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Economics, Finance, Marketonomics

The picture isn’t that rosy, dissecting the internal and global risks and analyzing the U.S. economy

Fundamentally economy is growing but not at a pace it should after such a deep recession. For all of 2010, the U.S. economy grew by 2.7% (real GDP .., inflation-adjusted). Just 2.7% growth from such a low base (-2.8% in 2008 and 0.2% in 2009) tells us that we are definitely not in a V shaped recovery.

Source: Bureau of Economic Analysis http://www.bea.gov/
The above table shows nominal GDP growth rates for years it was less than 2.5% (highlighted in red) and the growth rates for next 2 years. The last row in the table is the addition of all 3 years. The growth rate from 2008-2010 is not only the lowest but significantly lower than previous recessions. Not to forget, the growth in 2010 was boosted by programs like Cash for Clunkers, First Time Homebuyers Tax Credit along with inventory adjustments (refilling) and enormous stimulus (QE1 and QE2). Now that most of the government programs have ended and so has QE2, will we be able to sustain the recovery?

The systemic risk which bought down the world markets in 2008 has been transferred from the private sector to the public sector. In terms of stock market, extremely aggressive fiscal and monetary policies, some of which, not to forget, have ended recently, have pushed the prices up. The 2010 stock market rally is a classic case of newly-created money bidding up asset prices along with the notion that valuations are cheap. Though
the latter was right but the question is will stock prices keep increasing from these levels? I don’t know, but if you think logically the answer is clear. Market goes up in anticipation of future profits. Future profits come from increased investments by businesses (capital expenditure) and governments which drives the personal income. Both of these don’t look very promising, especially the latter. Lets analyze each component of GDP, i.e.  Consumer spending + Investments + Government spending +(Exports – Imports)… [C+I+G+(X-M)] to better understand the situation.

(C) Consumer spending  (real annualized growth on Q-o-Q basis, unless mentioned):

Consumer Spending (70.8% of GDP) grew by 2.5% in 1Q11, which is a very subdued taking into consideration we are in a “recovery”. This is when the savings rate has gone down from 5.4% in 4Q10 to 5.1% in 1Q11 and 5% in May 2011. It is imperative to analyze the breakdown of personal income and expenditures which is the heart of consumer spending. Wages and salaries from private industries, 41% of total personal income in the economy, increased by 4.14% in April 2011, on a Y-o-Y basis, with a 10 year average of 2.76%. This shows that the private sector is improving and hiring. However, wages and salaries from government sector, 9% of total personal income in the economy, decreased by 0.13% in April 2011, on a Y-o-Y basis, with a 10 year average of approx. 4%. Looking at just one quarter or a month wouldn’t be very right. A lot of analysts’ base their assumptions based on the latest monthly or quarterly data, without understanding the future dynamics. Below is the breakdown of personal income by each category with 5 and 10 year increases in the same.

Table 1: Source: Bureau of Economic Analysis http://www.bea.gov/

The data clearly shows that increases in government wages and salaries and government social benefits have been significantly higher as compared to other categories. An increase of 17% and 50% in government salaries and social benefits, respectively, as compared to just 8% for corporate in last 5 years. The question is will this be the case in the future. Will government be able to sustain the huge debt and the fiscal deficit, which is approx. 10.5% of GDP and is growing? U.S. is  6th in the list among countries with highest fiscal deficit as a percentage of GDP. This will only increase as the aging population would make the large future structural deficits of Social Security, Medicaid and Medicare even worse. Below is the chart:

Table 2: Source: World Bank

The answer to the above questions is a simple no. Government spending cuts are imperative and will happen. In fact, we are seeing it. Government spending, approx 19% of GDP, contracted by 5.8% in 1Q11 and 1.5% in 4Q10. The point I am trying to make is that in the future we may see a drag in government spending which will be the main cause of downcast in GDP growth.  States are in crunch and we are already seeing cuts in spending from local and state governments. This would have a double negative impact on the economy. First, decline in government spending and second, decline in consumer spending due to cuts by government spending [table 1 shows that 9% of the total income is from government salaries and 18% from government social benefits]. Also, one thing to keep in mind is that most of the money earned by government employees and from government social benefits to people is spent, unlike that from corporate. Besides, there is a huge difference in the savings rate between the emerging/less developed (approx 20%) and developed economies (approx 5%), the main reason being Social Security and Medicare. In emerging and less developed economies there is no such concept of Social Security and Medicare and so people save for old days. So if the U.S. government reduces social security and Medicare benefits, people would save more which is again not good for the economy.

