Ironically, Japan’s massive debt pile means that the secondary market for its bonds is larger than most other countries, simply by virtue of the vast amounts of bonds that it has to keep issuing in order to roll over its debt.

This provides the repo market with an alternative to US Treasuries; and more importantly, German and Swiss debt. Both of which are issued by governments with strong reputations for fiscal probity, and thus in much smaller amounts.

This perspective also provides another way of understanding why German and Swiss debt have such low (i.e. negative) yields.

Their governments’ aversion towards borrowing naturally means that they issue less debt, while their perceived sense of fiscal responsibility lowers the probability of default in investor’s minds.

The consequence of this is low supply and high demand, especially for use in repo transactions, where the bonds’ negative yields are of less importance than their utility as collateral.

All of which only serves to further highlight the importance of having JGBs as another source of collateral in the global repo market.

Which brings us to an ironic, and quite surprising potential twist in Japan’s saga of over-indebtedness – the country’s own central bank, the Bank of Japan (BoJ), might play a crucial role in accelerating default.

How is this possible?

Simply because of QE.

As with European and American sovereign debt, the supply of JGBs has been reduced (severely, in some cases) by central bank bond buying. The Bank of Japan (BoJ) has been implementing QE for the last 20 years, reducing liquidity in its own domestic bond markets in the process. (The BoJ owned about 48% of all government debt at the end of 2020)

Reduced liquidity in turn reduces the utility of JGBs as collateral in two ways.

Firstly, the people who need or want to purchase JGBs for use as collateral in repo cannot easily do so.

Secondly, repo market participants who accepted JGBs as collateral and want to sell them cannot do so without moving prices sharply in a manner unfavorable to themselves. 

Both these consequences make JGBs less attractive to use as repo collateral, which could in turn lead to severe second order effects such as JGBs losing their collateral premium.

Which is just a fancy way of saying that traders and investors could stop buying JGBs for use in repo transactions, resulting in higher JGB yields, especially at the short end of the JGB curve.

While this is an extreme scenario, considering that JGBs remain the best “safe” asset for Japanese banks and insurers to own (owning other sovereign bonds comes with FX risk, regardless of how highly rated they are), it is not an entirely remote possibility.

The BoJ themselves tacitly admitted as much by recently announcing that they would reduce the amounts they would purchase in order to make trading in the secondary market more active.

Ultimately, the Japanese government’s dependency on being able to roll over its debt puts it at the mercy of market demand.

Moreover, the enormous amount of debt that they have to continuously refinance leaves little margin for an increase in interest rates. If liquidity issues turn out to be the spark that finally blows it all up, the BoJ might end up having to finance an even larger portion of the government’s borrowing.

How would markets react then?

“Roll over” in the context of debt simply means refinancing, that is, taking a new loan to pay off a previous loan.

While this may sound crazy, it is a widespread practice, and not just for financial institutions and governments. Homeowners refinance their mortgages all the time, although the primary reason they do so is to take advantage of lower interest rates.

Of course governments can, and do, refinance to take advantage of lower interest rates as well, but a government’s ability to do this is influenced by how reliant it is on debt financing.

This reliance in turn depends on their willingness to run up fiscal (budget) deficits.

Naturally, the larger the deficit, the more a government has to borrow in the bond market to fund its spending. And, the more time they spend running a deficit, the more time they spend being indebted.

At some point, it is quite possible for a government to become totally reliant on debt financing.

That is, the amount of money they owe is so large that they cannot afford to repay principal payments at a bond’s maturity. Instead, they must borrow again just to pay off the previous loan, regardless of the level of interest rates.

This is one of the most pressing concerns raised in current discussions of the world’s large public sector debt loads (exacerbated by COVID). That high levels of global indebtedness could easily become mass defaults should interest rates rise, and governments cannot afford to make higher interest payments when rolling over their debt.

Which begs the question, why do investors keep lending to the Japanese government?

Surely the combination of extremely low interest rates and a mind bogglingly large debt pile would send potential creditors running away in fear?

The popular, and often repeated explanation is that most of Japan’s debt is held by domestic investors. Which implies that domestic investors are keeping their own government afloat out of some sense of patriotism or national self interest.

This could be true, at least to a certain extent, but is difficult to prove, and overlooks a far more important consideration – the global repo market.

To be continued…

If this is confusing, think of it this way: anyone who fails to make an interest payment is quite likely to be in a financial situation which renders them unable to pay off the full amount that they’ve borrowed.

Therefore, interest payments must be met, which means that the total amount of debt is of secondary importance, at least when considering if a country will default. 

That being said, total debt is not an insignificant factor in all of this, simply because more borrowing means higher interest expense.

Consequently, there is an upper limit to how much a country can borrow, but this isn’t set at a fixed threshold or some magical predetermined amount.

Instead, it is the result of two factors: the first being interest rates, since lower interest rates mean lower interest expense, and the market’s willingness to allow a country to continuously roll over its debt.

