FINANCIAL ICEBERG

Always consider hidden risks

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MARKET INSIGHT

The Japanese Abenomics Experiment : A Fukushima Kind of Result !

​( From IMF, Japan Ministry of Finance, JapanReviewNet, Yahoo Finance, Trading Economics, CNBC, Fair Observer, The FreeLibrary )

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The Situation



Abenomics describes the plans of Japanese Prime Minister Shinzo Abe to revive growth in the world’s third largest economy, which is struggling to find traction under the impact of a strong yen and stubborn deflation.

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Following significant pressure from Abe for bolder action, the Bank of Japan in January doubled its inflation target to 2 percent and made an open-ended commitment to buy assets from 2014. The central bank's new governor Haruhiko Kuroda, has vowed to do "whatever it takes" to achieve the inflation goal in two years.



Japanese ​​are trying it in despair after more than two decades of unsatisfied reforms...



We will show you that even if Abenomics can achieve it s inflation goal, in a longer time frame, it s gonna fail tremendously.



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Japan Government Bond 10Y Yields

Growth Outlook from IMF



​​The near-term growth outlook for Japan has not been downgraded despite renewed recession. Activity is expected to expand by 1.2 percent in 2013, broadly unchanged from October forecast. The recession is expected to be short-lived because the effects of temporary factors, such as the car subsidy and disruptions to trade with China, will subside. And a sizeable fiscal stimulus package and further monetary easing will give growth at least a nearterm boost, with support from a pickup in external demand and a weaker yen.



​​In Japan, the priority is to underpin the renewed emphasis on raising growth and inflation with more ambitious monetary policy easing, adopt a credible medium-term fiscal consolidation plan anchored by the consumption tax increases in 2014–15, and raise potential growth through structural reforms. Absent a strong medium-term fiscal strategy, the stimulus package carries important risks. Specifically, the

stimulus-induced recovery could prove short lived, and the debt outlook significantly worse.



​​What we must realize is that Japan s economy can t rely only on exports for growth. As we can see on the graph below, even from the past ten years, exports contribution from total gross domestic product climbed from 10% to 15%, it didn t avoid a stagnating economy. So it is pure illusin that Japan s own destiny can be changed only by the export sector...

Conclusion

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The Elements of Abenomics - Or the Fukushima Effect



The government of Prime Minister Shinzo Abe has already announced plans to overcome deflation and restore growth with a three-pronged approach—the “Three Arrows for Growth”. This plan includes a bold monetary policy through the institution of a 2 percent inflation target, flexible fiscal policy combining short-term stimulus with a medium-term objective to achieve a primary surplus by 2020, and a medium-term growth strategy.

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The fisrt and immediate impact has been on the Yen. Weakness in the yen is a doubled edged sword for the economy, while it boosts the competitiveness of Japanese exporters, it also increases the cost of the country's fuel imports. Japan's dependence on fuel imports has increased after the Fukushima nuclear disaster in March 2011, which led to the closure of most of the country's reactors.



Read also : ​​



And now on the inflation front :​​ How much can inflation help? Inflation helps in two ways. First, it increases seignorage, that is the amount of resources that governments can buy by printing money. Second, it erodes the real value of public debt in circulation issued at fixed interest rates.



With the 92.6 trillion yen in spending, the government effectively trimmed the size of its draft budget from the previous year for the first time in seven years, taking into account government funding for basic pension payouts, but still relies on borrowing to cover 46.3 percent of its spending.

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And even if they succeed, the tremendous rise interests costs of 2% (and the Interest Costs on the budget rise from 10.7% to 18.2% or from a ¥9.9 trn to ¥16.8 trn !​​ , so a rise of 7.5% in total budget expenses ) will make the budget deficit unsustainable...



​But the assumptions of the Abenomics are really scary ; just because they think that this reflation process can be done in an orderly manner without creating any financial tsunami !​​ Mr Abe, be aware of what hapepned at Fukusima !