(I) Investments:

Yes, balance sheets are stronger and companies have taken advantage of the low interest rate environment and have refinanced their debt. They have good amount of cash, and margins are better as they are leaner. With all that cash on the sidelines due to debt issuances and better earnings we have seen decent capital expenditure. Below is the chart:

Source: Bureau of Economic Analysis http://www.bea.gov/

The increased investment in capital expenditure is because of 2 reasons. First, during recession companies had cut down on their capital expenditure significantly. For almost 2 years, to cut cost, they did not invest in capex. Now that we are out of recession and companies have cash, they are investing in capital expenditure. Second, 100% depreciation allowance along with all the government programs and stimulus, as mentioned above, contributed to investment in capital expenditure. Due to these reasons we have seen a spike in capex. However, businesses spend depending on anticipation of future demand. The main question is will there be a sustainable growth in demand? Bank lending is still low. The sluggishness of loan demand in spite of recent improvements in bank lending attitudes highlights the weakness in demand and hence consumer spending. To some extent, the authorities have addressed the supply side problem by injecting massive amount of liquidity and capital. However, nothing much can be done on the demand side of it, which is still weak. Weakness in demand would mean lower businesses spending in anticipation of lower growth.

So where would all that cash on hand go? It might go in buying back stocks, reducing debt, m&a and probably in emerging economies where the huge population of middle class is driving growth. That said, none of these activities create jobs domestically. To reiterate, what drives job and income creation is domestic capital expenditure by companies and spending by government. The labor force has fallen consistently to 64.1% as of June 2011 and is at its 26 year low. Below are the two charts comparing reported unemployment rate (U-3) and labor force as a percentage of total civilian population.  With all talks about jobs being added in the economy and the job market is improving, it is the same problem of looking at one month’s data of making conclusions. With government cutting spending, we will see layoffs in the government sector, which will mitigate hiring in the private sector, if any. Government employs approx 22m people, which is approx 14.4% of the labor force.

Source: Bureau of Labor Statistics  http://www.bls.gov/

Source: Bureau of Labor Statistics  http://www.bls.gov/

(G) Government spending:

Government spending, approx 19% of GDP, contracted by 5.8% in 1Q11 and 1.5% in 4Q10. This shows that the government is cutting spending to get the fiscal deficits under control. As mentioned above, government employs approx. 22m people, which is approx 14.4% of the labor force.  Below is a table highlighting yearly increase/decrease in government employees.

Source: Bureau of Labor Statistics  http://www.bls.gov/

To cut spending, government is reducing its workforce. In 2011, until May, government has already downsized its work force by 188k, approx 80% of what it did in the entire calendar year of 2010. This figure is expected to go up to 400k by the end of the year.  Also, Increased lay off or retirement means increased outflow of money due to higher pension further stressing the cash flow situation of states and municipalities. Though that’s a sensible thing to do and will help in long run, it would have a negative impact on the economy in short to medium term. Now we are seeing the impact of massive shift of debt from corporate to public. With infrastructure getting old, baby boomers retiring and the population of 65 years and older estimated to increase significantly as compared to the working population, need for government services will only increase and the cost of programs like social security and medicare will only swell. In the midst of need for government to increase expenditure, we are seeing spending cuts by government. This is expected to continue, which means more layoffs, less government spending and hence lower economic growth.

Federal government has had deficits for a long time which have only been by increasing. Below is the chart highlighting difference between federal government’s receipts and expenditures.

