A brief look ahead at the market next week & review of key indices

Week 09 | 27 Feb 2012

Marketexpress
How long can Japan afford its huge debt ratio?
Even Greece and Italy (see graph) have a lower debt to gross domestic product (GDP) ratio than Japan. Yet, Japan pays very low long-term nominal bond yields. Why can Japan afford a debt of 200% (versus GDP), while markets require much higher bond yields from Eurozone peripheral countries? What is the reason of Japans high government debt? Which lessons can Eurozone leaders learn from Japanese policy making? Japan: high government debt and low economic growth Since approximately 1995, the US economy and the Eurozone economy have seen around 70-80% increases in nominal GDP (inflation included). The Japanese economy is an outliner as it is still some 10% below the peak of early 1997. The main culprit is a declining trend in prices by more than 15% from the peak; the country finds itself in a situation of structural deflation or, better said, in a self-sustaining deflationary spiral and very low economic growth. What does this mean for nominal and real interest rates? Japanese real interest rates are higher than in the US With bond yields of 1%, Japanese rates are low in nominal terms. But because of the structural price decreases, real rates in Japan are currently clearly higher than real rates in the US and Germany. So at least to some extent the better sovereign debt fundamentals including higher nominal growth in the US and Germany (versus Japan) is being reflected in real yield differentials. What is the reason of the low economic growth and the structural price decreases in Japan? Anticipation of falling prices and absence of any meaningful nominal income growth The private sector in Japan invests too little and saves too much. Initially, such a period of resource underutilisation causes price and eventually also wage inflation to become negative. In itself this can be helpful in closing the output gap, provided consumers and companies expect the price level to be higher again in the future. However, this benign mechanism will go into reverse if consumers and companies expect wage and price levels only to decline in the future. In this case inflation expectations become persistently negative, so that the

Japan has a very high (+200%) debt-to-GDP ratio. At the same time it has very low nominal bond yields. Why do Eurozone peripherals have to pay higher interest rates than Japan? The Eurozone can learn from Japanese policy making.

economy will fall into a deflationary trap: the anticipation of falling prices and the absence of any meaningful nominal income growth become self-fulfilling. This happened in Japan. Is there an effective therapy for this economic illness? Good policy measures can break a deflationary spiral and cure the patient, as history learns. A crucial reason that Japan did not succeed in breaking the deflationary spiral is that Japan did too little too late, especially on the monetary policy side. In the 1990s, the Bank of Japan (BoJ) was very slow to cut interest rates and it only embarked on a quantitative easing (QE) program in 2001, about five years after the economy had fallen into deflation. It then unwound its relatively modest balance sheet expansion in 2006 when inflation started to hover around zero, but inflation expectations were arguably still negative. Since 2008, the BoJ has once again expanded its balance sheet, but only by a meagre 20-25%. This pales into insignificance compared to the +200% expansions implemented by the Federal Reserve and the Bank of England. In this respect, the BoJs latest decision to expand its asset purchase program by 10 trillion yen to 65 trillion yen will do little to change the deflationary psychology. The same holds in our view for the fact that the BoJ has now announced an inflation goal with a midpoint of 1%. Setting a target is one thing, but implementing the tools to achieve is quite another. Japanese debt ratio is structurally huge
250%

200%

150%

100%

50%

0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Japan Gov Debt / GDP

Italy Gov Debt / GDP

Source: Thomson Datastream, ING IM (2002 - 2011)

What the Eurozone can learn from Japan As in Japan, also in the peripheral countries in the Eurozone structural price decreases can emerge as consumers and companies become primarily afraid of the future and concentrate on savings (as do companies in Japan). As a result, economic growth cannot pick up and tax revenues will continue to disappoint. If this happens, debt will only go up and not down. Therefore, a program that concentrates only on imposing savings does not work. The liquidity programs of the ECB are very positive, but we think that monetary policy has to be combined with fiscal policies. Apart from savings the peripherals need a Marshall plan to succeed in reducing debt and reforming their economies. All in all, the Eurozone peripherals need to prevent with all means the self-fulfilling deflationary spiral in which Japan has positioned itself. Private sector Japan finances its own government The big difference between the peripherals and Japan is that Japan can easily finance its debt. The main reason is that Japans government debt is for more than 90% in the hands of its own citizens and companies. They put their savings in government bonds and have no doubts that their government will repay its debts. On the back of this confidence, there are not yet signs that the current situation is going to change; the situation in which large deficits are needed to provide a partial offset to the vast surplus in the corporate sector and thus prevent GDP from declining. This results in a combination of a steadily rising public debt-to-GDP, low nominal bond yields and a dire outlook for nominal economic growth. As we have seen this can go on for a long while. This has also to do with another big advantage of Japan in comparison to the Eurozone peripherals. Japan issues debt in its own currency that it prints. Therefore, Japan can and will prevent a possible liquidity crisis from morphing into a solvency issue. Unknown at which point Japanese debt level becomes unsustainable In our opinion there will be some level of the debt-to-GDP ratio where the Japanese private sector will deem the debt to have become unsustainable. However, nobody knows at which debt level this will be the case. As the Eurozone debt crisis learns, it would be far better for everyone to avoid this point by finally igniting domestic demand growth (instead of growth of government debt). History shows that igniting domestic demand growth may be difficult for Japan, but certainly not impossible.

MSCI Regional Indices (EUR)

17 - 24 Feb
MSCI World MSCI Europe MSCI Emerging Markets MSCI US MSCI Japan MSCI Developed Asia ex Japan

%
YTD 6.36 8.12 12.56 5.40 5.82 9.09 -1.23 -0.46 -1.74 -1.86 -1.00 -0.22

MSCI Sector Indices (EUR)

17 - 24 Feb
MSCI World Energy MSCI World Materials MSCI World Industrials MSCI World Consumer Discretionary MSCI World Consumer Staples MSCI World Health Care MSCI World Financials MSCI World Information Technology MSCI World Telecom Services MSCI World Utilities

%
YTD 5.66 10.77 8.34 9.67 -0.60 0.96 10.96 10.24 -2.71 -2.60 0.04 0.25 -0.88 -1.67 -1.88 -1.81 -1.81 -1.07 -1.64 -1.86 24 Feb

Bond & Credit Yields

10-yr Bund (Germany) 10-yr Treasury (US) US Investment Grade Credits Euro Investment Grade Credits Global High Yield EMD Hard Currency Asian Debt Composite

%
17 Feb 1.91 2.01 3.40 3.47 7.65 5.57 5.04 17 Feb 1.316 103.24 293.05 Consensus 2.6% 50.8 1.88 1.98 3.34 3.34 7.37 5.47 4.94 24 Feb

FX & Commodities
EUR/USD Crude Oil (WTI Spot. USD) DJ UBS Commodity index

1.341 109.77 300.28 Date

Economic Releases (27 Feb - 1 Mar)

Eurozone CPI Estimate (Feb, y-o-y) China PMI Manufacturing (Feb)

1 Mar 1 Mar

1 Mar 54.6 US ISM Manufacturing (Feb) Sources: Thomson Datastream, Bloomberg. YTD data until 24 Feb 2012

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