Going back to the example of Japan and its ~USD 11 trillion mountain of debt, the country would probably have defaulted a long while back if its interest rates had moved higher. But, fortunately for the Japanese government, they haven’t.

Instead, Japanese interest rates have been very low for a very long time. 10y JGB yields have not been over 2% since 1997, and have even ventured into negative territory over the years.

Unfortunately for us, these two realities don’t really add up to a situation that makes intuitive sense.

Why would a country with such an enormous debt load have such low interest rates?

Aren’t interest rates supposed to rise as total debt levels rise because creditors are afraid the borrower cannot sustain such heavy debt loads?

Well, in theory this line of logic makes a lot of sense, but reality works differently, as Japan so clearly shows.

Interest rates are more than just a reflection of how much lenders are willing to charge for loaning their money, they also incorporate borrowers’ appetite and ability to borrow.

As such, low rates could also be a symptom of low or nonexistent economic growth that creates disinflationary, if not outright deflationary conditions.

Both of which have been endemic in Japan for decades.

To be continued…

A simple way to conceptualize stock vs flow is to think of filling up a bathtub with water from a running faucet.

Stock is the volume of water in the bathtub, and flow is the volume of water being added to the tub from the faucet.

Should the tub’s stopper not be in place, thereby allowing water to flow out at a faster rate than it is being added in, then the measurement of flow will be negative.

For those inclined to less abstract parallels, a company’s balance sheet is a stock measurement, as it provides a snapshot of its financials at a single point in time.

Its income and cash flow statements are flow measurements, as they measure changes to the company’s financials.

Since stock and flow inherently measure different things, they can’t really be compared to each other.

That is, stock measurements need to be compared against other stock measurements, and flow with flow.

If this confuses you, think of the unstoppered bathtub.

Would it be more informative/appropriate to compare the outflow of water with the amount of water in the tub, or with the inflow of water from the tap?

Naturally, the inflow of water is the better comparison, since if the inflow is larger than the outflow, the net change to the volume of water in the tub is positive. Should the other comparison be used, that is, the outflow of water with the volume of water in the tub, one would reach the incorrect conclusion that the volume of water is decreasing. 

The same concepts apply to a country’s (or for that matter a company’s or individual’s) financials.

Total debt is a stock measurement, while GDP is a flow measurement, and comparing the two doesn’t really provide an accurate picture of a country’s ability to sustain its debt. 

A better measure would be to calculate the ratio of government tax receipts against interest payments.

Both are flow measures and their ratio will show if a government is generating enough revenue to cover its interest expense for the fiscal year.

The corporate equivalent of this is the interest coverage ratio, which takes a company’s operating income divided by its interest expense. Again, 2 flow measures are being compared to each other, money coming in from operations vs money going out as interest payments.

To be continued…

Rising global debt piles are not a new phenomenon, and many forecasts have been made over the years predicting a wave of government defaults. Japan is the best example of this, with predictions of its imminent default stretching back decade. 

Japan still hasn’t defaulted.

As a matter of fact, a good number of traders betting on a Japanese default have instead gone bust themselves.

So much so that shorting Japanese Government Bonds (JGBs) has been nicknamed the “widowmaker” trade. Ostensibly because Traders who have gone bust shorting JGBs proceed to take their own lives, making widows of their wives. 

But why hasn’t the Japanese government defaulted yet?

After all they are in debt to a tune of about 1.2 quadrillion Yen, that’s 1 with 15 zeros behind it, plus an extra 200 trillion for good measure; which works out to be around 11 trillion USD.

Surely any government would have crumbled underneath such an enormous debt load by now, with the Japanese debt to GDP ratio at 266% in 2021, having first moved above 200% in 2009.

That’s 12 years of owing twice as much as the country produces!

Since debt to GDP is the most prevalent, if not popular, metric used when discussing public debt loads, and Japan’s ratio is mind-blowingly high, let’s answer the question of why Japan hasn’t yet defaulted by first understanding what the ratio does and does not represent.

All the ratio represents is how much the country has borrowed relative to how much it produces, and that’s all it is.

It doesn’t tell us how much more a government can borrow before markets stop lending to it, Japan is the perfect example of this.

It also doesn’t tell us if or when a government will default. Again, Japan is a perfect example.

However, a lot of folks intuitively equate production with income, and therefore take the debt to GDP ratio as an indicator of a country’s ability to repay its debts, which just isn’t the case.

Why?

Because, firstly, governments do not pay off their debts using GDP. Governments pay off the interest and principal amounts of their debt using public sector revenues (mostly from taxation).

Since taxes can only be a portion of GDP, this means that the debt to GDP ratio overstates a country’s ability to repay its debt, that is if one interprets the ratio in the conventional way.

But, even with this overstatement, Japan still hasn’t defaulted.

There has to be something more going on.

Which takes us to the next problem of the conventional interpretation – misunderstanding measures of stock and flow. 

To be continued…