (contrary to what one hasty investment bank said last week – consider spare capacity and operating leverage). The amount that the yen needs to fall to achieve this is less than in prior years due to efficiency gains.

 

4. I am expecting you to now trot out the tired argument about debt-to-GDP ratios, and the This Time It’s Different book (yes, I’ve got it too).

What I agree with in this line of reasoning is that the debt is not sustainable – the only difference with the Kyle Bass crisis camp is that they say there is no route but default. Their argument is one of similarity – saying that Japan is just like Greece.

My point to you is that Japan is the polar opposite to Greece in almost every important way. And, the scenario I describe here covers the mechanism of reflation, while there is a conspicuous absence of mechanism-related explanation from the default camp thesis (e.g. How will the big holders shoot themselves in the foot by selling, and how will the BoJ not intervene in a foreseeable national crisis).

Lastly, as I have argued before, if you think the good ship the Japanese Banking Industry is heading for an iceberg, don’t short JGBs, but short Japanese insurers and banks. And, as you know that JGBs behave like a haven asset, albeit as absurd as the Pavlovian fall in treasury yields during excitement over US government funding, what about the perverse but likely reaction of JGBs rallying based on expected government funding issues?

So, you think about it for a second – are we going to see inflation of the debt away or default?