Global markets face a nervous few weeks as they wait to assess the full impact of the devastating Japanese earthquake that has left the world’s third-largest economy confronted with its worst crisis since World War Two.
Some fear the repair bill — estimated at more than $100 billion — will be enough to tip the already precarious Japanese government finances over the edge. Japanese government debt already stands at a prohibitive one quadrillion yen (one thousand trillion yen or $US12.2 trillion) — roughly 20 times the Japanese government’s revenue of 48 trillion yen ($587.6 billion).
The Japanese government has been able to afford to pay the interest bill on this massive debt because, for the past 20 years, Japanese investors have been prepared to accept a yield of around 1.5% on Japanese government bonds. (After all, there are very few attractive ways for Japanese investors to invest their money in the local market. Over the past two decades, Japanese shares have plunged 75%, while Japanese real estate is down 70%. Compared to these two markets, the Japanese bond market has performed brilliantly because falling Japanese bond yields have pushed Japanese bond prices higher.)
As a result, the Japanese government has been able to “self-finance” by selling its bonds to Japanese households and corporates. Typically, Japanese pension funds, insurance companies and banks gather up deposits, and recycle them into government bonds.
But large and persistent deficits means that Japanese government debt is compounding at an alarming rate. At the same time, the Japanese population is getting older and beginning to withdraw from the workforce. As Japanese workers reach retirement age, they start down to draw down their savings. Instead of being lenders to governments, Japanese households will switch to running deficits.
Some analysts believe that in the next few years, the Japanese government will reach the point when it will not be able to fund its deficits by borrowing from its people. At that stage, the country will face two invidious choices. Either the Japanese government will have to pay sharply higher interest rates by borrowing offshore, or else the Japanese central bank will print money and buy Japanese government bonds.
Japan’s horrific earthquake and tsunami will bring this tipping point forward. In the first place, the Japanese government will have little choice but to ramp up its borrowings in order to help pay for rebuilding the country.
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At the same time, Japanese households and companies will likely be saddled with a large share of the losses. The Japanese government runs a “Japanese Earthquake Reinsurance”scheme will provides homeowners and storekeepers with earthquake insurance. They buy earthquake an insurance company — limited to 30% to 50% of the amount insured under comprehensive insurance policy — from a private insurance company. These insurance companies are ultimately back-stopped by the Japanese government.
But because there are restrictions on the amounts that can be insured, as well as strict limits on the size of the payouts, it’s likely that even those households with insurance will be still left with hefty losses.
At the same time, commercial losses are only covered by private insurers. But because this insurance is expensive, and there are very restrictive terms and conditions, very few businesses take out earthquake insurance.
As a result, households and businesses will be forced to dig into their savings to pay for a significant slice of the repair bill. This means that the savings of Japanese households and corporates will be eroded, at a time when the Japanese government is under intense pressure to borrow more to rebuild after the devastation.
But, of course, the JER and other Japanese insurance companies will face major claims in the wake of the earthquake. And to meet these claims, they’ll have to sell off assets — many of which they hold offshore.
Fears that Japanese insurers and pension funds will be forced to sell US bonds roiled the US bond market on Friday, pushing prices lower and yields higher. Japan is the second largest foreign investor in US government bonds, holding $US882 billion at the end of 2010, compared with China’s $US1.16 trillion.
One thing is certain: the global economy will not escape the fall-out from the Japanese crisis.
*This article was originally published at Business Spectator