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[Type text] [Type text] Jason Campbell

[Type text] Research Report: Japanese Debt

Executive Summary
- Government Debt levels are at dangerous proportions and the level of cuts needed to restrain debt growth are unrealistic. - Extreme debt load leaves Japan vulnerable to either a slight rise in interest rates, slight decrease in demand or any type of loss of confidence by the market. - Demographic shifts are visible and posing more of an issue to future government demand and could potentially increasing government expenditures like social security. - The potential for a financial shock event in Japan is very possible and will be tough to contain due to the size of the Japanese economy. This makes various short positions very attractive due to the lower risk as a result of currently low yields within the country.

Government Finances
The Japanese government currently estimates the nation's debt to GDP ratio to be 219.1%. Furthermore, as shown in the table below, the countrys debt grew at an alarming rate from 1997 to 2012 compared to that of other countries. Note:
Canadian debt decline was result of massive government cuts in 90s and resulting Debt repayment

Country(19972012 est.) Japan U.S. U.K. Germany France Italy Canada

Gross Debt% GDP 219.1% 103.6% 97.2% 87.3% 102.4% 128.1% 92.8%

Gross Debt CAGR 4.99% 2.72% 3.99% 2.33% 2.51% -0.07% -0.23%

Net Debt% GDP 134.8% 80.3% 68.9% 51.6% 66.2% 100.6% 36.6%

Net Debt (CAGR) 8.83% 3.16% 5.20% 2.93% 2.82% -0.02% -3.50%

The figures above indicate that Japan not only has significant gross and net debt relative to GDP, but it also has growth rates much higher than other nations. This debt, already at unsustainable levels, is growing at a troubling rate. Sadly, a look at government debt from the perspective of interest relative to revenues or the budget does not yield a more positive result, as shown below.

[Type text] [Type text] Jason Campbell

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As the above chart illustrates, Japans bond dependency ratio is now at a historic 49%, this means that the government of Japan currently relies on debt issuance for 49% of government spending (10% of which is interest on debt ). This is a dangerous dependence on the financial markets for funding. Most alarming is the high dependence on debt at a time when the countries debt levels are unsustainable along with high debt growth. As the world becomes less and less accepting of large sovereign debts the willingness of the market to lend can change rapidly, as evidenced by the crisis in Europe.
Cost of Debt(curre ntly 1.3%) % of spending cuts to stop debt growth

0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00% 2.25% 2.50% 2.75%

43.18% 46.53% 49.75% 52.83% 55.78% 58.62% 61.36% 63.98% 66.51% 68.95% 71.30% 73.57%

The level that interest payments represent as a percent of the budget and as a percent of government tax revenues is alarming. For 2012, 10% of government spending is on interest alone, while the on balance sheet cost of debt is at a record low 1.3%. At the same time, this interest cost is 20% of government tax revenues. If government on balance sheet cost of debt rose to 2000 levels (a period when net debt was less than half current levels) of 2.7%, then 41.5% of government tax revenues would be needed to pay the debt interest alone. In order for the Japanese government to run a balanced budget, at 2.75% cost of debt, there would need to be a cut to spending of 75%. That level of cuts would be enough to wipe out all government spending aside from social security and an additional 15% cut to social security from current levels would be needed. To the left is a chart showing the level of budget cuts necessary to stop the growth of the debt assuming social security and other expenses do not rise and stagnant tax revenues.

[Type text] [Type text] Jason Campbell

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This level of spending cuts or austerity would be unprecedented and never yet undertaken by any western government. It would significantly hurt tax revenues and GDP. As a result absolute debt would decrease while at the same time causing % of GDP to debt ratios to continue rising. In conclusion the government's massive debt load relative to its economy and significant reliance on debt issuance for expenditures leaves the country vulnerable to any increase in interest rates and dependent on constant demand for new debt. The next section will discuss why that demand may begin dwindling.


