Cooler Heads: The Rebuttal to Kyle Bass’s Japan Market Meltdown Scenario from JPMorgan’s Jesper Koll and Masaaki Kanno

By Stephen Harner

Bass comments:

At 24 times central government tax revenues, cumulative Japanese government debt has reached a level which ensures financial collapse.

Not, just a reserve drain.

With the Abe/Aso government setting a 2% inflation target, the collapse will occur sooner—probably within the next 18 to 24 months.

Not, inflation targets are meaningless. Inflation expectations theory is a myth.

The revelation will be that interest on the debt—currently 25% of national tax revenue—will double under higher interest rates.

Could be. But deficits generally come down as well during an expansion, of course posing a risk to that expansion, etc.

The result will be massive JGB selling, a collapsing yen, and systematic financial crisis resulting from a collapse in yen asset prices.

Yes, when rates go up bond prices go down. There are both winners and losers when/if prices change.

Koll suggests:

Rising interest rates would of course raise debt service costs for all borrowers, and especially the hugely indebted government. But they would enable lenders–including household depositors–to charge higher rates on new debt and raise returns on non-fixed rate debt. Since net stock of private savings is larger than the net stock of public sector liabilities, Koll reckons that the overall effect on the economy would be positive.

Agreed! Rate hikes are expansionary, cuts contractionary due to interest income channels.

Rising interest rates would not spell large losses for Japanese financial institutions because these institutions’ bond–and especially JGB–portfolios are largely held to maturity, avoiding the requirement to be marked to market. The institutions would have no incentive to sell, and ample incentive to hold the JGBs [the weighted average duration of which they have in any event been shortening to well under five years–Harner].

They represent at least lost income, and if implied costs of funds rise implied losses. Etc. Again, winners and losers with change.

As to who is or would buy JGBs, the answer for the present and foreseeable near term future is: the Bank of Japan. BOJ is already committed to buying the entire debt out to a maturity of three years and a new governing board to be installed in April may extend the range to three to five years. Interest rates will rise only as much as BOJ will allow. This is why foreigners and domestic institutions are still buying the bonds.

Note that functionally the BOJ buying is the same as the MOF not issuing.

Whether or not significant inflation develops in Japan depends on productivity. Significant increases in productivity could fully mitigate inflationary pressures.

I’d guess most ‘inflation’ comes through the ‘cost channels’ as low aggregate demand tends to keep ‘monetary inflation’ in check.

There is plenty of room in Japan’s economy for raising productivity. Agriculture, in particular, has abysmal productivity that could easily be raised through deregulation. Land policy that affects housing is another. Health care is another. Indeed, deregulation is needed throughout the economy. “The Abe administration must implement real deregulation, so that private investors put their savings and capital to work, by building new factories, new hospitals, and so forth.” [This is a point I emphasized in my post a week ago on Abe’s “Three Arrows” program.–Harner]

Deregulation could be deflationary as suggested.

The proposed BOJ policies won’t do anything, the fiscal could move the needle some. And relighting the nukes will firm the yen.