Coming Crisis in Japan?
Board: Macro Economics
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My notes (Cross post from Deranged Monkey Board):
Myron Scholes Global Markets Forum: The Coming Crisis in Japan - Kyle Bass
20 lost years in Japan. GDP back to 20 years ago level. Real estate down 75%. 1 thousand trillion yen debt. As Japan issued more debt, their interest rates were falling. Interest expenditure is 10 trillion yen. Tax revenues are 43 trillion yen. One quarter of tax revenue goes to interest alone, and that's when its free. 5 year treasury bonds are 17 basis points.
This is the zone of insolvency. There is no looking back. Japanese debt is 24 times govt tax revenue. If Abe achieves an inflationary outcome, they're finished. Every hundred basis points of cost of capital for the country costs them another 11 trillion yen. A 200 basis point move has their debt service exceeding government tax revenue.
Those people wishing for inflation in Japan, know not what they wish for. Back in 1990, the peak level of tax revenue the government ever brought in, back when the imperial palace was worth more than all of Canada, was 60 trillion yen. They are now around 40 trillion yen of tax receipts. For the 5th year in a row, they are going to spend more than twice what they make in taxes in Japan. This year they will take in 46 trillion yen in taxes and spend 102 trillion, and they will probably up that number with the current stimulus.
There have been 10 finance ministers in the last 5 years. 5 in the last 3 years. This is the most obvious scenario I have ever seen in my entire life. It's just a question of when. When that switch is flipped, it happens all at once. The demographics are the most important thing in my opinion.
In the US we can't pay for medicare and social security, we all know that. How we abrogate these contracts going forward is up for debate. You can make promises as long as you have more dummies entering the system than leaving. As soon as that relationship changes, the gig is up. In the US we still have population growth. We have more people entering the workforce than exiting.
The people in DC can keep doing what they are doing. There is no consequence of fiscal profligacy as long as that relationship exists. In Japan that has changed. They had 127.9 million people at the peak. Now they are down to 125 million people. You are going to have a mass problem with the finances of the country when you have more people exiting the workforce than entering. That's happening right now. Over a third of the population is over the age of 60 and 25% is over the age of 65. In the developed world that number is around 8%. You have a problem with a xenophobic society. The elderly are keeping big stacks of cash by their bedside. They have to pay off the ambulance drivers to get them to the hospital.
Two years ago we said they would sell more adult diapers than kid diapers in Japan. That happened in August. 95% of their debt is held internally. And 95% of that 95% is held institutionally. It's all held in just a few hands. The largest pension fund in the world, the largest bank, be deposits, in the world.
If we're right about the demographics changing, what would you expect to see? Look at these press releases: Japan's pension fund was a net seller in 2012. Not only did they not buy anymore, they had to sell some. You have to find new buyers to buy everything that all these guys are going to sell. So what you are seeing now is an accelerated pace of central bank balance sheet expansion in Japan.
These press releases are on the back pages of the Asian Wall Street Journal. They are not going off on CNBC with red lights pointing you to a flowchart with, if this happens, you know what happens next?
These press releases come and go and no one is paying attention. The writing is all on the wall. The largest owners of the bonds have to sell them now. Right at the time the country is running the largest fiscal deficits of any developed country in the western world at 10.5% of GDP.
Do you remember what happened in Mexico in 1995? The wealthy Mexicans and the corporations decided that Mexico was in an untenable situation, They started running with their pesos, moving them out of the country. They started acquiring western assets, external to Mexico and that was the beginning of the end for the Mexican currency in 1995.
What will happen in Japan? The largest external M&A boom in their history happened in the fourth quarter of last year. You had Soft-Bank for Sprint for $20B. $32B in the fourth quarter. Their external acquisition pace was 70% of the U.S.'s last year, in an economy that is less than a third that of the U.S.
Bank of Tokyo Mitsubishi has they're personal savings rate going below zero this year. If you had been saving your whole life and you exit the workforce, you start harvesting your savings.
