If economics could be studied in a laboratory, scientists might concoct something like the circumstances now unfolding in Japan – and policymakers should be paying close attention. According to Kyle Bass, Japan’s currency – and its bond market – are about to collapse under the weight of the country’s unsustainable fiscal deficit.
Bass is the founder of Hayman Capital, a Dallas-based hedge fund. He was featured prominently in Michael Lewis’ book, The Big Short, for profiting from investments during the sub-prime crisis, which he accurately predicted. Bass spoke last week at the University of Virginia’s Investment Conference.
Bass said Japan faces a “huge problem” that will lead to “a massive loss of purchasing power and default,” and US policymakers will have a front row seat to observe the debacle. He hopes Japan’s example will prompt the US to rethink its dependence on countercyclical spending measures, which have led to trillion-dollar deficits. Instead, Bass said, we should “embrace austerity.”
The market is assigning a remarkably small probability to the likelihood of a Japanese default, according to Bass, presenting investors with a tantalizing opportunity. The market’s optimism is illogical, Bass said, and the only reason to think Japan will avoid catastrophe is that it hasn’t happened before.
Betting on a Japanese default has been the undoing of innumerable macro investors. Let’s review why Bass believes this time will be different and what is at stake for the world markets.
A Potemkin village
Fiscal profligacy has been Japan’s undoing, Bass said, and monetary policy is the enabler that will lead to default.
Bass’ talk was titled “The Central Bankers’ Potemkin Village,” and he said that Japan will be the next developed nation to engage in unlimited quantitative easing – window dressing that obscures the underlying crisis.
For the US, Bass said that QE1 was a “desperate need for countercyclical spending,” and QE2 was another “anomalous one-time emergency printing.” But with QE3, Bass said that easing is now the norm.
On December 16, Shinzo Abe will likely become Japan’s next prime minister, and Bass said his taking office will mark the beginning of Japan’s commitment to a similar regime of permanent easing.
On a global basis, that policy is unsustainable, and Bass expects that for Japan it will be particularly stressful. Bass said that global credit market debt cannot grow by 11% per year and central bank balance sheets by 16.4%, as they have over the last decade, while real GDP has grown by only 3.9% annually and population by just 1.2%.
“This is not going to work much longer, and, in fact, you are already seeing the diminishing marginal utility take its toll,” he said. “More debt is not generating more GDP.”
The endgame for some countries, Bass said, will be severe loss of purchasing power, default and hyperinflation at some point. “At a certain point in time, social fabrics will be torn in various countries, and we will see more conflict that will be violent.”
Japan has no chance of ever paying off its debts, Bass said. “When your debts are 24 times your central government tax revenue, you are finished,” he said. “It is just a question of what sets it off.”
Given the alternative of defaulting or inflating, central bankers have chosen the latter, Bass said. But that only delays the inevitable; inflation will lead to negative real rates until “the bomb finally goes off,” he said.
Don’t expect any warnings from central bankers, according to Bass. As was the case when Mexico defaulted in 1995, bankers will say that everything is fine right up to the moment of restructuring. He recalled that, in 2011, Jean-Claude Juncker, the prime minister of Luxembourg, denied attending a meeting about the restructuring of Greek debt. When that falsehood was exposed, Juncker said, “When things get serious, you just have to lie.”
Three false axioms about Japan
Investors have rationalized their belief that Japan can navigate its way around its fiscal problems by relying on three critical axioms, Bass said. He explained why all three are false.
The first contends that Japan can self-finance its debt through its positive current account balance and trade surplus. That statement exhibits a “colossal naiveté,” Bass said, because investors are not paying attention to the magnitude of Japan’s current account as compared to its fiscal deficit.
As for the current account, Bass predicted that, when the October numbers are announced later this month, they will show that it has turned negative.
Several factors are driving that inflection. A strong yen has hurt Japan’s competitiveness. The March tsunami forced all but two of Japan’s 54 nuclear reactors, which provide 31% of its power generation, to shut down. Japan has virtually no natural resources, so it has had to import gas and coal.
The tsunami also forced Japan’s industrial sector – primarily automobiles and electronics – to shift from internally sourcing its parts to using a global supply chain. That will be a secular shift, Bass said, further eroding Japan’s balance of trade.
Recently, Japan’s relations with China have been strained by a dispute over the Senkaku Islands. But unfriendly relations between the two countries are also a secular shift, according to Bass, one that will threaten Japan’s $360 trade balance with China. Bass said that sales of Japanese cars in China dropped substantially in the data reported in late September.
“The balance of trade for October is going to be shockingly bad,” he said.
Major Japanese investors are “exporting yen,” Bass said. One of its wealthiest citizens spent $20 billion to buy 70% of Sprint, even though that company is unprofitable. The Japanese company Dentsu is paying $5 billion to purchase Aegis, in the largest transaction ever for a Japanese advertising company.
