8 March 2010

Global Strategy
Alternative view
www.sgresearch.com

Popular Delusions
More on Japan’s brewing fiasco, and some musings on recent pushback

Dylan Grice
(44) 20 7762 5872 A few months ago I wrote about an impending government funding crisis in Japan. The
dylan.grice@sgcib.com
pushback was so interesting I thought it worth writing up. None of you really disputed the
long-term problems facing Japan but, for various reasons – which I’ll look at below – very few
of you thought it was worth worrying about just now. Meanwhile, the biggest JGB holder on
the planet – the Government Pension Investment Fund (GPIF) – which has already admitted
it’s no longer able to roll maturing bonds, has announced that it will open credit lines so it
doesn’t have to sell them to fund its obligations. With ¥213 trillion of JGBs to roll this year, or
around 45% of GDP (see chart below), maybe I’m not the only one scared stiff after all!

Q One of the great things about doing this job is the feedback you get from pieces you
write. I have to admit, I’m poor at predicting the reaction a report will generate. In a warning
to anyone following the few predictions I do make, my own favourite pieces have so far
tended to be the ones eliciting the least reaction, while those that have made the biggest
splash have often been the ones which seemed the most obvious. Anyway, philosophically I
believe in reaction more than prediction, judging the response is always more interesting.

Q Broadly there are two types of ‘pushback’ which make you think you’re on to something.
One is outright hostility, sometimes verging on hate mail you receive when you know you’ve
touched a nerve (recently I’ve been called “dishonest” and “immoral” for holding certain
views!). The other is complete apathy suggesting a broad disinterest in the topic.

Global Strategy Team Q The stuff I’ve written on Japan’s fiscal problems recently has fallen into that latter
Albert Edwards category. I should stress, it’s not an apathy born of a lack of understanding of the issues –
(44) 20 7762 5890
albert.edwards@sgcib.com everyone acknowledges the long-term seriousness of Japan’s fiscal position. But people
seem almost fatigued with the idea that a country which has defied bond market logic for so
Dylan Grice
(44) 20 7762 5872 long now is ever going to change. This is what I wanted to talk about this week.
dylan.grice@sgcib.com

JGB maturity distribution; ¥213 trillion to roll over this year (about 45% of GDP)
250

200

Y213tr roll this year … GULP!!!

150

Interest
100 Amount

50

-
2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038

Source: Bloomberg

Macro Commodities Forex Rates Equity Credit Derivatives

Please see important disclaimer and disclosures at the end of the document
 Popular Delusions

To recap, the thesis I outlined back in January 1 was that since Japanese households – the
biggest effective drivers of JGB demand – are set to dis-save in coming years as they retire
(left-hand chart below) there will soon be no one left to finance the government’s nosebleed
deficits at current yields. Indeed, the chart below suggests households are already running
down assets. And because the interest rates which might attract international investors will
inevitably blow up the budget (debt service is already 35% of government revenues at existing
yields) there is a very clear and present danger that the government reverts to the well-
established historical precedent for cash-strapped governments of currency debasement.

Japanese households are set to dis-save (savings as % Japanese households are already running down wealth (non-
disposable income) equity, non life assurance household assets)
20
960
18

16
940
14

12 920

10
900
8

6 880

4
860
2

0 840
03/83 03/85 03/87 03/89 03/91 03/93 03/95 03/97 03/99 03/01 03/03 03/05 03/07 03/09 Q4 1997 Q4 1999 Q4 2001 Q4 2003 Q4 2005 Q4 2007

Source: SG Cross Asset Research

The most common argument I received on why I was wrong to worry was along the lines that
Japan has had rising debt ratios and huge deficits for many years now. Not only have yields
fallen, but the economy has struggled with deflation, not inflation.

