The chess and investing are similar processes. In order to be successful investors, we must foresee the coming, many moves before it happens and we must position ourselves for it.  I’m sharing this analysis with you so you can position yourself for the coming. I know that most of you are interested more of what is happening in Europe and it’s obvious as you are Europeans. But still I think that the best trade and most profitable trade from a risk/reward perspective is related to Japan. When we talk about Japan, I’m talking you about what will happen within the next 5 years as I believe that I’m many moves before the markets which are focused on Europe’s debt crisis.

In this analysis I will answer the following important questions:

1. Why Japan’s crisis will shake the world in few years?

2. Why for many years hedge fund managers betting against Japan lost money and why they were wrong?

3. How can I profit from what is coming? Why position now?

4. Why Japan’s debt and economy are not safe? Most people think Japan is save because: 

-  Japan is net creditor and have huge reserves.

- Japan has trade surplus so it gets more money than spends from outside.

- Japanese government bonds are locally hold so it’s not a target for sudden yield spikes or attacks from foreign bond holders.

I will prove you are wrong! And of course my final prove will come when you see Japan all over the news within the next 5 years at maximum.

1. Why Japan’s crisis will shake the world in few years?

First I would like to state that this analysis has nothing to do with the earthquake that hit the country. Even without it, Japan would still face what is awaiting it. The earthquake will only speed up the coming. If Europe’s debt crisis doesn’t put the world into a deep recession or depression, Japan will certainly do it.

The reason why it will happen soon is because the Japanese government financing works as a big Ponzi scheme that relies on new funds coming to feed it. Very soon the Ponzi will run out of new buyers of bonds. In fact, once there are no more enough buyers of bonds, and the 10-year Japanese government bonds go from 1% yield to 2% yield (or 1% increase) Japan will be near default. I will explain more about that below. Now let’s take a look at their balance sheet:

1. Government revenues in 2010 are 92.3 trillion yen of which 44.3 trillion yen are New Government bond Issues and 48 trillion yen are (real revenue).

2. Government expenditures in 2010 are 92.3 trillion yen of which 53.4 trillion yen are General expenditures, 17.47 trillion yen are Local Allocation Tax Grants and and 20.6 trillion yen is National Debt Service.

Source: Ministry of Finance Japan - http://www.mof.go.jp/english/statistics/

Ponzi system is one that relies on new money coming in to support the system. Let’s say they don’t issue new debt. That means they have real revenue of 48 trillion yen and they have 20.6 trillion yen in national debt service. That means that 43% of the whole Japanese government revenues goes only to service the national debt and that is when interest rates are at historical low levels. According to SG Cross Asset Research, the average Japanese bonds yield in the last 200 year is 5.8%. See a chart between 1985 – 2011, and think, can Japan interest rates go much lower than now?

According to the 2011 statistics, the service of debt is now approx 50% of the revenue with 10 year Japanese government bonds at 1.05%. Now, image what will happen if their yield suddenly spike not as in Italy (from 3-4% to 6-7%), but to 2%? All the revenue of the 3-rd biggest economy in the world will be consumed to service the national debt only. This is the checkmate of Japan.

Now let’s talk about what Japan can do to improve their finances. They either have to increase revenues or decrease expenditures.

But is that achievable? I will start with expenditures as they are less complicated.

Expenditures. For 2010 Japan’s expenditures are: 92.3 trillion yen of which:

Source: Ministry of Finance Japan - http://www.mof.go.jp/english/statistics/

Of course, there is no way to lower national debt service because Japan continues issuing new debt to pay old and to keep financing itself so even with interest rates going down, the debt service increases, and as you can see interest rates hardly can go much more lower than now – 10 year bonds at 1%. Local allocation tax grants can also hardly can be reduced in any significant amount. By most they can decrease some 2-3 trillion yen but this will stiff have negative impact on the Japanese economy. So only general expenditures are left to see.

Source:  Ministry of Finance Japan - http://www.mof.go.jp/english/statistics/ Data for 2010.