The second false axiom is that Japan is not monetizing its debt. That is no more true than was Bernanke’s statement, on 60 Minutes, that the US is not printing money, according to Bass.
This year the Bank of Japan (BoJ) will buy 31 of the 44.5 trillion yen it has issued in bonds, he said, adding that it will buy more over the next few years.
Moreover, the BoJ will lose its independence, according to Bass. He said that a couple of weeks ago a press release indicated that the Ministry of Finance and other government officials had attended BoJ policy meetings – the equivalent of having Hillary Clinton and Timothy Geithner attend a Fed meeting.
The implication, he said, is that the BoJ will print “as many yen as necessary to get to 3% inflation.”
Bass dismissed the notion that, as some advocate, Japan should continue to print money and monetize its debt, forever forestalling default. That process will lead to hyperinflation, he said. Hyperinflation, according to Bass, has occurred 23 times in history, always after that kind of printing spree.
Another worrisome sign is that Japan’s long-term rates have not come down, despite an impending recession with its GDP falling at a rate of 3.5% to 4%. Normally, Bass said, the yield curve would invert – or at least flatten – under those conditions.
The third axiom upon which investors have historically relied is that retail investors will support the Japanese government bond (JGP) market. That is a mistake, Bass said.
Bass said retail ownership of Japanese debt has fallen from 5.5% to 3.5% since 2008, and the underlying cause is demographics – a secular decline in population, caused by a death rate that exceeds its birth rate. About three months ago, according to Bass, adult diaper sales in Japan exceeded children’s – a milestone he half-jokingly referred to as a “critical threshold.”
Estimates are that the Japanese savings rate will be below zero for 2012.
“You have more people dis-saving than saving,” he said. “In fact, you are going to have to sell bonds.”
In what he called a sign of desperation, the Ministry of Finance has embarked on an aggressive marketing campaign for JGBs aimed at the retail market, Bass said.
“As long as you have population growth and worker growth, you don't have to live up to your promises,” he said. That is why the US can forestall dealing with its entitlement crisis and why Japan’s options are cut off.
The mispricing of risk
Japan runs the largest structural fiscal deficit of any country in the world, at 10.5% of GDP, Bass said. Its aging population is strangling tax revenue, and its GDP is plummeting. The flow of domestic JGB buyers is gone and, despite massive intervention, the yen is still strong. “It is the perfect recipe for disaster,” he said.
It won’t take a big rise in rates to cripple Japan, Bass said. “A 2% move and they’re dead.”
Things are in such disarray, according to Bass, that Japan has had 10 finance ministers in the last six years, and five in the last three.
“I am not naïve enough to tell you I can call the end of the debt supercycle with any kind of precision,” Bass said. “But I can lay out every single fact that exists, and it all points in the same direction. What is interesting is that no one is paying attention.”
The extraordinary detail is that the market is strongly betting against this outcome, at more than 300-to-1 odds against, according to Bass. “It's the single cheapest option I’ve ever seen in my entire life, bar none. And I don't believe you’ll ever see another one again.”
“At the point in time at which bonds have never been riskier in post-World War II history, the optionality on those bonds is the cheapest it has ever been,” he said. “The Black-Scholes model dramatically misprices risk at secular turning points.”
The reason for this mispricing, according to Bass, is a psychological bias. Investors have been numbed to believing that the current placid conditions that prevail in Japan will continue. “We are inherently optimistic,” he said, “and this outcome is so negative it is easy to dismiss.”
I spoke with a hedge fund manager, who asked to remain anonymous and said that the biggest payoff would come from shorting JGB futures. The leverage on invested capital is enormous, he said, with a payoff of between 50- and 100-to-1, but that same opportunity may not be available to retail investors.
Bass said that virtually his entire fund is invested in long positions in US mortgage-backed securities, but he is maintaining a 100- to 150-basis-point bet on a Japanese crisis.
Japan may be able to buy itself more time, Bass said. One way would be to peg its currency to the dollar, which would require further monetization. “They may have a few more moves left on the chess board,” he said, “but they are already in checkmate.”
Nobody is ready for this, Bass said, and a Japanese default or restructuring will hurt countless investors, including many of his friends. “I get paid to be a realist,” he said. “I put my portfolio together based upon our views, and my view is this looks like it is going to happen in the next couple years.”
One entity that denies the possibility of a problem is Japan’s Ministry of Finance. On the Q-and-A section of its website, it was asked what would happen to government bonds in the event of a financial collapse.
Its answer (through a Google translator): “The government bonds will be redeemed because the government is responsible. Please do not worry.”
Read more articles by Robert Huebscher
