Pettis: "Abenomics Likely to Fail in Medium Term, Debt Matters"

Michael Pettis, at China Financial Markets, discusses Abenomics, Japan's shrinking (for now) current account surplus, debt, and interest rates in an interesting email. From Pettis ...

Abenomics in Japan is likely to put upward pressure on the national savings rate in Japan (but not necessarily on the household savings rate). This implicitly requires that over the next two or three years Japan run a higher current account surplus. In a world struggling with excess capacity and insufficient demand, pressure to increase the Japanese current account surplus is likely to result in higher unemployment – either abroad, if Japan’s trade partners do not take steps to protect themselves from the counterbalancing deficits, or at home if they do.

It may seem a little quixotic to worry about a surging Japanese current account surplus just now when in fact Japan’s external balance has declined substantially and is surprising analysts on the downside.

As I discuss in the first two chapters of my January book, "The Great Rebalancing", currency depreciation does not affect the trade balance directly by changing relative prices. It does so indirectly by changing the relationship between savings and investment.

As production rises relative to consumption, the difference between the two – the national savings rate – must also rise. This means that as the yen depreciates, the consequence is likely to be an increase in the Japanese savings rate.

But it doesn’t end there. Japan seems to be taking other steps to force up its domestic savings rate. Here is last Tuesday’s Financial Times:

Shinzo Abe, Japan’s prime minister, pledged to press ahead with the first increase in sales tax for over 15 years despite objections from some of his closest advisers, gambling that measures to address the country’s massive debts would not hinder his attempts to jump-start the economy.

The increase in the consumption tax, part of the proceeds of which will be used to increase infrastructure investment, will accomplish many of the same results as the deprecation of the yen. A consumption tax, like a tariff, is effectively a kind of back-door currency devaluation, with a slightly different mix of losers among the household sector and winners among the producing sector.

By boosting production and reducing consumption, however, it automatically forces up the national savings rate in the same way as does currency depreciation.

So far, this all looks like an attempt by Abe to increase Japanese competitiveness and so increase its total share of global demand, but not by increasing Japanese productivity, which is the high road to growth, but rather by reducing the real Japanese household income share of what is produced. This effectively means Japan will be growing at the expense of its trading partners. As the Japanese become less able to consume all they produce, the excess must be exported abroad.

If the world were in ruddy good health, we might not worry too much about policies aimed at Japan’s pulling itself out of the mess created in the 1980s, but with the whole world struggling with weak demand and with country after country trying to reduce domestic unemployment by selling more abroad – effectively exporting unemployment (with Germany in particular hoping to resolve the European crisis not by increasing its net domestic demand, as it should, but rather by forcing German surpluses outside Europe) – there is a real question in my mind as to how successful the Japanese program of Abenomics is likely to be if it implicitly requires a burgeoning trade surplus.

Expect Higher Unemployment

If Japan forces up its savings rate, and assuming that we are unlikely to return in the next few years to a credit-fueled consumption binge, the only way the world can respond to a structural forcing up of the Japanese savings rate is either by higher unemployment outside Japan or, if Japan’s trade partners take steps to protect themselves from higher Japanese trade surpluses, higher unemployment inside Japan.

Enormous Debt-Servicing Cost

Japan is struggling with an enormous debt burden, and perhaps this explains why Tokyo is so eager to engage in policies that force up the Japanese savings rate. As long as more than 100% of Japanese borrowing is funded by domestic savings (if Japan runs a current account surplus is must be a net exporter, not importer, of capital), it doesn’t have to rely on fickle foreigners, who might not be satisfied with coupons close to zero, to fund its enormous debt burden.

But the debt burden creates its own very dangerous source of trade instability. To understand why, we need to consider what happens to interest rates in Japan if nominal growth rates rise.

In Japan, interest rates are currently very low, close to zero. With total government debt amounting to more than twice the country’s GDP – which puts it among the most heavily indebted governments in the world – it is not hard to see how low nominal interest rates benefit Japan. With interest rates close to zero, there is very little cashflow pressure on the government from servicing its debt.

Real vs. Nominal Interest Rates

Some people might argue that nominal interest rates do not matter. We should be looking at real interest rates, they would argue, and with Japan’s having experienced deflation for much of the past two decades, real interest rates in Japan are high and the nominal rate is largely irrelevant.

This is true, real interest rates do matter, but it doesn’t mean that nominal interest rates do not. In fact both real and nominal interest rates matter, albeit for different reasons. Real rates matter for all the obvious reasons – they represent the real cost to the borrower in terms of a transfer of resources from the borrower to the lender. But nominal rates also matter because they effectively determine the implicit amortization schedule of principal payments.

When the nominal rate is zero or close to zero in a deflationary environment, in other words, interest is effectively capitalized in real terms. In fact, whenever the real rate exceeds the nominal rate, as it has in Japan for much of the past two decades, the cashflow cost of servicing the debt is lower than the real cost, and the difference is effectively converted into real principal and deferred. In real terms, in other words, Japanese debt is growing by the difference between the real rate and the nominal rate, and this effectively represents a reduction in the cashflow cost of servicing its debt.

When nominal interest rates are positive and higher than the real rate, however, there is effectively an acceleration of real principal payments. This means that as long as nominal rates are very low, the real cost of servicing the debt is low and the principal payments are postponed, with some of the interest even being capitalized. As nominal rates rise, however, the real cost of servicing the debt during each payment period consists of interest plus some real principal.

This is just a long, perhaps pedantic, way of pointing out that even if the real interest rate in Japan declines, debt servicing is likely to be much more difficult as the nominal rate rises. Japan might be paying a lower real rate, but it is also implicitly paying down principle, instead of capitalizing it. Tokyo would need a significant increase in revenues, or a significant decrease in expenditures, to cover the cost.

So what would force Japan to raise its nominal interest rate? In principle the nominal interest rate should be more or less in line with the nominal GDP growth rate. If it is higher, growth generated by investing capital is disproportionately retained by net savers (including mainly the household sector). There is, in other words, a hidden transfer of resources from net borrowers to net savers.

If the nominal lending rate is lower than the nominal GDP growth rate, as is the case in China today and Japan during the 1980s, the opposite occurs. There is a hidden transfer from net savers to net borrowers, and because net savers are mainly the household sector, this will put downward pressure on the household share of income even as it gooses investment growth. This hidden transfer has been at the heart of the rapid economic growth that typically occurs in financially repressed economies during the earlier stages, and is also at the heart of the investment misallocation process that typically occurs during the later stages. We have seen this very clearly in China.

Will Tokyo Raise Interest Rates?

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.

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.