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The Elements of Abenomics - Or the Fukushima EffectThe government of Prime Minister Shinzo Abe has already announced plans to overcome deflation and restore growth with a three-pronged approach—the “Three Arrows for Growth”. This plan includes a bold monetary policy through the institution of a 2 percent inflation target, flexible fiscal policy combining short-term stimulus with a medium-term objective to achieve a primary surplus by 2020, and a medium-term growth strategy.The fisrt and immediate impact has been on the Yen. Weakness in the yen is a doubled edged sword for the economy, while it boosts the competitiveness of Japanese exporters, it also increases the cost of the country's fuel imports. Japan's dependence on fuel imports has increased after the Fukushima nuclear disaster in March 2011, which led to the closure of most of the country's reactors.Read also : ​​ Japan s Yen UnCompetitveness And now on the inflation front :​​ How much can inflation help? Inflation helps in two ways. First, it increases seignorage, that is the amount of resources that governments can buy by printing money. Second, it erodes the real value of public debt in circulation issued at fixed interest rates.With the 92.6 trillion yen in spending, the government effectively trimmed the size of its draft budget from the previous year for the first time in seven years, taking into account government funding for basic pension payouts,​​And even if they succeed, the tremendous rise interests costs of 2% (and the Interest Costs on the budget rise from 10.7% to 18.2% or from a ¥9.9 trn to ¥16.8 trn !​​ , so a rise of 7.5% in total budget expenses ) will make the budget deficit unsustainable...​But the assumptions of the Abenomics are really scary ; just because they think that this reflation process can be done in an orderly manner without creating any financial tsunami !​​ Mr Abe, be aware of what hapepned at Fukusima !



So even with the lowest interest rate ever, the National debt service is taking 10.7% of the budget expenses as interest payments and 13.3% for the National Debt Redemtion purposes ( more explanations below ). Interesting indeed, it s crucial to remember that :

​we ll come later on that subject...

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​Japan recorded a Government Budget deficit equal to 9.70 percent of the country's Gross Domestic Product in 2012 as shown by the graph below...

Read also : Highlights of the Japanese Budget for FY 2013

Shrinking Population



​​Fiscal and monetary measures could not provide a rapid cure for massive balance-sheet recession, and long-term economic stagnation has been complicated by structural problems, primarily by aging, and soon also shrinking, population, growing income disparities and disappearing local economies.

A Financial Tsunami

​Some History - Back in 1998



​​The danger from Japanese public debt is not from insolvency, that is, from the stock of debt amassed, but from illiquidity, that is, volatility in the flow of payments. An austerity minded combination of budget hawks within the Japanese bureaucracy, impatient advocates of structural reform provoking a sense of crisis, and bond rating agencies trying to demonstrate that this time they are ahead of the curve, have all added uncertainty to the JGB market. Investors are encouraged to look for signs of "backsliding or "runaway spending" in the issuance of Japanese government debt, rather than focusing on the costs and benefits of specific regulations and spending decisions, which are what count. That kind of financial scenarios can happen again, especially with the political situation, the Japan/China fight over Senkaku Islands and world economy slowing...

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The consequence of such scaremongering is a tendency in the JGB market to panic. Such panics result in sharp spikes in interest rates with abrupt movements of funds out of the market. And the economic impact of such a panic can be sizable. Directly, the rise in interest rates and the increase in volatility of the Japanese benchmark add greatly to the cost of borrowing, thereby diminishing investment. Through Japanese banks' unusually large holdings of JGBs -- increasing in the last 18 months as recapitalized banks have gone to safety rather than rolling over bad loans -- a rise in JGB rates further harms the credit markets by crunching bank balance sheets. Uncertainty about the longer-term course of the yen increases as well, with a short-term surge in the yen against the dollar likely resulting from narrowing interest rate differentials.



This panic scenario played out in January 1999 ( see graph below ). The Trust Fund Bureau of the Ministry of Finance intentionally created a stir in the Japanese press by announcing that it was out of funds to buy government bonds, and they tried to suggest the limits of Japanese government borrowing were being reached. (In reality, the bureau was running up a 1 trillion yen surplus). This was preceded by a Moody's downgrade of Japanese government debt (to Aa1) in November, explained by specific reference to the increasing debt level. The good news on financial reform and tax cuts, and Japan's enormous reserves, was ignored.