Source:Bureau of Economic Analysis http://www.bea.gov/


Source:Bureau of Economic Analysis http://www.bea.gov/

The above chat shows that the federal government spends approx 60% more than it earns. This is big number. It will take a lot of time cuts to balance such a big number. Its not only just federal government. We are hearing about states like NJ using the bridge loan by banks to fund their
operations and California using IUO’s to pay its vendors. With the end of the federal stimulus to all states by the end of this year the picture wouldn’t be that rosy. Federal funding for Medicaid will decrease by 13 percent for the fiscal year starting 1 July 2011. The health reform law signed by the president in 2010 prohibits states from reducing their eligibility requirements for Medicaid through 2013. This means the funding is reduced by the federal government but the states cannot cut back on Medicaid. Medicaid represents the single largest component of state spending. States are cutting Medicaid payments to physicians and other health care providers and establishing higher copayments. Bottom line being, reduced government spending, more layoffs by government resulting in reduced consumer spending and hence lower economic growth.

It is important to note that if spending is reduced and/or taxes are raised, it would give investors confidence in the U.S. economy. It might slower
the growth of the economy but will fundamentally strengthen it. If the market reacts to this and falls, it would be an opportunity to invest, especially in those companies which generate most of their revenues from emerging markets.

If right policies like raising taxes for wealthy, allowing the corporate money which is parked abroad (approx USD 3tr) to be repatriated back to the U.S. at low (5% to 10%) tax rates, reducing social benefits like SSN, Medicare and Medicaid, increasing immigration of wealthy and middle class to increase population and consumption, etc are implemented, the US economy and market has the potential to outperform the expectations.

Analyzing the risks:

The reduction in government spending is the main risk to the economy which has been discussed in detail above. Below I have highlighted the other risks, internal and external, to the global market:

Internal risks to the economy

1)     Aging population:

As per Census, there will bea shift in the age structure, from 13 percent of the population aged 65 and older in 2010 to 19 percent in 2030. The age group between 20-64 will grow by 5.4% from 2010 to 2020 and 4%  from 2020 to 2030, while the population aged 65 and older will grow by 36% and  32% in the same years, respectively. Below are the numbers:

Source: http://www.census.gov/prod/2010pubs/p25-1138.pdf.        http://www.econdataus.com/workers.html

The U.S. has large future structural deficits of  Social Security, Medicaid and Medicare which will only get worse by the aging  population. This would also weigh heavy on corporate profits with a rise in  health and pension expenditure. The counter argument to this point is that you can always increase immigration of young and productive people from other countries which would earn and pay taxes increasing the government tax revenue. That’s a fair point but this would make sense if there are opportunities in the country. The economy is growing at a very slow pace and is expected to be that way. Also, the unemployment number is high. With the emerging economies getting wealthier with better standard of living the motivation of the young and the brightest, which always moved to the U.S. for success, would decline significantly.

2)      Appreciation of Yuan and China’s internal growth:

China has depended on its exports and real estate for growth. It has been able to grow its exports by artificially keeping its currency value low. China plans to increase its minimum wage by at least 20 percent annually in the next five years, more than doubling it by 2015. This was reported by the South China Morning Post on 21 September 2010 quoting government adviser Huang Mengfu. The idea is to increase domestic demand to ease dependence on exports and narrow the gap between rich and poor. This is good for China as it would boost its internal demand but at the expense of increased price of Chinese good in USD terms. With pays in China increasing more than 100% in 5 years, cost of goods would increase too making the end product expensive. This accompanied by stronger Yuan or weaker USD would make Chinese goods expensive. As of 2010, US exports to China were 91.9bn and while its imports from China were USD 364.9bn (source: http://www.uschina.org/statistics/tradetable.html). This would mean higher cost of goods for the already distressed U.S. consumer and hence lower consumer spending.

3)      Mounting foreclosures:

Information provided by LPS Applied Analytics. Source:
http://www.lpsvcs.com/LPSCorporateInformation/ResourceCenter/PressResources/MortgageMonitor/201105MortgageMonitor/LPSMortgageMonitorMay2011.pdf

The above chart gives a summary of whats happening in the U.S. housing market. Foreclosures are increasing at 2.5x than houses in foreclosures are being sold. This was as of May 2011. To put this in perspective, if in a month 1 foreclosed home is sold, 2.5 more enter the foreclosure inventory. Total inventory of 90+ days delinquent loans and loans in foreclosure is 51.9x of monthly foreclosure sales. This ratio will increase, as more foreclosures are added to the inventory than they are sold. Even if we assume that the inventory remains constant, it would take approx 4.5 years just to clear it. I guess this chart explains everything about the present housing situation in the U.S. and I wouldn’t need any more data. However, the situation is not as bad as it was a year back and is improving. The growth of delinquency and foreclosure is negative now. Fewer houses getting delinquent and going in foreclosures, delinquencies and foreclosures as a percentage of total loans are declining. Below is the chart.