Age Group/ 1970 4025.20 64(Savers) % of population 65 and older 7.07 % of population Savings Rate%

1980 28.80

1990 35.10

2000 35.60

2005 35.20

2010 34.50


12.05 14.7(199 2)

17.34 8.7

20.09 3.9

22.88 2.4

The Japanese government has benefited from a domestically high savings rate (14.7% in 1992), a larger population age group more bias towards saving for their retirement and an elderly population small relative to the whole population. As the above table illustrates, all 3 of these areas are progressively getting worse as the population saves less and demographics shift towards an older population which will save less. This will limit the domestic demand for government debt. This aging population will increase social security costs within the country thereby pushing up mandatory government spending. The impact of demographic changes on Japanese debt owners will be discussed in the next chapter called capital flows. Capital Flows As of Dec.2010 pension funds and life/nonlife insurance companies held 34.4% of outstanding government bonds. Banks own 45% of outstanding bonds (partially for individuals and corporations) and as discussed by Lam and Tokuoka in the IMF paper "Assessing the Risk to the Japanese Government Bond Market", these corporate funds may start to reduce holdings as they start expanding domestically or internationally and begin increasing wages following the 2008 financial crisis. This same report shows how the National Pension Fund has already begun reducing its holdings due to the need to pay new retirees as the population ages. As the population ages, pension funds will begin reducing the duration of their holdings to properly match their future liabilities and this could result in a reduced market demand for government debt. The large degree of government financing that is dependent on Pension Funds and domestic savings is alarming. The savings rate of the population is declining and the

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simultaneous demographic shift could create a rapid evaporation of demand. This rapid change will impact banks significantly by possibly forcing a change to risk models or a reduction in the proportion of their assets in government debt. Lam and Tokuoka discuss how any change in Interest rates will cause potential write downs to bank holdings of government bonds and currently those holdings represent 15% of the total asset base. I find their discussion of a "VaR shock" to be worrisome. This type of shock relates to how any increase in interest rate volatility would cause investors to change their risk assessments and thereby forcing them to reduce holdings. This large reduction in holdings, at a time of interest rate volatility, could potentially cause a cascade of market participants selling to avoid losses. This would be at a time when the government cannot handle any type of debt market shock. Lastly, the government's large debt rollover needs combined with its large dependency on debt markets exposes significant roll over risk. In 2012 alone Japan needs to roll over 3 trillion (US dollars) of government debt and 55% of total government debt needs to be rolled over within the next 5 years in addition to significant debt issuance to fund deficits. The Japanese debt levels are so large that any type of global effort to stabilize the market would be difficult. This increases the likelihood of either a write-down/default or Yen devaluation. Lastly with an average debt maturity of 5.4 years there remains constant roll over risk for the foreseeable future.

The current finances of Japan are disastrous, although its effects have not yet become visible. It is my belief that the situation will dramatically worsen in the future, eventually reaching a point of default or extreme devaluation. Either of these options would, in turn, cause a severe disruption to the Japanese economy and potentially the world. Currently the large dependence on debt issuance at a time when factors point to a future of reduced debt demand signals a significant risk to the governments ability to continue to finance itself. The large interest burden at a period of record low cost of capital shows the risk the government faces to any interest rate increase. The large interest rate risk banks are facing, due to their large ownership of government debt both relative to assets and as a proportion of the overall market, is cause for concern. The sad fact is, even assuming none of these risks happen, dramatic reforms are needed just to stop the continued accumulation of debt. All of these reasons though only represent part of the picture for why the Japanese economy is at risk. Other areas to further review: - Capital flows such as current account and capital account to better gauge capital flows accessible to the government debt market. - Impact on Japanese industries from a Yen devaluation. - There is also the risk bank and financial institutions face due to a sovereign downgrade forcing higher haircuts on assets and creating a situation of forced liquidation.

[Type text] [Type text] Jason Campbell

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Potential Investment Opportunities (lack access to proper data for specific investment analysis, so will outline what I would like to look for) The first area to look at is a direct short of Japanese government bonds or bond futures. The reason this looks so attractive is due to the currently low 10 year yield of 1% the potential loss is limited by yields going to 0%. This represents an extreme case, even the historical low yield is only 50 basis points away. This limited loss is attractive due to the potential gain of not only 100 basis points, which would still have yields very low relative to risk and historical levels, but also a rise in yields could precipitate a serious debt problem leading to some measure of default or at least a temporary spike in long term government yields. I would also look at potential options or derivatives contracts relating to government debt and interest rates in the country. I believe the historically low yields and very low variability may have created an environment where the risk of a sudden crisis is underpriced in the market place. Along with government options on debt I would look into options or derivatives on the Yen due to the desire to have short exposure to potentially be protected in the event of extreme yen devaluation. The cost to carry different types of positions would impact which investment is best. Lastly I would look at shorting some of the financial institutions in Japan based on their individual exposures or certain Japanese indexes. Summary Short Japanese Government Bonds Short exposure towards the Yen Short exposure towards specific financial institutions depending on Debt or yen exposure. (Citations available upon request)