Japan: Land Of The Rising Sum

Shawn D. Baldwin 07.21.10, 8:00 AM ET

Sensitivity to the sovereign debt crisis has brought scrutiny to Japan.

The nation's already high debt has continued to escalate. In the 1990's the debt was 86% of GDP, and now it has
reached nearly 200% --twice the size of its $5 trillion economy. The budget deficit will continue at 5% until 2021. The
country is referred to as the land of the rising "sum" and many speculate on its demise. The combination of an aging
population, low tax revenue and rising debt make these fears palpable.

Japan is positioned by size of its debt to be at risk of de-leveraging, but this is unlikely to happen in the immediate
future. The government's debt is offset by financial assets and girded by domestic household savings in the banks
which buy Japanese Government Bonds (JGB's)--of which 95% are held by domestic investors.

Japanese debt is unique to other countries because Japan has been indebted for the past two decades, its leverage
didn't increase rapidly and the gap between Japan and others declined because other countries' debt-to-GDP ratio
increased.

The country has proven to be adept at managing debt. From 1980 through 1990, private sector debt increased at 5%
CAGR, government debt has grown at about 7% since 1990 (at 5% CAGR since 2000), Bloomberg statistics show.
There isn't a high risk, there has been no significant de-leveraging since the 1990's. Unlike the U.S., Japan saved
excessively instead of spending excessively.

The stated debt is deceiving because in real terms Japan only owes the equivalent of 100% of GDP--Japan has
Y1,000,000 billion in foreign exchange reserves and owns part of its debt, it doesn't offset debt for reporting purposes.
There is still reason for alarm due to the nation's demographics and low tax revenue which will constrain capacity for
debt absorption, create increasing cash outflows and create future concerns about market instability.

However, just because the market hasn't imploded doesn't mean that it can't. Will it? A comparison with the Greek
situation suggests we shouldn't worry about Japan.

Japan's debt is larger than Greece's and it has government bond issues that exceed tax revenues--however Japan is
less susceptible to speculator pressure.Unlike Greece, Japan is a surplus nation--it holds $149.7 billion while Greece
has a deficit of $31.5 billion. And Japan has extraordinarily high cash on company balance sheets. Additional factors are
low unemployment, great social standards and a growing economy in the global recession. Japan announced it would
create spending caps but will stick to issuance of ¥44.3 trillion ($507 billion). Economists expect GDP growth for the
nation should reach 2.4% in 2010 then dip to 1.8% next year.

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The government has begun initiatives to increase foreign investors through tax incentives. By proxy Japan's deflation is
understated by dated CPI calculations and effectively generates a tax-free gain to the holders of Japan's cash and
bonds.

The currency in Japan performed well during the global financial crisis. The yen has appreciated 16% since the collapse
of Lehman Brothers, with demand accelerating: China has increased its holdings and in May bought a record $735.2
million JGB's after buying $5.8 billion in the first quarter. The yen has strengthened 5% against the dollar, hitting a high
of Y86.94--20% higher than the euro and 12% stronger than sterling.

The JGB's 10-year yields rose to a five-month high of 1.48, signaling that the market seems to value Japanese credit.
The volatility has been in the "swaptions" market and was due to influential relative value (RV) hedge fund managers
who were operating in Japan's markets, ringing the alarm.
There will be a tremendous rollover of debt within the year. Spreads have widened in Japanese corporate bonds. The
corporate market has been buy-and-hold, which created a lack of secondary market liquidity. Long positions at the CME
are over $5 billion and are a clear indication that more hedge funds are placing bets.

What is the path for reinvigoration?

A simple reduction of state debt will not be enough. Japan needs spending cuts in combination with tax increases and
nominal growth--which could come from the energy sector. Potentially, health care could boom after deregulation.
Reflation of the economy through monetary policy is needed, and that will mean higher interest rates, which will create
opportunities for traders.

Shawn Baldwin is Chairman of Capital Management Group, an investment advisory and research firm based in Chicago.
Neither he nor his family nor CMB own Japanese government bonds.

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