If you own real estate or stocks in Japan, you have lost 75% of your money. One asset the Japanese people have bought where they never lost any money was their own bonds. So the period of time where government of Japan bonds are at their riskiest point in history, the optionality on that asset is cheaper than its ever been. The Black Scholes model dramatically mis-prices risk at secular turning points.
The balance of trade, the current account is turning negative.
31% of their power was nuclear, and those have been turned off after the earthquake. They have no resources, everything has to be imported.
The Chinese are informally boycotting Japan (over the island crisis). They are not buying Japanese goods.
The spread between 20 and 30 year bonds is already showing signs of stress. It should be close to zero and not at 20 year highs.
The move in the yen so far is pretty small compared to the chart gong back to the 70's. We think the yen will really move. Say north of 250 (to the dollar). We think rates go into the teens in a full bond crisis.
Q There are 3 countries with surpluses: Germany, Japan and China. That has to be absorbed somewhere. China is facing the same problem Japan was facing 20 years ago. China wont be able to balance its accounts because of japan collapsing. Will the same scenario happen in China?
A If we are right about Japan, the social fabric of that region will be torn. There will be a war. China's banking system has expanded at 50% of GDP three years in a row. Think about what if the US lent $16T into our banks in the last 2 years, we would have had over 8% economic growth. China is still having trouble getting to 7.5%. The banking system is 350% of GDP. Their non performing loans are 1% in China. There average npl's are around 17% and higher in periods of stress. If the npl's show upo in the banks they have to recapitalize the whole banking system. Japan will be the first one to go.
Q Japan holds a lot of treasuries. What happens to them when all this happens?
A They have $990B of US treasuries. The 2 largest contributors to the IMF are the 2 largest debtor nations in the world. There is no lender of last resort for Japan. The IMF was designed to help really small nations with balance of payments problems. $990B won't fund their problems for 18 months. Then what?
Q If you were in charge of Japan what would you do?
A There is nothing you can do. They are already insolvent. Of the last 10 finance ministers, one guy killed himself. These people are going to lose so much of their purchasing power at the wrong time of their lives, given the age of the population. It will tear the social fabric of the country. There is nothing you can do.
Q Talk about the swaps market.
A When the swaps market believes they can get to 2% inflation, that blows the bond market up. The swaps will lead everything else. So far nobody believes in it. As soon as they move, it will be too late, you won't be able to get involved. Right now it is just something we are monitoring.
Q Do you think the capital markets can attack both Europe and Japan simultaneously? How long will Europe be in the dumps?
A If and when the Japanese situation materializes, I think both US and Japanese rates will go nominally negative. That will be the time to make the bet against the US and Germany, from a rates perspective, but not now. In Europe, they fixed nothing. We own some special situations in the US. All of our hedges are with European equities. I don;t know if it can happens simultaneously. If it does our rates will really go negative for a short period of time. I think Japan happens first.
Q Do you have a forecast for Japanese equities?
A There are 2 precedents. One is Mexico in 1995. They devalued their currency roughly 60% overnight after many affirmations that they wouldn't devalue, they just did, because they had to. In theory, if you devalue your currency 60%, what should happen to your equity market in nominal terms? It should take off right? What happened in Mexico? Their equities dropped 70% in 40 days. So you lost 60% in the currency and 70% in the stocks when that happened.
The other example is Zimbabwe. As they dialed up inflation, their equity markets did really well, and after 10 years you try to harvest it, and you could buy 3 eggs with the money, because you weren't paying attention to real rates of return.
I think when it is a shock, equities don't do well. The people who own Japanese equities today are kind of macro tourists. They think: cheaper yen, buy stocks. They don't realize Japanese industry has been hollowed out. Some of the companies will do a little bit better. It's not going to change the secular trend. For me it would be pretty scary to be long Japanese equities right now.