Information provided by LPS Applied Analytics.

Source:
http://www.lpsvcs.com/LPSCorporateInformation/ResourceCenter/PressResources/MortgageMonitor/201105MortgageMonitor/LPSMortgageMonitorMay2011.pdf

However, its far from over due to the huge inventory overhang. Also, still 30% of current loans that are making payments on time are at risk, as they have negative equity due to falling house prices. Below is the chart. Besides, a lot of option arms have already defaulted but still second half of 2011 has the maximum and a huge increase in resets. In addition, there is still skepticism to lend especially in the housing market by banks. This is fair on the banks part as no one wants to lend against a depreciating asset and if they do, they are only considering good credits and increasing the down payments to save them against the depreciating house value. This is not helping generate the demand even though house prices have declined significantly and are still declining.

Information provided by LPS Applied Analytics.

Source:
http://www.lpsvcs.com/LPSCorporateInformation/ResourceCenter/PressResources/MortgageMonitor/201105MortgageMonitor/LPSMortgageMonitorMay2011.pdf

4) U.S. debt:

The growing U.S. debt which stands at approx. USD 14.3 tr is a topic of concern. U.S. has a current account deficit of approx 9%. The debt has increase by 147% in last 10 years while revenue only by 29%. The U.S. is spending approx 31% more than its revenues. Below two charts highlight receipts and expenditures of the U.S. and the difference between receipts and expenditures as a percentage of receipts.

Source: Bureau of Economic Analysis and Treasury Direct

Source: Bureau of Economic Analysis and Treasury Direct

As mentioned above, the U.S. is spending approx. 31% more than its revenues. Never in history we had such an imbalance. To fix this either you increase taxes or cut spending or a combination of these, none of which are good for economy. With the U.S. now on negative watch by credit agencies, even a one notch downgrade by any rating agency can result in sudden flight of investors from the U.S. treasury and USD. Both of these would have negative effect on the economy. Reduction in demand for treasury would result in increase in interest rate for treasuries and hence higher interest expense. Depreciation of USD would mean imports getting expensive, as the U.S. imports most of its items for daily use, which would mean stagflation.

Interest rate on the U.S. debt is at its historical low (chart below). Increase in interest rates would have a negative impact on the growing U.S. fiscal deficit. There could be various reasons to increase in interest rates such as, but not limited to, downgrade by any rating agency/agencies and demand supply factors. To sustain the growing fiscal deficit, the U.S. has to issue approx. USD 1.5tr of debt every year. With the end of QE2, the supply of the U.S. treasury might increase or remain the same while the demand may decline which might result in increased rates. Also, the relatively low risk that the market attaches to US public debt makes the market more susceptible to a fall.

Source: Bureau of Economic Analysis and Treasury Direct

5)     Mutual fund cash levels:

Market is still at elevated levels due to i) FED pumping in money in the market , ii) fund managers expectations of corporate profits continue to be good, and iii) fund managers have this notion that P/E levels are low so the market is cheap. I don’t buy it for all the reasons I have mentioned above, in fact I am a little skeptical. Mutual fund cash levels are at a historic lows and QE2 has now ended. With over USD 10tr in assets, stock-based mutual funds are the big boys of the investment world and a decent benchmark for the herd. If they are fully invested in the market, this means there are few buyers left to push stocks higher as now the FED has withdrew the support.