So, as you can see Social Security is 51% of all the expenditures. You can hardly cut here without first seeing the debt crisis as the government will not have reasonable motive for the population.  Japan has one of  the most aging population in the world, so the social security share of all only keeps increasing and even if you have reason and people agree on a cut here, the social security expenditures will hardly go down. So with :  Social security + National debt service = 47.8 trillion yen, and Real government revenues (48 trillion yen), you can see why Japan is near. Basically if all expenditures are cut and Japan only pays social security + national debt service, Japan will soon won’t even be able to afford them without issuing new bonds …

If we image that somehow worldwide investors believe that it doesn’t matter what Japan issues new debt to cover old, and look at it’s fiscal situation as (Revenue = revenue + new bond issues), to balance the finance of Japan we can cut from here and there to decrease the expenditures. By how much do you think, Japan can cut some of the expenditures above? If you agree that social security expenditures can’t be lowered, now let’s look at next most most important expenditures: Education and science, Public works, Miscellaneous accounting for about 30% of the expenditures. Can Japan, close schools and universities now ? Can they cut public works? Yes, but not significantly. Miscellaneous is hard to analyse so I have no idea but I believe it won’t be significant. Japan’s economy is near recession and if they cut expenditures that will surely be very negative, so in fact if they cut expenditures, revenues will also go down and will probably off-set for the expenditures cut.

My final conclusion about expenditures is that Japan has no big room for manoeuvre that will make change or will increase significantly the extra time before a gigantic debt crisis.

Revenues. For 2010, Japan’s government revenues are 48 trillion yen.

Source:  Ministry of Finance Japan - http://www.mof.go.jp/english/statistics/ Data for 2010.

Now, let’s take a closer look at Japan’s revenue and see if they can be improved. The 5 most important revenue streams are: Individual tax, other revenues, consumption tax, corporate tax and gasoline tax. They account for 40 trillion of the 48 trillion yen revenues.

Even by increasing by 20% the tax for the inheritance, liquor, tobacco, customs duty and stamp tax, the revenue will increase only by 1-2 trillion yen at maximum so it won’t significantly change the finance of Japan. That’s why I will take a closer look not at these but the other 5 revenue streams.

1. Individual tax. Individual taxes are progressive in Japan and are at a level at which no double increase can be made. In September 2011, Japanese government proposed major tax increases of about 5%. One of them is the income tax of individuals, regional taxes, alcohol and cigarettes and consumption tax. The measures are aimed at raking in 11.2 trillion yen in 10 years, needed for the reconstruction of Japan after the earthquake. So basically most of the measures for increasing revenue are already offered, but not to improve the debt problem but to recover from the natural disaster. I’m not sure which of these tax increases will finally be approved and put in place. Noda is already facing opposition within the DPJ to the tax rises. That’s why I believe that tax increases will be much less than needed and finally even for the reconstruction will be paid via new bond issues. So basically there is an opposition to tax increases for only 1.1 trillion yen per year or 2.3% of the revenues. How do you think with revenues you can fix their huge debt problem? Social security expenditures and national debt service will eat such 2.3% increase after after year, when in reality you can’t continue increasing taxes year after year without end.

2. Other revenues. No comment here as to what can be done to increase them significantly, but I believe that it won’t be a game changer for the finance of Japan.

3. Consumption tax. As can be seen by the desperation of Japanese officials, this is the only one tax that can be increased to really make a different. Some commentators on Japan think that this will make a huge difference and will save Japan or give it some more time. What they miss is that raising the consumption tax will not come free and will have significant implications. That’s why they proposed to start increasing the consumption tax from 5% to 10% by 2015. They can’t raise it now, because it will kill their weak economy. They planned it from 2015, because they think there will be a global recovery by then, which I doubt. There will never be a good time to raise the consumption tax in Japan. In my opinion their action will be too late.  I refer you to read an IMF report called: “Raising the Consumption Tax in Japan: Why, When, How?” to get an insight about the IMPACT OF A VAT INCREASE ON GROWTH, INFLATION, AND EQUITY. Contrary to the readers, I believe that the consequences of VAT increase will be worse. They write:

“Higher inflation expectations would be a positive development for Japan, which has been trapped by deflation for year”

I disagree. Japan need deflation or the private sector won’t find the Japanese bonds attractive. 10 yrs Japanese bonds yield 1% now, but with deflation of 1%, it’s 2% real yield. What happens when inflation is 1%? The real yield is 0%. So by increasing inflation the bond appetite will decrease. With rising commodity prices, there could be additional inflation spike and that could be very negative. No matter what is publicly said, Japan need low deflation, more than inflation.

