The Frozen Avalanche

by Mitch Feierstein about 11 years 7 months ago

OK. We know the picture.

Europe is in crisis. Italy shivers on the brink of default. The United States has an utterly unsustainable deficit and politicians who can neither rationalize taxes nor cut entitlements.

Banks are overleveraged and have their books stuffed with low grade assets. Their capital buffers are made up of nonsenses such as tax losses and goodwill. Banks need to meet tougher new capital adequacy thresholds soon, but the equity markets aren’t so crazy that they’re offering heaps of new money.

High Quality Collateral - suitable for ECB

High Quality Collateral - suitable for ECB

Meanwhile, the ECB is extending credit to anyone at all (Big Issue, sir? That’ll do nicely). Sarkozy, Merkel and Obama are all thinking about re-election. Central bankers are printing money till the smoke rises from their printing presses.

But in all of this, Japan remains quiet. Its bond yields remain subdued. Sure the country has problems – those nuclear reactors are almost all silent now – and it’s become exquisitely dependent on imported fosil fuels. But Japan is still Japan. It doesn’t need to tap international markets for its bonds – its domestic savers will take care of all that. And that pool of savings is pretty much infinite, right?

Well, I don’t think so. Financial gravity ALWAYS works. What goes up must always come down. You don’t know when. It’s always tough to call the turn in the market. But simple math tells you that something has to change. Greece got into trouble – got into CCC-rated, 50% haircut, sorry-we’re-bankrupt type of trouble – with a debt to GDP ratio of around 165%. Italy got into yikes, scary, 7%-yields-and-fire-the-government trouble with debt to GDP of 120%.

And Japan? Its gross debt to GDP ratio is way over 200%. Its net debt to GDP ratio (possibly a fairer one to look at) stands at closer to Italy’s 120%.

And that’s OK … so long as lenders lend at near-zero rates to the government. If lenders start to demand an ordinary market return on funds – let’s say something nearer 5% – that debt to GDP of 120% looks like being very lethal, very fast.

Japan's bank balance sheets look worse than this

Japan's bank balance sheets look worse than this

So far, domestic savers have indeed been willing to fund the government. But for how much longer? The country is aging. Food and fuel prices play as great a part in Japanese household budgets as they do elsewhere. The country’s great manufacturers are increasingly offshoring jobs. Japan is not a convincing provider of services. The costs of nuclear catastrophe and rebuilding are huge.

If the currency stays strong, then manufacturers bleed – which is bad news for the government’s finances. And if the currency weakens, then the low-yield case for holding yen fails – which is even worse news for the government’s finances.

Meantime, don’t even talk to me about those Japanese banks: they’re mountains of insecure assets glued together with dubious accounting and lashings of hope.

Stand well clear: this avalanche is melting.