Japan's need for a post-earthquake economic overhaul

The country is reeling from the impact of an earthquake, tsunami and critical damage to a nuclear facility, but its people have shown remarkable solidarity. The coming year offers a perfect time for Tokyo to raise taxes and allow inflation, potentially shaking the country out of its two-decade economic torpor.

  • 13 Apr 2011
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Three weeks after the devastating earthquake and subsequent tsunami that hit Japan’s Miyagi prefecture in north-east Honshu island and crippled a nuclear plant, rescue workers are still scouring wrecked towns for survivors, while engineers desperately work to prevent any further radiation leaks.

The havoc wrought on March 11 has left more than 11,000 dead so far, and another 16,000 missing. Tens of thousands are homeless, while a swathe of infrastructure in north-east Honshu was destroyed.

In the face of this catastrophe, the world has been awed by the stoicism and bravery of the Japanese people, which has helped prevent widespread panic or wholesale looting.

Yet the short-term economic impact is likely to be harsh. The failure of the doomed power plant has meant power shortages, affecting a much wider area, including the industrial plants of prominent companies. The nation is still struggling to avert a nuclear catastrophe at the plant, while locals worry about radiation spreading.

Many Japanese economists believe the direct economic loss looks set to reach US$200 billion, meaning that the country’s economy will shrink in the second quarter. Production capacity is set to slow over the coming months, which could develop into deeper inertia if power shortages are extensive and prolonged.

Reconstruction costs are also set to further impede the country’s weak fiscal situation. Forecasts of the eventual bill differ, but all are substantial. J.P. Morgan predicts the cost for reviving the damaged areas should be at least ¥10 trillion (US$120.8 billion).

Credit Suisse is less pessimistic, projecting that the initial disaster relief package, which focuses on the four worst-affected regions of Iwate, Miyagi, Fukushima and Ibaraki, will cost roughly ¥2 trillion. However, it notes that the recovery process could cost ¥4 trillion to ¥5 trillion over the next three years.

All in all, a terrible situation has struck a country already struggling with a stagnant economy and huge debt burden.

Yet the earthquake has also created a spirit of solidarity among Japan’s people. This should help Tokyo raise the debt funding it needs to begin paying for reconstruction.

It also offers a rare opportunity for the government to conduct some sorely needed economic changes, if it is to avoid a continuation of its slow economic decline. Tax hikes would be one sensible move, as would allowing some inflation to take root.

Debt concerns

Japan has long struggled under enormous fiscal deficits. Its budgeted upcoming fiscal year deficit is going to hit ¥44 trillion. It also has a public debt burden that has been rising for the past three years, reaching roughly US$10 trillion.

On paper, Japan’s public liabilities will hit 204% of GDP this calendar year, larger than the 137% pressing down on Greece or the 113% borne by Ireland, according to the OECD.

However, unlike those two countries, Japan enjoys a current account surplus and very high national savings. The latter stood at a net US$4.89 trillion in 2008, according to the World Bank. That’s nearly one-third the value of the US’s GDP.

One reason Japan’s public debt is so high is because Tokyo has been able to lean heavily on this accommodative pool of capital. Local investors have bought about 95.4% of the government’s outstanding Japanese government bonds (JGBs), whereas 70% of Greece’s public debt is held by foreigners.

This captive pool of capital gives Tokyo’s policymakers a huge advantage and certainly more room to manoeuvre than either Greece or Ireland would have had.

Additionally, if one deducts the country’s US$1 trillion in foreign-currency reserves from public debt, Japan’s overall liabilities would fall to roughly 120% of GDP this year.

But for all this, the country is still labouring under a lot of debt, with little sign of it decreasing soon. As a result, the ratings agencies have taken an increasingly dim view of Japan’s prospects.

Moody’s and Standard & Poor’s cut Japan’s sovereign rating from Aaa/AAA in 2001. Today it sits at Aa3/AA-. S&P’s last cut was in late January, when it said the country lacked a credible plan to fix its debt burden.

Of course, that was before the earthquake. S&P was more accommodating on March 15, four days after the event, noting “we expect a sharp economic decline in the short term but reconstruction and recovery efforts in later quarters will, however, offset some of that”.

Raising debt to rebuild

The earthquake means that Japan’s debt total will only rise further. While Tokyo can meet some of the reconstruction bill by tapping into contingency reserves, it will have to issue more JGBs to pay for rebuilding.

J.P. Morgan believes that the government may need to issue an additional ¥3 trillion in JGBs over and above the ¥169.6 trillion it had already budgeted for the 2011-2012 financial year, which started on April 1.

The size of Tokyo’s debt burden means that adding another few trillion yen to fund reconstruction will make relatively little difference to its economic outlook. Many observers applaud such an approach.

“[Japan] should be willing to act aggressively to increase the budget deficit in order to have the money to rebuild the damaged areas promptly,” wrote Sebastian Mallaby, a New York-based economist with the Council on Foreign Relations. “Now is not the time for being cautious or conservative. Now is the time for a bold response.”

Even the agencies agree that increasing Tokyo’s public debt even more is unlikely to change the picture much.

“The markets are likely to be able to absorb additional debt without a major increase in risk premiums, and we do not expect major capital outflow,” S&P noted in its March 15 report.

Once the government raises the money it needs, it will need to begin spending it. And it’s here that the main economic benefits should take place.

Rebuilding flattened villages and towns, repairing rail lines, ports, electricity networks, and water and gas pipelines will cost. Local businesses will need to be contracted to do the majority of it, bolstering their revenues and offering a fillip to the country’s stuttering economy.