“Many have expressed concerns about the short-term impact of a VAT increase on the level of activity, but Japan’s own experience does not strongly support such views.”

I disagree again. VAT will decrease GDP because the Japanese economy is very weak. Any growth decrease will affect very negativly the finance of Japan. An increase of VAT will also add to the negative local views of the economy and will hurt the low-income population. I with the IMF analysts, that consumption tax is positive long-term, but we must live short-term now, because such an increase could not improve the situation and could expose how bad Japan is. This is similar to Italy’s debt situation. No matter what austerity measures they introduce, the market lost confidence and don’t wanna take the risk. There is also an important problem. Japan can’t implement the VAT increase fast. They can’t do an increase of 5% this year or next … they can increase by some degree with time so it’s a long-term measure. Again that will not help to improve much the finance of Japan and even if it do, it will be after 2015 as they plan to raise the VAT then.

4. Corporate Tax. In 2011 Japan national corporate tax is 30%. The yen is appreciating and companies are hardly making profits. There is also a problem that companies are starting to move factories in other Asian countries. That is a big problem and can’t be overtaken by increasing tax rate, or by letting the yen strength even more. Just the opposite. That’s why if they increase the corporate tax, probably more companies will move overseas and that will lead to 1. higher unemployment with less individual tax revenue + more social benefits 2. less corporate tax revenue. That’s why I doubt Japan will increase the corporate tax rate, even if they do, it will be with very low positive impact if any. It will either increase the corporate tax but decrease the individual or will decrease both revenue streams. I don’t think Japanese government wants their economic machines ( (corporations)) to leave the country…

5. Gasoline Tax. No significant increase can be made that will make change. By somehow getting 20% more revenues from gasoline tax will add just 1.2 trillion yen in revenues. But if they increase the tax during a period like now, when oil price are high, they will cripple the weak economy and will in fact decrease the revenue coming from gasoline tax. The economic activity will decrease and that will lead to deterioration of other revenue streams. In April 12, 2011 was reported that Japan had $6.77 a gallon average price while USA had  $3.79 a gallon.

My final conclusion about revenues is that Japan will hardly improve it’s finances by hurting the private sector’s. Not much can be changed even if the most severe austerity reforms are passed which is in doubt. Japan had six Prime Ministers in 5 years. Don’t wonder why.

2. Why for many years hedge fund managers betting against Japan lost money and why they were wrong?

Bad finances of a country doesn’t mean it will face a debt crisis. The bad finances only add to the problem and one day the confidence is lost. There are two risks that lead to a debt crisis of a country with bad finances. 1. Loss of confidence. 2. Lack of Ponzi buyers. When there are no more ponzi buyers, the confidence is also lost. When confidence is lost there are no more ponzi buyers. So far the confidence in Japan is high as can be observed by the interest rates on Japanese government bonds and there is a reason for that. That is also the reason why many hedge fund managers betting against Japan lost money and were wrong. They just didn’t know when there will be no more Ponzi buyers or at what point of bad finance of a government the confidence is lost. They only looked at the revenue and expenditures situation which shows how bad Japan is, but it was like that since many years. Now I will focus on what exactly hedge fund managers are missing.

Most of the them shorted Japan under the assumption that Japanese investors would simply stop funding Japan because of the bad finance and low yields. But in fact, the yield + deflation, and with lack of other attractive domestic opportunities (decreasing stock, real estate prices …), some investors didn’t have an alternative and Japanese government were able to “self‐finance” by selling government bonds to its households and corporations. As can be seen in some survey, individual investors in Japan don’t think they are exposed to Japanese government bonds and don’t think a collapse of them will impact them. In fact it’s not true.  Japan financed itself because : GPIF, other pension funds, life insurance companies, and banks like Japan Post) have little appetite for more volatile alternatives and little opportunity to invest into something else. Essentially, they take in the savings as deposits and recycle them into government debt. So the whole Japanese population is exposed to the Japanese government bonds. Japan was able to finance so far because the pool of money (or new Ponzi buyers), was more than the need of money (deficit).