To me this feels like ‘recency’ bias at work, which is a type of ‘availability’ bias by which we
overweight events we find easy to imagine relative to those we don’t. Japanese debt markets
have been stable for such a long time it’s difficult to imagine anything different, so we don’t
imagine anything different and predict that the future will look like the past. Now, Japan’s debt
markets may well remain very stable in the future and I’m very open to the strong possibility
that I’m barking up the wrong tree. But ‘logic’ like that outlined above is lazy indeed. It echoes
Bernanke’s now infamous 2005 conclusion that nationwide housing collapse in the US
wouldn’t happen because it hadn’t happened before.

More thoughtful critics argued that I was ignoring the Japanese government’s significant
financial assets. Taking this into account shows a net debt position of closer to 100% of GDP
(chart below), considerably more manageable than the 200% gross debt-to-GDP ratio and
more in line with other OECD economies such as Italy and Belgium (great!).

But I’m not so convinced by this argument, or to be more accurate, I’m not so convinced the
numbers underlying this argument are correct. For a start, around 40% of the assets recorded
on the asset side of the Japanese government’s balance sheet don’t actually belong to the
Japanese government. They belong to Social Security and therefore to the Japanese public.
That the vehicle which owns the assets happens to be publicly owned doesn’t change the fact

1
See “A global fiasco is brewing in Japan” Popular Delusions 11/01/10

2 8 March 2010
 Popular Delusions

that it is a very real liability owed to individuals who must be either paid or defaulted on. It
doesn’t just cancel out.

On a net basis Japan isn’t such an outlier: OECD gross and net debt ratios (% GDP)
250

200

Net Debt to GDP Gross Debt to GDP

150

100

50

0
Japan Italy Belgium USA France Portugal UK Canada Germany Spain

Source: OECD

And who on earth knows what the other assets are worth anyway? The central government,
for example, has funded projects deemed “socially useful” and which private markets
wouldn’t finance. These loans, made via direct ‘investments’ in public sector organisations
(called Fiscal Investment and Loan Program [FILP] agencies), are recorded as assets on the
government balance sheet worth around 10% of GDP. Yet we know from decades of banking
problems and bank recapitalisations that even the loans that markets did finance soured
pretty spectacularly, so one wouldn’t imagine the FILP agency loans to be of particularly high
quality. Indeed, a few years ago two economists at the NBER reckoned that nearly half of the
FILP agencies were insolvent. Maybe those assets are being provisioned for correctly on the
government’s books, but – and call me a cynic if you like – I really doubt it.

But even if we assume those numbers are a fair reflection of asset value there is also the
implicit assumption that the Japanese government can monetise them. But I don’t think they
can. Shares and equity stakes are marked at around 20% of GDP, mainly reflecting Japan
Post Bank - the “jewel in the crown” - with $2.5 trillion in deposits. But last year, plans for its
long-awaited privatisation were shelved, apparently for fear that on a purely private sector
calculus, many small and medium-sized companies wouldn’t qualify for the funding they need
to stay afloat. Keeping it in public sector hands was the only way to ensure their life-support
credit lines weren’t cut. Of course, I may just be being cynical again, but I note that Post Bank
is also a huge buyer of JGBs and doubt it was just the SMEs life support the government was
worried about…

This leads nicely to the other argument worth thinking about, which runs like this: the
household sector may well be retiring and less able to absorb new JGB issuance, but the
corporate sector is expanding thanks to a vibrant export sector. Since corporate sector
savings are as large as households’ isn’t it reasonable to expect them to take over as the
primary source for government funding? The honest truth is that I don’t know. Maybe, I guess.
But my gut feeling is pretty definitively no. For one, the corporate sector doesn’t actually have
as large a pool of savings as the household sector.

