I had an interesting conversation with a hedge fund manager today, during which it became quite clear to me that we may be mere years away from profound economical and political changes in Asia. Japan's Debt
It is a well known fact, that Japan has a tremendous amount of outstanding public debt, amounting to around 200% of Japan's GDP. In comparison, Greek public debt stands at an equivalent of about 110% of GDP. The reason this pile of debt doesn't trigger a crisis alike to that of Greece, is that the Japanese government bonds (JGBs) have a very loyal investor base, consisting almost entirely of Japanese domestic investors, most of them institutional. The yield on long term JGBs is extremely low, and recently touched 0.9% before getting back into 1% territory. Why do the investors hold onto anything that is yielding so little?
One reason is deflation. As Japanese investors are in JPY, the actual return is yield + rate of deflation. Second, and more important reason, is that they simply have very little else to invest into. Take banks. They are sitting on piles of cash, but weak domestic economy does not generate enough lending opportunities, and tight regulation makes it very difficult to invest into anything but low-risk assets. Take pension funds. The IFRS reporting is about to be introduced in Japan, and it will require corporations to reflect pension funds assets on their balance sheets. No room for losses. JGBs look to be in fashion for a long time.
Here Comes China
The news is, JGBs are now popular with a new investor with great appetite and deep pockets: China. As widely discussed in press (see links below), China has recently become an active player in the JGBs market, expanding its position as a net buyer. This trend has intensified since beginning of 2010 and was explained by China as a play on safe assets (note that Japan cannot buy Chinese government bonds).
Now, as explained above, Japanese government bond is a time bomb, which doesn't go off only because of the unique balance in the domestic market. What happens if this balance is broken?
I do realize this scenario is a bit of a stretch, but let's imagine a situation, where China holds a significant portion of Japan's government debt, and something triggers a massive sell-off by domestic investors. The spreads widen, Japan cannot manage the debt burden anymore, and defaults on some portion of, or in the worst case scenario, all of its debt obligations.
China's ambitions in the region are well known, and they are not limited to purely economical interests. It is like a swollen river held by an old dam - there is a good chance it may break through with a bang. What if China makes political demands to Japan using the defaulted debt as a pretext? What if a chain of events triggers a makeover of the world power balance that came together after the end of
Unlikely? Yes. Impossible? Definitely not. We may quite possibly see in our lifetime Japan becoming alike to what Hong Kong now is. Autonomous, but under the thumb of mainland China. See you in Chipan...
FYR: Links to articles on Chinese purchase of JGBs (in Japanese)
中国、日本国債の購入拡大 （日経新聞 2010/7/6）
中国の日本国債購入、米国債より安全との見方反映 （Thomson Reuters）
中国の日本国債購入急増 円高要因 高まる警戒感 （SankeiBiz）
FYR: An interesting brief on public debt and fiscal crises
Federal Debt and the Risk of a Fiscal Crisis
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