Earthquake in Japan to Bring Debt Crisis of Epic Proportions

Lawrence G. McDonald, On Tuesday March 15, 2011, 12:10 pm EDT

The earthquake and tsunami that struck Japan on Friday have caused tragic devastation to lives
and property, but Japan may soon be overwhelmed by a debt crisis of epic proportions. With
crony deficit spending by the Japanese government having destroyed its economy over the last
two decades, Japan now has a real national crisis that will force the government to engage in
massive deficit spending. There is a strong risk of a financial meltdown in the world's most
indebted nation. (Also read The Economic Impact of the Earthquake and Japan's Struggle to
Recover.)

After the credit-induced boom in the late 1980s, Japan's high rate of growth stumbled and bank
loan defaults skyrocketed. Over the last 20 years, asset prices are down by 65% for
the Nikkei stock index, 50% for residential real estate, and 70% for commercial real estate. The
centrally planned Japanese government responded to this crisis of falling asset values with wave
after wave of colossal deficit spending stimulus. Japan's public debt rose from virtually nothing
to 225% of gross domestic product (GDP), but the economy has remained stagnant.

Japan is sitting on central government debt approaching one quadrillion (one thousand trillion)
yen and central government revenues are approx ¥48 trillion. Their ratio of central government
debt to revenue is a fatal 20x. (See also Will the Yen Rise? Explaining the Currency's
Movements.)

Both Japan and the USA need interest rates to stay low to fund their enormous deficits.
According to J. Kyle Bass' Hayman Capital, every 100 basis point change in the weighted-
average cost of capital (interest rates) is roughly equal to 25% of Japan's central government's tax
revenue.

Put another way, a 200 basis point move higher over time in Japan's interest rates will increase
their interest expense by more than ¥20 trillion. If Japan had to borrow at France's rates (an
AAA-rated member of the UN Security Council), the interest burden alone would bankrupt the
island nation.

Japan has engaged in about the same level of 7% deficit spending as the US has averaged for the
last two years, except Japan has sustained this level of spending for the last 20 years. Normally,
heavy deficit spending quickly exhausts a nation's internal markets to buy its own debt and the
country is forced to auction bonds at higher and higher interest rates to outsiders, which also
increases the costs of the debt and forces the nation to sell even more debt. At some point the
country becomes so indebted that credit agencies downgrade the country's quality rating to junk,
foreigners refuse to buy new debt, and the country defaults. Japan has avoided this deficit
financing end-game because the nation has been able to finance 95% of its debt at home. Over
the last year Greece with a third less and Ireland with less than half the debt to GDP ratio of
Japan imploded when foreigners refused to invest.

In the USA we're not that far behind. According to Congressional Budget Office data, every one
percentage point move in the weighted-average cost of capital at the end of the day will cost the
US $142 billion annually in interest alone. A move back to 5% short rates will increase annual
US interest expense by approx $700 billion annually versus current US government revenues of
$2.228 trillion.

As deficit spending has remained extraordinarily high for such a long period, Japan has
maintained a 41% corporate tax rate; the highest in the world, 10% above the US and Europe and
triple the fast growing Asian economies of Taiwan and Singapore. This has made Japan an
unattractive location for private investment. The complete lack of job security for young workers
who can only find temporary employment has made life difficult for new families and caused the
birth rate for Japanese women to be cut in half. Lower family formation has caused the
household savings rate for the thrifty Japanese to fall from 5% at the end of the 1990s to just
above 2% currently.

Japan has maintained current-account surplus and has been sending more than 3% of its GDP
abroad, providing more than $175 billion of funds this year for other countries to borrow. This
paradox of a stunningly indebted nation financing the world is explained by a combination of
high corporate saving and low levels of residential and non-residential fixed investment due to
poor investment opportunities in Japan. That money is gone after this crisis. Millions of Japanese
savers are about to start spending their savings on essentials, since they have lost their jobs and
businesses due to the damage. Tokyo Electric Power Company will suffer losses of over $100
billion from its Fukushima Daiichi nuclear power plant meltdown and most of Japan's northern
corporate facilities that hug the eastern coastline have been destroyed or incapacitated. Japan
averages one earthquake every four minutes, but Friday's quake and tsunami were both the
largest in the history of the country. Earthquake insurance in Japan is very expensive and only
10% of homeowners buy coverage. Therefore, the Japanese government will be on the hook for
several hundred billion in infrastructure and reconstruction costs.

Many naive analysts are commenting about how this natural disaster will be good for the
Japanese economy because of the substantial rebuilding program. That might have been true if
Japan was not already on the verge of a man-made debt disaster prior to this natural disaster.
Standard & Poor's credit rating service had just downgraded Japan's sovereign debt to AA- in
mid-January. The huge increase in the costs for welfare and unemployment payments, the
economic disruption, the scale of the devastation, the lack of insurance and the minimum five
years to rebuild the country may take Japan's credit rating down to “junk bond” levels. The
earthquake and tsunami that have devastated Japan came quickly and violently. But the debt
crisis has been building for 20 years and may be much more devastating to the future of Japan.

Editor's Note: This article was written by Lawrence G. McDonald, president of McDonald
Advisory Group and a partner with DC Tripwire. It was co-written by Chriss Street.

Nothing contained in this article is intended as a solicitation for business of any kind or for
investment in the firm.