8 March 2010 3
 Popular Delusions

Japanese household and corporate assets compared (¥ trillion)

1,600
Non-cash Cash
1,400

1,200

CAN be recycled
1,000
into the JGB market

800

600
CAN'T be recycled
400 into the JGB market

200

-
Non-f in corps Households

Source: SG Cross Asset Research

For another, the corporate sector – even in Japan – doesn’t have anywhere near the same
propensity to hoard cash (see chart above). Open the papers today, for example, and you
read about Astellas Pharma going hostile on OSI, where it thinks it can buy its way out of
Japanese stagnation. When companies have money, they need to spend – sorry ‘invest’ – it
(occasionally they even need to return it to shareholders). Anyway, it looks unlikely to me that
companies are going to take over from households in financing the government’s deficit.

In passing, I think this is why the idea that Japan can’t have a funding crisis because it runs a
current account surplus might not actually stack up. I readily admit to having forgotten most of
the economics I’ve ever done and I will happily stand corrected if any of you think I’m wrong
on this, but I think that if a current account surplus is increasingly dominated by a sector (e.g.
non-financial corporates) with a lower propensity to fund another sector (e.g. the domestic
government), then that other sector must face problems funding its deficit. So is Japan’s
current account surplus even relevant for assessing the risk of a government funding crisis?
Clever economists out there, let me know.

Corporate cash balances as a share of household cash balances (4q mav)

26%

25%

25%

24%

24%

23%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: SG Cross Asset Research

Anyway, if the corporate sector was about to suddenly increase its cash holdings, we’d
expect to see the ratio of corporate sector cash relative to household sector cash begin to
rise. In fact over the last five years it’s been falling (chart above).

4 8 March 2010
 Popular Delusions

So I still worry. Households are retiring and running down their wealth; non-financial
corporates don’t hold as much cash. So the non-financial sector (i.e. households plus non-
financial corporates) just isn’t going to be in a position to provide the financial sector with the
deposits it needs to recycle into JGBs.

That leaves the foreign sector as the only candidate to fund the government’s ever increasing
structural deficits and explains the increased frequency of JGB roadshows we’re seeing
around the globe. But is it realistic to expect foreign investors to fund a likely insolvent
government at 1.5% (if this week’s Greek financings are a fair gauge, investors want closer to
6% to fund insolvent governments)? Anyway, debt service already accounts for 35% of the
Japanese budget! Any reasonable interest rate will expose Japan’s budget for the mess it is.

But why take my word for it? Why listen to the rantings of some supposed “perma-bear”; a
deranged strategist working on a cold rainy island on the other side of the Eurasian continent
from Tokyo, and with no great insight into the workings the JGB market or much else for that
matter? Well, you shouldn’t. But you might want to take Takahiro Kawase, head of Japan’s
$1.2tr Government Pension Investment Fund (GPIF) and the largest owner of JGBs on the
planet, more seriously. He said last summer, “The big change this year for us is that there is
zero new money to invest, so we may need to be a seller in the market to meet the pension
benefits … our bond allocations are overweight, so we may need to reduce those a bit to raise
cash.” Not to worry, though, because he doesn’t think it will have much effect on the market.
“… the sales are not expected to be big, as we can cover the shortfall from maturing bonds.”

How significant a problem is this? In last week’s FT, Gillian Tett pointed to the importance of
debt maturity in assessing fiscal breathing space. UK debt maturity, at 14 years, is one of the
longest, while the US, at 5 years, is one of the shortest. In Japan, based on the Bloomberg
data on the front page chart, the number is around 6, and ¥213 trillion matures in 2010.

To spell that out: we are going into a year in which the government has ¥213 trillion of
bonds to roll over (chart below), and the biggest holder of JGBs is openly admitting he
has no new inflows of money. I suspect he’s not as confident as he’s making out that this
won’t be a problem, and I suspect the Japanese authorities aren’t either. Otherwise, they
wouldn’t be scrambling to arrange a new borrowing facility for the GPIF so that it doesn’t have
to sell JGBs to fund its pension obligations …

Average duration of Japanese government debt

Average JGB Maturity (years)