The available pools of money are comprised of two accounts – household and corporate sector. The former is the incremental personal savings of the Japanese population, and the latter is the after tax corporate profits of Japanese companies.

As seen in the chart below, as long as the sum of these two numbers exceeds the annual government fiscal deficit, the Japanese government has the ability to self‐finance or sell additional government bonds into the domestic pool of money.

This is the key relationship the investors have missed for the last decade – it is not a question of willingness to finance Japan, but one of capacity. So, it’s not a question of confidence but a Ponzi buyers (which have no idea they have money in a Ponzi scheme).

BTMU believes Japanese household savings will cross into negative territory in 2015 – the downward trend is irreversible without a significant change in demographic profile. The government is also thinking about increasing the tax rates which will lower the pool of money. (NEGATIVE)

Corporate sector profits are hurt by the always increasing yen value. For example, this year they hedged around 85-83 USDJPY and now the exchange rate is 76-77 USDJPY, EURJPY is hedged at 110-113, but the rate is 103 now. This year some companies posted loss for first time in their history like ( Nintendo ), while car makers can hardly profit if the Yen keeps rising. (NEGATIVE)

So my conclusion is that the pool of money will decrease and right now there is also a debt crisis in Europe, which will make investors more scare, there will be less buyers of sovereign debt. Until few years it was believed that bond holdings are risk-free but now the people and investors are well aware the risks.  (NEGATIVE)

Mr Uchida notes that under Basel 2 bank-capital rules there are so-called “outlier criteria” for banks with a heavy exposure to interest-rate risk, such as the Japanese banks. This will eventually limit how many JGBs the Japanese banks can hold. Under a stressed scenario in which JGB yields move up or down by two percentage points, the loss the banks would suffer must not exceed 20% of Tier-1 and Tier-2 capital. This is putting a limit to how much banks can continue to buy bonds. (NEGATIVE)

On the other hand, GPIF, the public pension fund was a net seller between April 2009 and March 2011 and is likely to be a net seller on going forward due to aging population and more money needed.  Foreigners are unlikely to be a buyer at such low yields. (NEGATIVE)

Japan Post Bank started diversifying away from low-interest government bonds into more lucrative investments. In December 2010, sources said it was considering opening its first overseas office in London, “aiming to obtain the latest financial information there to help diversify its asset management schemes.” (NEGATIVE)

So all related to the buyers of bonds and the pool of money is getting very negative. Not only the biggest buyers are not buying more, but they are becoming seller. And here is a (POSITIVE) one which I will call “Japan desperately needs more buyers of bonds to keep the Ponzi running. Japanese government advertisement on Taxi Cabs targeting the population and recommending buying Japanese bonds:

Conclusion: Japan relies on new buyers of bonds and without them they are bankrupt. This kind of structure can be called “Ponzi”. Participants don’t know it, and that’s why confidence can’t be lost without bond auction failures when there is lack of buyers. That will happen probably, when the pool of money is too small to absorb the Japanese financing needs. I advice you to watch for significant bond rollover years as that is probably when there will be auction failures. I believe it’s coming sooner than 5 years because Japan have big debt roll-overs in the next 2 years. Credit rating downgrades will only accelerate the inevitable and will add to the lack of confidence and need for diversification. Probably very soon, not only pension funds and insurance companies will start selling bonds but also the banks.