The press initially treated the January JGB developments as vindicating the downgrade. As a result, yields on 10-year government bonds shot up 120 basis points in two spikes over just six weeks, peaking at 2.4 percent the first week of February. After choosing not to respond at its January 19, 1999, monetary policy meeting, the Bank of Japan (BOJ) took action at its February 12 meeting by lowering the overnight rate target to below 0.15 percent. The Bank also made it clear, at least as importantly, that the long-term interest rate rise should be opposed. Meanwhile, without announcement, the Trust Fund Bureau reversed course that same week following the peak, and began buying 10-year JGBs again.



Thus, the seemingly open-ended climb of interest rates, once the panic set in, scared the policymakers into more responsible action, and order was restored. However, yields on 10-year JGBs have remained at 1.7 percent since March 1999 rather than the 1.2 percent level they had smoothly risen to before the panic hit. This 50-basis point panic premium, now 15-months old, has cost Japanese taxpayers at least 0.5 percent of GDP in increased interest payments. It has also cost Japanese business an unknown amount both in higher borrowing costs and in coping with a higher yen.



The Japanese Budget

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The first full-year draft budget compiled under Prime Minister Shinzo Abe, who led his Liberal Democratic Party back with promises of economic revival, marks symbolic improvement after years of deterioration.



With the 92.6 trillion yen in spending, the government effectively trimmed the size of its draft budget from the previous year for the first time in seven years, taking into account government funding for basic pension payouts, but still relies on borrowing to cover 46.3 percent of its spending.



Taken together with an 10.3 trillion yen extra stimulus plan signed off earlier this month and financed in more than half by new bond sales , it drives borrowing to new highs, pushing Japan's record high debt further into uncharted territory.



In fiscal year 2013/14 starting in April, the government plans to issue new bonds worth 42.8 trillion yen, below this year's 44.2 trillion yen initial target. But combined with the extra budget borrowing of 5.2 trillion, Abe's government will borrow 48 trillion yen, though technically the extra budget borrowing will be booked in the 2012/13 accounts.



Tax revenue is targeted to rise 750 billion yen to 43.1 trillion yen, mainly reflecting an expected pick-up in economic growth to 2.5 percent from 1.0 percent forecast for the current year .















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Within the 92.6 trillion yen general-account budget, spending excluding debt servicing costs is estimated at about 70.3 trillion yen, slightly less than the 71 trillion yen earmarked in the regular budget for the current fiscal year.



So far, however, vast domestic savings have allowed Japan to comfortably cover nearly all of its financing needs at home and at record low interest rates.



With Japan's population rapidly ageing, social security spending reached 29.1 trillion yen, including a natural annual increase of 800 billion yen and accounting for about one-third of the budget spending.



The snowballing debt has boosted debt-servicing costs -- interest payments and redemption -- to 22.2 trillion yen, up 300 billion yen from a year before, even with an expected interest rate at its lowest ever.



And as we can see on the graph below, Japan debt to Gross Domestic Product is the highest among the developed nation and climing very fast...​​

The Japanese Public Debt



Find in the table below ( from Ministry of Finance of Japan ), the details about the Japanese public debt.​​



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Observations from the Total Japanese Public Borrowings :

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In Trillion Yen​ Amount % Total Debt

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1) Total debt 9.972 100.0

2) ​​​ Financing Treasury Bills 1.313 13.2

3) ​ Long-Term debt (10 years or more) 5.433 54.5

4) Medium-Term debt (from 2 to 5 years) 2.167 ​ 21.7



5) Debt with term below 5 years 3.480 34.9

6) Debt with term between 5 to 10 years ​1.059 10.6

The What If Abenomics Scenario



The Abe s Scenario ​​means that with the new mandate of the Bank of Japan is to re-inflate the economy with an inflation target of 2 percent. What we are forgetting, is that Japan reached a 2 percent inflation rate in 2008 as shown by the graph below.