2005

2006

2007

2008

2009

2010

0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0

Source: MoF, SG Cross Asset Research

8 March 2010 5
 Popular Delusions

IMPORTANT DISCLAIMER: The information herein is not intended to be an offer to buy or sell, or a solicitation of an offer to buy or sell, any
securities and including any expression of opinion, has been obtained from or is based upon sources believed to be reliable but is not
guaranteed as to accuracy or completeness although Société Générale (“SG”) believe it to be clear, fair and not misleading. SG, and their
affiliated companies in the SG Group, may from time to time deal in, profit from the trading of, hold or act as market-makers or act as advisers,
brokers or bankers in relation to the securities, or derivatives thereof, of persons, firms or entities mentioned in this document or be
represented on the board of such persons, firms or entities. SG is acting as a principal trader in debt securities that may be refered to in this
report and may hold debt securities positions. Employees of SG, and their affiliated companies in the SG Group, or individuals connected to
then, other than the authors of this report, may from time to time have a position in or be holding any of the investments or related investments
mentioned in this document. Each author of this report is not permitted to trade in or hold any of the investments or related investments which
are the subject of this document. SG and their affiliated companies in the SG Group are under no obligation to disclose or take account of this
document when advising or dealing with or for their customers. The views of SG reflected in this document may change without notice. To
the maximum extent possible at law, SG does not accept any liability whatsoever arising from the use of the material or information contained
herein. This research document is not intended for use by or targeted at retail customers. Should a retail customer obtain a copy of this
report they should not base their investment decisions solely on the basis of this document but must seek independent financial advice.
Important notice: The circumstances in which materials provided by SG Fixed & Forex Research, SG Commodity Research, SG Convertible
Research and SG Equity Derivatives Research have been produced are such (for example because of reporting or remuneration structures or
the physical location of the author of the material) that it is not appropriate to characterise it as independent investment research as referred to
in European MIF directive and that it should be treated as a marketing material even if it contains a research recommendation
(« recommandation d’investissement à caractère promotionnel »). However, it must be made clear that all publications issued by SG will be
clear, fair, and not misleading.
Analyst Certification: Each author of this research report hereby certifies that (i) the views expressed in the research report accurately reflect
his or her personal views about any and all of the subject securities or issuers and (ii) no part of his or her compensation was, is, or will be
related, directly or indirectly, to the specific recommendations or views expressed in this report.
Notice to French Investors: This publication is issued in France by or through Société Générale ("SG") which is authorised by the CECEI and
regulated by the AMF (Autorité des Marchés Financiers).
Notice to UK investors: This publication is issued in the United Kingdom by or through Société Générale ("SG") London Branch which is
regulated by the Financial Services Authority ("FSA") for the conduct of its UK business.
Notice To US Investors: This report is intended only for major US institutional investors pursuant to SEC Rule 15a-6. Any US person wishing
to discuss this report or effect transactions in any security discussed herein should do so with or through SG Americas Securities, LLC
(“SGAS”) 1221 Avenue of the Americas, New York, NY 10020. (212)-278-6000. THIS RESEARCH REPORT IS PRODUCED BY SOCIETE
GENERALE AND NOT SGAS.
Notice to Japanese Investors: This report is distributed in Japan by Société Générale Securities (North Pacific) Ltd., Tokyo Branch, which is
regulated by the Financial Services Agency of Japan. The products mentioned in this report may not be eligible for sale in Japan and they may
not be suitable for all types of investors.
Notice to Australian Investors: Société Générale Australia Branch (ABN 71 092 516 286) (SG) takes responsibility for publishing this
document. SG holds an AFSL no. 236651 issued under the Corporations Act 2001 (Cth) ("Act"). The information contained in this newsletter
is only directed to recipients who are wholesale clients as defined under the Act.
IMPORTANT DISCLOSURES: Please refer to our websites:
http://www.sgresearch.socgen.com/compliance.rha
http://www.sgcib.com. Copyright: The Société Générale Group 2010. All rights reserved.

6 8 March 2010