Q If you were a retail investor, how would you profit from Japan's fall?
A The instruments available to retail investors are just not there.
Q If Japan falls, what is the next domino to fall and what does it do to investment strategies in the future?
A The best time to invest in Japan is afterwards. Currencies typically overshoot. Stocks get too cheap. That's when you move your money in. You just have to have a plan. Be rational about this. Don't believe what the central banks are telling you. They will never tell you the truth, until its too late. The day before Mexico devalued they said they would not devalue. Protect yourself. Own physical assets that are productive. That's the only way to save yourself from the stupidity of these people.
Q America is running a $65B a month trade deficit. When the dominoes start to fall, how will the US turn out?
A I think our rates will go much lower in that environment because of the Pavlovian response to safety. DC is seeing low interest rates and using it as a barometer for crisis. It is a lagging indicator. The US is on a terrible path. Our debts are 5 times our central government tax revenues. We are not in the zone of insolvency yet. I am a fan of restructuring medicare and social security, and raising taxes. It is what you have to do. But there is no impetus to do that. We're on the same path, just years behind. We also have the biggest blue water Navy, that's a good thing.
Q There are large volumes of futures trading in yen and dollars. Are these good instruments for investors?
A That's evidence of macro tourists. Its a Pavlovian response to a weak yen, then buy stocks.
Q The G7 rich countries are all broke, except maybe Canada. Japan is beyond the brink, what about other countries?
A As long as you have population growth, you can make those promises and live up to them. It's really simple. When you have a secular decline in population, you blow apart. We have years before that happens here. The debt only matters when it is untenable. I don't think it is untenable in the US today, unless you want to bring on balance sheet contingent liabilities, which can change.
This is how Bush got a second term: Carl Rove sat in a room and he said we need to buy the votes of the elderly. Well we just need to give them free drugs. But his economic advisers said it would cost 1.5% of GDP for eternity, and you can never pay for it. He said we need these votes. So that's how medicare part D got passed. That's how laws get passed. It wasn't the benevolence of Carl Rove. It was Carl Rove buying votes. If you are Obama or whoever is next, if you try to change free drugs, you lose.
Q What if Japan eases immigration, prints money, cuts spending.
A And monkeys fly. Come on, we will all be unicorns and rainbows. They are the most xenophobic society in the world. Of 125m people, less than 3m are non-Japanese. They hate Koreans, Chinese. I don't know who you are going to invite in. If you do, what is going to happen to wages?
Q what are the right physical assets and instruments to own?
A Apartments, oil wells, operating businesses things that are productive. As far as instruments, we don't talk exactly about what we do. 27 year old kids sell junk risks in Japan for less than one basis point, $5B worth at a time. Why? Because it is outside the 95% bar, less than one year to maturity, so guess what the regulatory limit is for the bank? It rhymes with hero. If the bell tolls at the end of the year, the 27 year old kid gets a bonus. If he blows the bank to smithereens, he got a paycheck all year. We are right back (to AIG). The memory of financial markets is only about 2 years. I wouldn't sell nuclear holocaust risk in Dallas for less than a basis point. You should be fired for selling something for less than 50 basis points. Yet this is happening again. It's happening in huge sizes.
We bought half a trillion dollars worth of these options. Recently one of the biggest banks in the world called me up and asked me if I closed my position. That also happened to me in 2007 right before the mortgages crashed. They said we ran some new risk tests. I said, really? But we don't want to share our new stress test.
They are starting to run stress tests. Why? Who would have them run stress tests? This is happening.
Q Are you buying gold or guns?
A Do I think there will be anarchy and a need for guns? No. I think the payments systems will still function. I think what they are going to pay you with is going to be wampum. But it is still going to work. Things are just going to be tougher. If you asked me which one investment I would make for the next 10 years, I would buy gold in yen. Sell yen and buy gold and go to sleep. But don't do that with all your money. I think that's the single best investment you could make today.