Source: http://home.comcast.net/~RoyAshworth/Mutual_Fund_Cash_Levels/Mutual_Fund_Cash_Levels.htm

Market rallied in 1974, 1982, and 1990 when mutual fund cash levels were greater than 11%. While S&P declined in 1973, 1976, 2000 and 2007 when mutual fund cash levels were below 4.5%. A low of 3.9% in cash levels occurred in May 1972 and the markets topped in December 1972 (approx. 7 months lag), following which it declined 46%. The next historical low in cash levels was 4.0% in March 2000. September 2000 is when the market peaked (approx. 6 months lag) and then sold off for a year declining by 43%. The next historic low of 3.5% in cash levels was in June 2007. S&P topped in October 2007 (approx. 5 months lag) following a 1.4 year sell off and declining by 56%. In May 2011 mutual fund cash levels were at 3.5%, pretty close to its historic low. However, cash levels have been in a range of 3.4% – 3.8% for a year now while stock prices have continued to rise. S&P is up 99% from the 9th March 2009 low of 676. Historically, market may have seen a fall off from here but the prices going up can be explained by QE2, which has ended now, fund managers expectations of corporate profits continue to be good, and the notion
that P/E levels are low and hence the market is cheap. Also, the chart below shows the level of leverage in the financial system: essentially how much borrowed money exists relative to actual capital, which is at pretty elevated levels.

Source: Diapason Commodities Management    http://www.investorvillage.com/smbd.asp?mb=4143&mn=200551&pt=msg&mid=10691384

A combination of leverage in the system along with low mutual fund cash levels isn’t a good indicator. The point being, there is not much money to be invested, leverage is high and there are a lot of underlying risks in the U.S. and global economy. This doesn’t make the market attractive even if expected P/E’s are low.

Analyzing external/global risks:

1)     Chinese real estate:

Watch these video:

 http://www.sbs.com.au/dateline/story/watch/id/601007/n/China-s-Ghost-Cities

http://www.insidermonkey.com/blog/2011/01/18/hedge-funds-short-china/

To verify this I spoke with a few of my friends who are from China and travel home frequently. Their response was this is true but there is a lot of wealth in China and those wealthy people think that real estate is a safe and good investment. According to them there is so much demand that people are ready to pay the entire house value in cash, no loan at all. Wealthy are buying second, third and fourth homes for investment purposes. Property values have almost tripled in 6 years. Sounds like a bubble?

The analyst in the video already mentions that there are approx. 64 million apartments empty in China. According to him, there is a massive oversupply and overvaluation of houses in the market. Also, a lot of buying is done by the speculators who are in for quick profits. Famous hedge fund manager Jim Chanos, who is known for his bearish calls, is short Chinese real estate. For last 21 years China has maintained an average quarterly GDP growth of 9.3%, which is now increasingly dependent on the real estate market. Investing in large infrastructure projects has become a notable method of maintaining the GDP growth rate. In the process a huge oversupply is built.

Chinese authorities are considering all the policy options available to them to put an end to the property bubble as that is one of the main reasons for inflation in China. They have repeatedly raised interest rates, increased bank reserve ratios, increased the down payment for homebuyers to 30–40% and have tried to cut off the credit supply to real estate companies by restricting their access to loans from banks. To counter that, Chinese real estate companies have turned to overseas funding sources, especially Hong Kong, for their finance. However, the foreign capital is coming at an increased cost but because the profits and the margins for these real estate companies are so high, they don’t mind the increase in cost of capital.

Household leverage is low in China, savings are high and down payments for houses are high. Due to these reasons we won’t see a U.S. style bubble burst. Also, need of house for millions of people would help in capping a significant price decline. That said, if the bubble burst or if there is a significant slowdown in demand and hence the house prices go down, not only the real estate companies would be affected but also the Chinese local governments which rely on real estate related revenue. In that case, we may see losses and an increase in nonperforming loans by Chinese banks, resulting in tighter lending conditions further slowing of the Chinese economy.  Recently China’s finance ministry failed to sell all of the three-year debt offered at an auction on behalf of local governments. This was mainly because of concern about revenues of Chinese local governments and the secondary market for debt not being liquid.

If Chinese economy decelerates, the Chinese government will provide the needed longer-term support with fiscal and monetary policy. With USD 2tr of reserves and the authoritarian economy, I think, the Chinese government is well equipped to handle such crisis. But if occurred, it will do the damage of bringing the world markets down.