3. How can I profit or hedge from what is coming? Why position now?

First, I want to clear that both BOJ and the government know what is coming and probably already have different ideas on how to manage the problem. As they have already shot even their biggest bullets as “advertising bonds to their population”, “allowed small depositors of banks to buy bonds”, there is not much more than they can do related to bond buyers. In my opinion and as conclusion of the written above, I believe that Japan will have no other choice but to monetize. There will be no buyers when the debt crisis start at interest rates as low as now. But at higher rates Japan will default. That’s why there are not many options. When you don’t have buyers of debt, you can simply print yen to buy it and monetize the deficit. As we know this is highly inflationary and is even a risk for hyperinflation. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining hyperinflation periods.  In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations – all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government’s deficit exceed 40% of its expenditures.  So in both cases there will be a devaluation of the yen by a significant rate. I believe that it will be near 50%, and also there is a risk of hyperinflation. You can see that for 2010, Japan will issue 37.9 trillion yen deficit financing bonds, and for 2011 expects to issue 38.2 trillion yen of the deficit financing bonds. Expenditures for 2010 are 92.3 trillion yen or the deficit/expenditures ratio is 41%. Once there are no buyers of the bonds and BOJ has to monetize them, there lies the risk of hyperinflation.

We should position now, because when nobody expects the even, the cost to position is cheap. Let me emphasize. When everybody knows the BOJ will print money to monetize debt, the yen will have already weaken significantly and the options will be expensive. The same applies to interest rates which will be much higher than today. That’s the reason we should position now.

Without us, Japan will still face what is coming, so keep in mind that what we can do is only try profiting from the event or to hedge our portfolio or other positions from the negative event that a Japan’s debt crisis will be. I believe that it will bring worldwide equity markets down by 30-40%, as well as commodities because the world will slip back to recession. That’s why if you do have portfolio with significant amount of equities and commodities, it’s very wise to hedge it cheaply by purchasing long-term out of the money options on interest rates and the yen.

I bought OTM call options on USDJPY with different strikes for 1.5-2 years out. If they expire worthless, I will repurchase them at x2 time the size now, especially if they are still cheap and the USDJPY didn’t move much from the current exchange rate of 77-78 USDJPY.

Of course for professional investors, there are many options to bet or hedge. Some of them are: Call spreads, CDS, short treasuries, JPY payer swaption.

4. Why Japan’s debt and economy are not safe? Most people think Japan is rock-solid as it’s an Asian country with huge reserves, one of the biggest exporters with locally held debt. I will show why they are all wrong.

- a) Japan is net credit and have huge reserves.

- b) Japan has trade surplus so it gets more money than spends.

- c) Japan finance itself so it’s not a target for sudden yield shocks or attacks from foreign bond holders.

a) Japan has foreign reserves at $1.2 trillion USD in October 2011. Of which $0.956 trillion USD in US Treasuries. Let’s image that Japan will not sell it’s GOLD, SDR and will keep some reserves. Now let’s image that Japan sells all of it’s US Treasuries, ignoring that it needs them to keep a currency stability. So, by the time it starts to dump the treasuries and bring back yen, it will make the Yen strength by much, and that will in fact devalue it’s own holding of US debt so will bring less Yen back at home. I won’t discuss how bad this will be for USA, but I will focus on how bad it will be for Japan. That will create an absurd problem on many counter parties in Japan but let’s ignore that and focus on what the final effect will be. By the time Japan had sold of all the treasuries, they will probably have revalued the yen by at least 30% as it will be hard for the market to find $70-80 trillion yen for the conversion of treasuries in USD to YEN. I believe the revaluation will be even higher, but let’s fix 20%. That means that the Japan’s holdings of $1 trillion USD, are in reality not 77 trillion yen at current exchange rate of 77 USDJPY, but are at least 20% lower if dumped. So Japan will not get more than 65 trillion yen back at home for sure. Now, let’s see how big the debt and deficit are. Total Japan’s debt will be around 1000 trillion yen by the end of 2011 or some 220% of it’s GDP. Let’s say they use the reserves to pay debt. The debt is in yen, so using the 65 trillion yen they will reduce it from 220% of GDP to 213.5% (And that’s all positive). That’s first option. The second is to use the 65 trillion and to cover some 1.7 years of deficits as for 2010 Japan had 38 trillion yen deficit. And then what? There will be no reserves …

