Abenomics might eat itself, a Pettis production

Abenomics might eat itself, a Pettis production

David Keohane

| Oct 21 12:28 | 9 comments | Share

It may seem like an odd time to stress out about Japan running an overly aggressive current account surplus, which might in turn push Abenomics off the tracks, but since the fears over a deficit have been so well covered… This is from Michael Pettis, who argues that one of the automatic, if not always intended consequences of Abenomics is to really force up Japan’s current account surplus, and it’s not clear the world will be ready or able to absorb it. In his defense he’s looking a few years, rather than quarters, out: What matters, I think, is that in order to generate growth Tokyo is planning to implement polices aimed at raising both inflation and real GDP, and these policies are likely to force up the national savings rate relative to investment.What is more, to the extent that these policies are successful in generating higher nominal GDP growth, they create a problem for Tokyo in how it decides to set domestic interest rates. Japan has never really resolved the overinvestment orgy of the 1980s. Instead of writing down bad debt it effectively transferred much of it to the government balance sheet, and now this huge debt burden is itself becoming, I think, a constraint on the success of policies designed by Tokyo to spur growth.

The argument for why there hasn’t been a Japanese sovereign debt crisis are pretty well known and are also a large part of why Pettis thinks Tokyo is so eager to engage in polices that force up the Japanese savings rate — as Citi put it recently “so long as the current account is in surplus, the marginal purchaser of new JGBs issued by the sovereign can always be a domestic buyer.” The Bank of Japan now aggressively included.

That’s why the problem most people foresee is that Japan’s current account turns negative. From Citi’s Buiter and Rahbari:

As Japan continues to age rapidly, its household saving rate will continue to decline. It is possible, but not likely, in our view, that the corporate saving rate will continue to rise to offset this…

At the point where Japan becomes a persistent current account deficit country, the marginal purchaser of newly issued Japanese securities is less likely to be a domestic investor. It is quite plausible that yields on Japanese securities, including but not limited to Japanese government bonds, could rise quickly and sharply once the marginal purchaser is a foreigner.

Frankly, while that only underlines scepticism about how realistic a longer-term current account surplus is, we lack the tools to balance the ongoing demographic shift with Japan’s desire to generate growth by structurally forcing up its savings — or to put it another way, growing at the expense of its trading partners who might fight back anyway — and it doesn’t seem too silly to cover one’s bases here.

(This might also be a good place to point towards Citi’s aside on the current account and the exchange rate on p38 of their note. In summary: “The notion that any sharp depreciation of the real exchange rate, regardless of what causes it, is necessarily accompanied by an increase in the trade balance surplus or current account surplus is theoretically suspect… even the data don’t speak clearly – they barely whisper.”)

That said, we should push on and note that Pettis is increasingly wary of Japan’s nominal interest rate and worries that as it rises debt servicing is going to get a lot more difficult as “the real cost of servicing the debt during each payment period consists [then] of interest plus some real principal.”

“Nominal rate rise,” you say dubiously? It depends on what path Japan chooses to tread. A large final chunk from Pettis with our emphasis:

Japan is trying to generate both positive inflation and real GDP growth, so that it is trying urgently to raise the growth rate of nominal GDP. What happens if and when it is successful? For example let us assume that Japan’s GDP is able to grow nominally by 4-5% a year – what will happen to the nominal Japanese interest rate?

Tokyo can either raise interest rates in line with nominal GDP growth rates or it can keep them repressed. In the former case, debt-servicing costs would soar, ultimately to 8% of GDP or more. This would create a problem for Tokyo in its ability to service its tremendous debt burden. It would need a primary surplus of around 8% of GDP just to keep debt levels constant, and it is hard to imagine how such a huge surplus would be consistent with nominal GDP growth rates of 4-5%.

If it were to raise income taxes it would create a huge burden for the household sector and almost certainly force up the national savings rate by forcing down the household share of GDP. Remember that during the 1980s Japan, like China today, generated rapid growth in part through financial repression, and one of the consequences of that rapid growth was an extraordinarily high savings rate along with a huge current account surplus, both of which were ultimately unsustainable. Japan has spent much of the past twenty years rebalancing GDP back in favor of the household sector, and to reverse this process may provide relief in the short term, but it is hard to see how I can be helpful in the medium term.

On the other hand if, in order to make its debt burden manageable Tokyo represses interest rates to well below the nominal GDP growth rate, it is effectively transferring a significant share of GDP from the household sector to the government in the form of the hidden financial repression tax. This is what Japan was doing in the 1980s, with all of the now-obvious consequences.

Japan’s enormous debt burden was manageable as long as GDP growth rates were close to zero because this allowed both for the country to rebalance its economy and for Tokyo to make the negligible debt servicing payments even as it was effectively capitalizing part of its debt servicing cost. If Japan starts to grow, however, it can no longer do so. Unless it is willing to privatize assets and pay down the debt, or to impose very heavy taxes of the business sector, one way or the other it will either face serious debt constraints or it will begin to rebalance the economy once again away from consumption.

As this happens Japan’s saving rate will inexorably creep up, and unless investment can grow just as consistently, Japan will require ever larger current account surpluses in order to resolve the excess of its production over its domestic demand. If it has trouble running large current account surpluses, as I expect in a world struggling with too much capacity and too little demand, Abenomics is likely to fail in the medium term.

Perhaps all I am saying with this analysis is that debt matters, even if it is possible to pretend for many years that it doesn’t (and this pretense was made possible by the implicit capitalization of debt-servicing costs). Japan never really wrote down all or even most of its investment misallocation of the 1980s and simply rolled it forward in the form of rising government debt. For a long time it was able to service this growing debt burden by keeping interest rates very low as a response to very slow growth and by effectively capitalizing interest payments, but if Abenomics is “successful”, ironically, it will no longer be able to play this game. Unless Japan moves quickly to pay down debt, perhaps by privatizing government assets, Abenomics, in that case, will be derailed by its own success.