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And back then the market was convince that the inflation spike was temporary ; even then, the yield on Japanese bonds with a maturity of 10 years rose from 1.3% to 1.8% as shown by the graph below...

Japan Government Bond 10Y Yields

What if they succeed with their inflation target ?



The what if scenario is simple ; ​​what can happen if they succeed with the perception of a permanent 2 percent inflation rate ?

The most obvious one is that interest rate will rise according to it by at least 2 percent. But let s stay conservative and say that a permanent rise on the whole interest yield curve of 2 percent will occur quickly...



What can be the consequences for the Japanese ?



Let s evaluate the potential cost of arise of 2 percent interest rate. We know from the table above that 35% of the total debt will mature within the next 5 years. Let put an immediate rise of 2% intrest rate on that as shown in the table below :​​ ​ ​

Potential Cost of a rise of 2% in Japanese Interest Rates





In Trillion Yen



​​Debt Amount



Debt Total 9.972



Interest on Debt 0.99027​​

(from the budget)​​​



Average cost on debt (yield) 99.3 basis points

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The Redemption of the National Debt - The Hidden Part of the National Debt Service

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As a result of the successive issuance of the government bonds, the cost of overall national debt services (i.e., interest payments + bond redemption + administrative costs) reached approximately ¥22.2 trn in the FY2013 budget, amounting to 24.0% of general account expenditures. According to the Ministry of Finance, ¥9.9 trn of this cost is for interest payments, and amounts to 10.7% of general account expenditures. The amount of outstanding bonds have increased annually, along with annual bond issuance, but interest payment have been maintained at approximately ¥9.9 trn, or 1.7% of GDP, due to the historically low interest rates. If interest rates take a rising trend along with future economic recovery, interest payments will also increase accordingly.



​​However, in addition to interest payments, a number of economists also acknowledge the growing question of Japan's redemption costs. In contrast to most other advanced countries, the redemption system for Japanese Government Bonds, or JGBs, is based on the use of sinking debt funds that distinguish between new bonds and refinancing bonds.



Known as the "60-year redemption rule," Japan's system requires JGBs to be completely redeemed in cash over a 60 year period irrespective of bond duration. These cash redemptions are required to be paid from sources other than refinancing bonds. For example, if ¥60bn-worth of 10-year JGBs were issued, ¥10bn would be subject to cash redemption 10 years later, with a ¥50bn balance redeemable through refinancing bonds; 10 years later, an additional ¥10bn would be subject to cash redemption, with a ¥40bn balance redeemable through refinancing bonds and so forth. The process continues until the ¥60bn of 10-year JGBs are completely redeemed through legitimate tax revenue sources. As government retained revenue is the final payable source of all its expenditures, the Ministry of Finance continues to look for ways to strengthen its debt management policies.



So for the fiscal 2013 budget, the redemtion cost ​of the National Debt is ¥12.339 trn or 13.3% of the total budget expenditures.



​​The history Japan's total debt service costs (i.e., interest payments + bond redemption + administrative costs) as a percentage of the central government's retained tax revenue (=tax and stamp revenue - local tax transfers) is quite scary indeed!. National debt service costs have risen to almost 51.6% of retained tax revenue, and are becoming a major burden to the Japanese financial system.

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So if we have 65% of the debt with an average cost of 99.3 basis points and the other 35% remaining cost rise 2%, so 99.3 +200 gives us 299.3 basis points, we have a new average cost in yield :



( 65% X 99.3 basis points ) + ​​ ( 35% X 299.3 basis points ) = 1.693 basis points



and the Interest Costs on the budget rise from 10.7% to 18.2% or from a ¥9.9 trn to ¥16.8 trn !​​

If we take account of the rise of 2% of interest rates ( we saw that the interest service costs was going from the 10.7% to 18.2% of the total budget , or from a ¥9.9 trn ¥16.8 trn ), and add the national debt redemption of ¥12.339 trn, we obtain a total of ¥29.182 trn or 67.7% of tax revenues !

Concerns over Japan



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