Now, let’s focus on the negative consequences to see if the positive benefit to sell the treasuries is really worth so much as it looks. And it doesn’t look much positive in my view. By sending the exchange rate of USDJPY to 55, Japan’s exports will be killed especially if the revaluation is so fast. Basically the Japanese exports have a hard time to make profit now at 77 USDJPY, but what if USDJPY goes to 55 in a year? So that will 1. Kill the exports and profits (so will lower revenues from corporate tax), 2. Will increase unemployment as more companies will move abroad. 3. Will have negative effects on the world economy because the yen is a carry-trade and is used for cheap financing. The revaluation of the yen will force million of investors worldwide to close positions and will lead to market collapses, stock and commodity declines of high and risky magnitude. In my option Japan will sell US Treasuries only when the yen start collapsing after a big debt crisis explosion and they need to stop the super-fast depreciation, so they can prevent the risk of hyperinflation. I doubt they will use the reserves to prevent debt crisis as it’s not even possible as you see.

b) Japan has trade surplus so it gets more money than spends. True, but still there is very high deficit. As you can see also the trade surplus is not improving. Japan recorded a trade deficit in October 2011 as exports dropped off more steeply than expected while imports rose on higher fuel costs, government data showed Monday. Japan had a deficit of 273.8 billion yen ($3.6 billion), reversing a year-before surplus of 812.6 billion yen. So the surplus is becoming a deficit. The reason is not only the earthquake, but also high commodity prices and strong yen which is negative as it lowers the company sells. By the end, if there is still surplus, how that will prevent Japan from a debt crisis when the pool of capital of households and corporation is drained and can’t adsorb all the bond issues  and financial needs of Japan.

c) Japan finance itself so it’s not a target for sudden yield shocks or attacks from foreign bond holders.

That’s not true. Sudden confidence collapse is possible especially if big holders of JGB dump them. The fact that they are local helps Japan finance cheap because there is deflation, but doesn’t save them from sudden yield spikes when trust is lost or there are not enough buyers and bond auction failure happens. The biggest buyers of JGB are the pension funds and they are becoming net sellers due to demographics. Other holders will follow as the big exit the market, even if there is no diffidence collapse, there will be weak bond auctions and finally even auction failures that will send interest rates higher and will put Japan in checkmate. So the fact that JGB are hold locally doesn’t make Japan safe, it’s still vulnerable when the pool of capital to buy new bonds is not enough. As you can see, most of the Italian debt is also hold locally but that doesn’t prevent the yields to spike when there are not enough buyers. In fact I believe that the Italian debt crisis is not caused by bad Italian finances, but because there are : a) steady hidden bank runs – banks can’t continue to adsorb the Italian bonds, b) big bond rollover needs, c) fear due to PIGS – more sellers of bonds. All that leads to yield spikes, and at the end of the day, Italy’s crisis is not only liquidity as there are no buyers, but also an insolvency as the yields are too high for Italy. In Japan the situation is different, Japan is insolvency, and soon I believe there will also be not enough pool of money to adsorb the bonds issues.

Conclusion: The Japanese government and BOJ will choose to devalue the Yen rapidly instead of defaulting on it’s debt and erasing almost all of their population’s savings as well as having broke banks, insurers and pension funds. That’s why I believe that BOJ will monetize their debt (deficit) and will risk sending the country in hyperinflation. The Japanese government really did everything it can to postpone the inevitable for many years. But at the end there is no way out. I believe that BOJ knows it.  The consequences of a debt crisis in Japan will be huge negative shock through the world and also a rapid decrease of the Japanese standard of living and wealth. The negative shocks are related to the fact that Japan is the third largest world economy, used to be second largest until 2011. Probably the world economies will print a highly negative GDP growth and will slip into a recession or depression with stocks and commodities going down big.

Here are some updates and warnings regarding Japan, that nobody discuss much as everyone is either focused on the European debt crisis or USA as a next potential target for a sovereign debt crisis. In fact I think the next is Japan and not USA. There are solid reasoning behind my view that Japan is before USA. If you are interested to know more, feel free to contact me.

OECD says Japan risks rise in long-term rates.

IMF Warns Japan Debt Could “Quickly Become Unsustainable”.

Weiss Ratings Downgrades Sovereign Debt of Japan (This is the rating agency I trust most). Japan is C- according to them.

S&P sounds fresh alarm on Japan debt. S&P cuts Japan sovereign rating outlook.

Moody has cut Japan’s long-term sovereign debt rating, citing concerns about the size of the country’s deficit and borrowing levels.