2)     European debt crisis:

On 1st July 2011, Greece got euro 12 bn (USD 17 bn) installment of bailout loans from the European Union and the IMF. The loan was on the condition that Greece will cut spending and raise taxes by euro28 bn (USD 40 bn) over the coming five years. A simple math shows that this is just to divert people/media’s attention and is not sustainable. As per Eurostat, as of 31 December 2010, Greece had a debt of Euro 328.5bn (USD 476bn). Its increasing at a rate of approx. 10% every year. Because of austerity measures, to be a little optimistic, lets assume it will only increase by 6% for next 5 years, which comes to USD 638bn. This is an increase of USD 161bn in next 5 years while the condition is that Greece will cut spending and raise taxes by just USD 40bn in these 5 years. There is no way the debt will reduce. Also, its just a condition and we are not sure if it will be implemented. Increased tax collection and privatizations previously promised by Greece were never implemented. Besides, cutting spending and raising taxes wouldn’t help as that would mean lower growth, and hence lower tax collection which would make it even more difficult for the country to pay back the debt. The unemployment rate has soared to 16.2%, compared to 11.6% in March 2010.

Approx USD 135 bn of Greece debt matures between now and the end of 2013 and an additional USD 82 bn in 2014. They are planning to roll over this maturing debt held by banks and ECB. That would be considered as default or selective default by the credit rating agencies. If the credit agencies consider it as a default, the ECB and banks can’t hold them anymore. Even if they provide an exception to this rule, the ECB and banks can’t use the Greek debt as collateral. Also, if rating agencies consider it as a default, the banks and ECB have to write down that debt on their balance sheet. Greece has already effectively defaulted by making it clear that it cannot meet its July debt repayment. The debt and the interest rate on debt is extremely high. The only way out is an orderly restructuring. Below is the table.

Source: Eurostat

We are talking about USD 476bn of debt here, of which ECB holds approx Euro 80bn or USD 113bn. Debt to GDP of Greece as of 2009 was approx. 138%. To bring it down to even 100% levels, Greece would need a hair cut of approx 40%. Even if we consider a hair cut of 20%, we could see a hit of approx USD 72bn (476 – 113 = 362 *20% = 72) in the system, excluding the debt that ECB holds. This is just the hair cut. The repercussions would range from losses on balance sheets of European banks, CDS’s being triggered, fall in global stock markets , and banks being conservative and hence reduction in lending resulting in slower growth. The bail-out is not about saving Greece, its about savings large banks who hold Greek debt and to avoid the above repercussions. But, its inevitable. This is just Greece, if we add all the debt of Ireland, Greece, Spain, Italy and Portugal, we are talking about approx. USD 4.5tr of debt. Above is the table.

3)     Japan’s debt and aging population:

Everybody knows about Japan’s enormous debt. Japan has been able to sustain itself by borrowing internally, from its people and corporations. Domestic buyers hold about 95% of the nation’s debt, according to the Japanese Ministry of Finance. It is very important to understand Japan, before analyzing it.

Understanding Japan: Until 1990, before the Japanese property and stock market burst, Japanese households saved money and businesses borrowed. When there were not enough borrowers for the available savings, the economy would weaken and BOJ would lower the interest rates. When there were too many borrowers, the economy would overheat and interest rates were raised. The end result in either case was that savings were borrowed and spent, which resulted in growth. When the market collapsed in 1990’s, prices of assets plunged, while debt was still on corporate balance sheets. The fear resulted in deleveraging by corporate world. This led to a situation where there were not enough borrowers regardless how far BOJ lowered interest rates, creating a surplus of private savings. To reverse the situation and to stimulate spending, BOJ borrowed those surplus private savings and started spending in the form of stimulus. Its been borrowing and spending since them, which has inflated BOJ’s debt to very high levels. On the other hand, Japanese corporations have been saving and deleveraging. So previously, BOJ’s debt was funded by private savings and now its been a mixture of private and corporate savings. For more than 10 years the institutional base in Japan has agreed to buy 10 year bonds and receive less than 1.5% in nominal yield. Investing in Japanese government bonds (JGB) with such low yields have not been a bad option for them as the yearly 1%-3% deflation in Japan has provided them with a real yield of 2.5%-4.5%.

Now here is the main question: is this sustainable? It is important to analyze data for each moving part. First in the list is savings, below is the graph.

