Japan follow-up

There have been many good comments in response to yesterday's blog entry on the Japanese economy, deserving of a more thorough response than a long comment. Besides, it's easier for me to write this way, so this is not an entirely selfless exercise.

Jakub Rehor commented on the yield curve:

Sorry, the yield curve is already squashed. The 1 year JGBs are yielding 0.0184%, the 30 years 1.4577%. Monetization of debt and reversal of deflation may not move nominal rates much, but the real rates would drop and stimulate the economy.

I'd add that the 10-year bond is now trading at around 70 basis points, so the yield curve is indeed pretty flat already. Squashing the yield curve down even further will indeed reduce interest rates, but I wonder how much stimulus this will actually bring to the economy. Suppose the yield curve goes effectively to zero all the way out to the maturities of 30 years. Initially this will produce a nice (but one-off) price gain for holders of the bonds, but once the curve is stuck at nominal zero, it will cause additional problems for financial institutions who won't be able to ride the yield curve anymore. This means they lose their last instrument for generating relatively low-risk investment income. Of course, with 10-year bonds at 70 bps right now, the situation is already serious, but flatlining at zero could make things worse for the financial sector. And the BoJ would have to keep buying JGBs in order to keep the yield curve pinned down. Once yields reach zero, there's little point in buying any additional bonds. Then again, the state of the financial sector is already so grim that a public bailout and de facto nationalization of the banks may already be inevitable. Whether it's a direct takeover or one that goes through the balance sheet of the BoJ does not matter too much in the end.

As for structural reform, there is indeed an additional deflationary danger in that. But the current situation of endlessly propping up zombie companies can't go on forever either. Corporate Japan has long had a problem with generating a good return on capital, as the fixation has always been on market share rather than economic value added. While the P/E ratio of the Japanese stock market has been very high compared to the US and Europe, its P/BV has been very low; in other words, the amount of earnings generated per unit of capital has been miserable. Eradicating excess capacity will be necessary, as is fixing the NPL problem. You can cure the NPL problem to an extent by inflating your way out of it, but thus far the money supply has proved hard to budge, even with huge increases in the monetary base. It's going to take both structural and monetary measures in order to get the economy going again, and that would require a level of cooperation between the government and the BoJ that we're unlikely to see anytme soon. Politics is a problem in itself, as Thomas Grover pointed out.

Tictoc commented on the demographic problems facing Japan, asking whether it's a big factor in Japan. The population pyramid for Japan is not looking good at all and is showing signs of inversion. According to the Aging Vulnerability Index Japan falls in the category of countries of medium vulnerability, with a score similar to Sweden's and Germany's. The demographics in Japan are far worse than in Europe, but the safety in Japan is not particularly generous, so the overall unfunded pensions liabilities are relatively small.

Clem Snide commented on derivatives scams that are going to blow up in the future. I don't have any knowledge of these (I haven't read the book he mentions), but (to go off on a slight tangent) what amazes me is that we have not seen any big blow-ups in collateralized debt obligations. Usually the equity portion of CDO ended up being a leveraged play on high-yield bonds. With the massive widening of credit spreads and the increased defaults, I would have expected a few CDO deals to go sour by now. Yet nothing big enough has happened to make it to the papers as far as I can remember. Now that credit spreads are tightening again, the worst may be over already. Fingers crossed.