Japanese sovereign debt soaring

Previous blogs rang the alarm bells on Japan's growing debt problems, while all the attention was focused on Dubai and Greece.

The financial news media is finally catching up to the massive debt levels in the US and Japan.

http://news.yahoo.com/s/afp/20100425/bs_afp/japaneconomydebt_20100425225204

However, the article misses some major points. What will happen going forward? How is the Japanese central bank able to issue debt at such artificially low interest rates, when their solvency is in question? Why haven't the bond vigilantes punished the bonds by bidding up higher yields? Who has been buying these Japanese government bonds, and creating the huge demand required of zero-interest rate policies from an essentially insolvent government (one would think investors would demand higher yields from a bankrupt country)? For bond investors, it is a bad bet to tie up your savings for years with little to no return on investment. Yet, buyers have stepped up to the fixed-income window for 20 years.

The answer is two-fold. Firstly, the Japanese have had competitive export industries, despite equities and real estate markets collapsing since 1990. Corporate profits have been vibrant, keeping the overall economy afloat (which, by the way, is a trait the US economy isn't fortunate enough to share, as our economy is 70% consumer-based).

Secondly, Japanese citizens in the past, have been big savers. They have for years methodically saved at least double-figures of their annual incomes, so the Japanese government had a willing citizenry to buy Japanese bonds for their retirements.

But the head winds are forming, and the aging Japanese population is not saving as much as they have in the past. They are becoming more "American-like" in this aspect, although a large portion of this non-saving trend is due to demographics. This pool of savers is disappearing, so Japanese bond auctions will experience a dearth of buyers. This can only mean higher yields, as buyers will demand higher returns to take on the increased risk of funding a government which is no longer creditworthy. And this will ultimately lead to a death (debt) spiral, as new debt is issued to pay off rolled-over old debt.

This will either result in a technical default (which is a rapid debasement of the yen caused by hyperinflation of the printing press), or actual default, where the government declares they cannot make payment on their obligations. When the world's biggest economies declare default, the effects on the financial systems will be catastrophic, as credit markets will seize up. Liquidity in capital markets will collapse, as counterparty risk intensifies.

We saw this happen in 2008, but now the risk of sovereign default is much higher, as toxic derivative assets were transferred from banks to government balance sheets. In other words, the Fed bailed out banks, auto companies, government agencies when they went belly up. Who will bail out the Fed? The level of non-performing assets and debt will eventually overwhelm most developed countries, as it has already Iceland and Greece, and the contagion will spread across Europe as debt levels grow to unsustainable levels.

All central banks, including the Fed, and the IMF will print even more currency in an attempt to stave off defaults, but this will only exacerbate the debt problems, eventually resulting in a currency crisis.