While Crédit Agricole revised down the country’s real GDP forecast to almost zero in 2011, it anticipates reconstruction will boost GDP growth to 2.3% in 2012. Meanwhile, Bank of America-Merrill Lynch only cut Japan’s GDP growth forecast from 1.5% to 0.9% this year due to reconstruction investments boosting growth in the second half.

“In the medium term, the rebuilding of the economy is going to contribute significantly to the GDP. The vast amount of money spending on infrastructure will trigger employment, which is also likely to help Japan step out of its current doldrums,” says Société Générale’s Asia chief economist Glenn Maguire.

Demanding more debt

Of course, Tokyo will have to convince its local investors to reach into their pockets yet again and buy more of its debt. And its additional needs, above what was already set to be its largest year of borrowing during a troubled economic time, make this far from a given.

Given the nation’s flagging economic outlook and minimal returns on its JGBs – those with a 10-year maturity yield only about 1.2% – the best way for the government to attract investors would be to offer juicier returns. It’s something that Tokyo may have to accept, especially with longer-dated JGBs.

“The super-long sector has been under [price] pressure, suggesting the market is becoming increasingly sensitive to fiscal concerns and cash outflow from the JGB market by life insurers,” says Takafumi Yamawaki, J.P. Morgan’s chief rate strategist in Tokyo. “The yields of the longer-dated bonds will need to rise further to attract domestic institutional investors.”

Other market participants agree.

“In order to tap into vast private wealth for reconstruction, the government needs to issue government bonds with a higher interest rate than its current close-to-zero level, otherwise few people will buy it,” an asset manager at a European insurance company in Tokyo tells Asiamoney.

“Many Japanese investors are holding foreign currencies or foreign bonds because of the interest-rate differential. If JGBs offer the same yields, they will prefer to hold Japanese assets to avoid FX risk,” he adds.

Raising returns is one way to gain more investor interest, but Tokyo may also adopt another tactic: playing on the patriotism of its investors.

Japanese newspaper Sankei reported on March 18 that the government is planning to issue more than ¥10 trillion of ‘emergency bonds’ to fund relief works, underwritten by the Bank of Japan.

Japanese officials denied the reports, but some observers think such plans are feasible.

“We Japanese have to help the reconstruction. [The idea of launching] emergency bonds will make it easier for the government to sell bonds to the personal sector,” Credit Suisse’s chief Japan economist Hiromichi Shirakawa said in Hong Kong recently.

Maguire adds that Japanese households would be more willing to lend to the government as an act of national solidarity.

Of course such debt would basically be JGBs by another name, but the act of buying it would no doubt make many locals feel they are helping the nation to recover.

Balancing the budget

But while Tokyo may be able to fund rebuilding efforts through debt for now, in the long term this will only lead to a greater budget deficit and larger debt burden.

There’s no escaping from this. If Tokyo does not raise more money or cut costs, the market will eventually doubt its ability to repay the money it owes, forcing its borrowing costs upwards and leaving it at increasing risk of bankruptcy.

The most obvious fix is a tax hike. And Japan’s 5% consumption tax looks like the most promising candidate to raise the revenue needed to help stabilise Tokyo’s debt-to-GDP ratio. The government could raise some ¥2.5 trillion each fiscal year for each one percentage point rise in consumption tax.

Observers feel it is a move that Tokyo will eventually have to implement. “In four to five years’ time, the government will need to raise consumption tax in order to source new revenue,” says Yasuo Yamamoto, an economist at Mizuho.

But why wait that long? With public solidarity high, now is the perfect time for Tokyo to increase taxes and cut expenses.

The government should announce a timetable for a planned consumption tax hike. By announcing a tax rise at year-end, for example, it could spur people to spend more beforehand, offering another boost to economic growth this year.

Inflation at last

The earthquake fallout has another potential consequence that the government could take advantage of, if it’s brave enough: inflation.

The massive investment required for rebuilding means imports of raw materials such as steel or crude oil will increase, putting upward pressure on prices.

“The constraints of electricity and provision of other services mean supply constraints and could lead to a bottleneck type of inflationary pressure,” Crédit Agricole’s chief Japan economist Susumu Kato says. “Once the recovery phase starts and demand tends to pick up quicker, it will further add to the bottleneck inflationary pressure.”

The French bank expects the core consumer price index (CPI) inflation rate to peak at 1.1% year on year this July on the back of reconstruction demand. This, combined with the higher JGB yields needed to attract investor interest, would offer increased signs of an eventual rate rise.

Japan’s central bank has typically baulked at the very idea of inflation, while Tokyo seems to think that inflation equals rising interest rates, making the cost of financing its debt higher. But in fact modest inflation would help Japan’s economy.

With the interest rate so close to zero, the central bank now has little flexibility and few options to implement any meaningful monetary policy except constantly injecting money into the system. As of March 22, the Bank of Japan had already injected ¥40 trillion cash following the disaster . This has to change.

If near-zero interest rates persist, ‘zombie’ companies, which are technically bankrupt, will continue to survive by rolling over debts they cannot repay at minimal expense – just as Tokyo itself is doing.

Additionally, while inflation would make a rate hike more likely, it would also effectively cheapen the overall cost of Japan’s debt burden, making it easier to repay. Plus switching from deflation to an inflation rate slightly above interest rate levels would hopefully incentivise bank savers to invest their money in other markets, as their bank deposits would no longer be getting more valuable for doing nothing. Steered correctly, this could improve Japan’s economic activity.

The central bank could even increase the amount of money it prints to stimulate a modest level of inflation – although this is unlikely as it would run contrary to its behaviour for the past 15 years.

The Japanese have shown admirable courage and selflessness in the face of unthinkable tragedy. It’s time that the country’s politicians emulate these traits as they plan for the nation’s financial future.

  • 13 Apr 2011

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