Source: World Bank

The data is from World Bank, which calculates savings as gross national income less total consumption, plus net transfers. Japanese savings, which fuels BOJ’s debt, has dropped significantly. Here savings are calculated as GNI − Consumer spending, which ideally in a closed economy is Investments and Government spending. This means, the above graph shows that government and business spending has been decreasing which mean less fuel to fund BOJ’s issuance of JGB’s. A lot of people argue that analysts only take into consideration the private savings rate of Japan and not corporate. This graph takes into consideration both. Savings has declined because of many reasons, main being the aging population in Japan and low birth rate. Below is the graph of aging population and birth and death rates in Japan.

Source: World Bank

Source: World Bank

Japan’s population age 65 years and above has grown exponentially and is highest as a percentage of total in the world. Its birth rate has fallen significantly over the years, and is the second lowest in the world after Germany. Besides, the birth rate is now lower than its death rate. This means negative population growth and an exponentially aging population, which is a recipe for disaster. This can have following consequences:

i)                   As more population continues to age and the population declines, the dependency of work force would increase.

ii)                 Aging population means more pressure on government in terms of higher social security and medical expenses.

iii)               Aging population means more pressure on corporate due to more pension outflow. A lot of pension funds in Japan hold JGB’s. They are now selling them to pay for growing number of retirees. This trend may continue putting pressure on JGB’s.

iv)               Private savings will keep declining and probably at an increasing pace, which is evident from Japan’s savings graph. As aging population doesn’t save, in fact they utilize the savings, it would mean less fuel to fund the BOJ.

In last 5 years Japan’s tax revenues have fallen by 15% but its debt has grown by 12%. This proves declining revenues due to aging population, which is unsustainable. This is not taking into consideration the effect of earthquake which would further bring down tax revenues and increase debt. Japan’s debt to tax revenue ratio is 23x: highest in the world. Below is the chart and a table.

Source: Bank of Japan

Source: Bank of Japan

Here is another graph showing that tax revenues collected by Japan are not sufficient to cover even the basic non-discretionary expenditure.

Source: MoF, SG Cross Asset Research.  http://www.zerohedge.com/article/dylan-grice-what-weimar-republic-popular-delusions-can-teach-us-about-japans-upcoming-hyperi

Also, it is important to highlight that pension funds in Japan, who are one of the biggest holders of JPG’s, are selling JPG’s to pay pensions for growing number of retirees. This trend will continue as the population ages and age group 65 years and older increases as a percentage of total population, putting pressure on JGB’s. If interest rates rise due to this Japan could face severe problems. As of 2010, Japan paid 24% of tax revenues as interest expense. Japan’s average interest rate is approx 1.2%. An increase of 50 bps would increase interest expense as a percentage of tax revenues to 35%. An increase of 11% with rise of just 50 bps. Not to forget its tax revenues are declining. Below is the chart.

Source: MoF, SG Cross Asset Research.  http://www.zerohedge.com/article/dylan-grice-what-weimar-republic-popular-delusions-can-teach-us-about-japans-upcoming-hyperi
We shouldn’t forget that to boost the economy Japanese government can print money and lower taxes, which it has done previously. However, with such high debt Japan is vulnerable. A small increase in interest rates could potentially increase the expenditures significantly resulting in worsening the fiscal imbalance. So far this has not happened.

The central banks are trying to push up asset prices by artificial stimulus and quantitative easing and are protecting financial institutions from losses. The resultant rise in asset prices represents a liquidity driven price increase. The question is whether the real economy can keep pace with the increased asset prices. The end of quantitative easing combined with the austerity measures which are still to come by the U.S. government due to large fiscal imbalance and hefty debt position could be the reasons for the decline in asset prices. Besides, the other risks to the global economy as mentioned above are significant. If the asset prices were to go down it would affect the balance sheet of financial institutions, which in turn would tighten the credit and lending standards, further depressing the overall growth of the economy. Some people argue that the recovery is too young to die. In 1996, Japan’s GDP growth was approx 4.4%. This was mainly due to government support in the form of fiscal stimulus worth 5% of GDP. Once that support was removed in 1997, Japanese economy experienced five consecutive quarters of negative growth. The recent fiscal stimulus in the US and UK was approx 10% of GDP.

Disclaimer: It is very important to read the disclaimer before making any investments based on the above article.

-         Suneet Chandvani

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