From the Mailbag: On Japan and the Yen

I’ve received a lot of responses to my thoughts on Japan from the post questioning Kyle Bass’ thesis on Japan earlier this week. I’ve taken two which I’d like to share with you today.

One reader raised a good point on the Japanese “monetary perpetuum mobile” ever being questioned:

Only missing one point: Spot on with your Japan thesis in my opinion, but there is just one thing missing.

Go back in history and you will see that anytime a country issued cash to pay bills, that government was overthrown or its leader died or it was ultimately phased out. Essentially, when the central bank buys the debt and recycles the interest back to treasury, the government can never default and I am wholly uncertain whether a key G7 country will ever see a central bank solvency questioned.

The banks have made untold fortunes off the issuance of sovereign debt when there was never any true reason against simply issuing cash. And more importantly, there is zero reason to collect taxes. If governments are issuing de facto cash why collect taxes?

Sadly, some countries have not overthrown their leaders for wrecking their economies and issuing cash to pay bills as you mention. Mugabe, for one, is still around. If anyone was to deserve a lynching, he’s your man. I’m often surprised by how much people put up with and for how long.

Regarding central banks not having their solvency questioned: they will be questioned. History indicates this WILL happen. We’re living in the twilight zone right now. Even where a country can print the dollars, yen or whatever to buy the debt issued in the same currency, the questioning of this can take place in the currency being revalued downwards. This also revalues the bonds downwards right as the bonds are denominated in the currency being printed.

So what I’m saying, and this is particularly relevant to Japan, is that in nominal terms there may not be any bond risk, but in real terms it matters a great deal if the currency goes “kablooey”.

Dear Chris,

You have touched on a topic I have been following with great interest ever since the yen was at 86 to the USD.

Yes, Kyle Bass was wrong about the JGB for the reasons you gave; virtually all JGBs are denominated in yen and there is no limit to how many yen the BoJ can create.

IMHO, there are two things that have kept Japan from imploding financially despite sovereign debt exceeding 235% of GDP and despite the government spending 25% of the budget on debt serve even though interest rates are at something like 0.2%:

First, I believe, but do not have proof, that the vast majority of JGBs are held by Japanese financial institutions. The management of such firms tend to be more concerned about saving face than acting in the best economic interest of their clients. None of these managements have been willing to appear on the front page of the newspapers as being disloyal to the government. Were this not the case and the financial firms did dump their JGBs, there would be a rush for the exits, the BoJ would have to create quadrillions of yen to purchase all of the bonds being sold, inflation would skyrocket, and the system would collapse in a heartbeat. So long as saving face is more important than protecting one’s clients, however, we likely will not see any of the major financial firm dumping JGBs and shorting the crap out of the yen even though the managements of these companies HAVE TO KNOW the economic policies of the Abe government will end badly.

Second, the Abe government has received a temporary reprieve from the dramatic decline in the price of most commodities. Japan is a resource poor country so it has to import most of its raw materials.  Even though the BoJ has increased dramatically Japan’s money supply, the depreciation of the yen versus the USD has been less than the decline in the price of most commodities, hence, inflation to date has been relatively tame. This, however, is a temporary condition. Abe wanted 2% inflation. The Abe government (and any government that follows) will continue to run massive deficits and the BoJ will continue to expend the money supply far faster than Japan’s economy is growing. So long as commodity prices continue to decline, the financial system likely will hold together. At some point, however, commodity prices will bottom and actually will rise in price relative to the USD and especially when denominated in yen. When that happens, the trade deficit will expand and the higher cost of commodities is going to give Abe inflation in spades and the yen will continue its long decline into oblivion.

This is why I am short the yen and not JGBs. (N.b., in the interest of full disclosure, I, regrettably, have lost money shorting the yen. I was shorting futures contracts and set my stops too close and I had too big a position when about a year ago the yen popped from 100 yen/USD to 92 yen/USD in a matter of days. I now simply purchase long-dated puts. I believe this ultimately will prove to be an exceptionally profitable trade as I believe the yen will be at 300 to the USD within 3 to 5 years).

One thing Japan does well is provide a lot of information directly on the Ministry of Finance website. I believe Japanese firms are holding bonds because they’ve been treated really well by doing so for the last 20 years. Bonds have gone nowhere but up. I know of quite a few Japanese corporations who are definitely more interested in making money and protecting their assets than they are in saving the BoJ.

Yes, Japan is insular and xenophobic but they’re still interested in #1. Most of the pension funds are the big owners and they’re having to sell to pay out. It’s not even a matter of saving face, it’s just called redemptions.

I’m not sure that these market participants believe this will end badly. Remember, they’ve enjoyed decades of deflation, which has meant decades of a bull market in bonds. They’re not necessarily ready to believe it’s over. People believe the strangest things.

For instance, recently in Hong Kong we’ve been hearing how it’s the Americans that staged the stock market crash. I explained why this is absurd a few weeks ago: foreigners make up such a tiny fraction of the market that it’s literally impossible for them to have any power to do this. Yet, at the same time, seemingly intelligent people parrot it without looking at the numbers and then thinking whether it makes sense.

You make a really great point about the reprieve Japan have had with the bear market in commodity prices. I don’t know how I missed this. Shame on me! They’re still struggling to get inflation running even, though they’re printing full steam. Certainly this would look and feel much different in a commodity bull market.

Futures are ALL about risk management. Actually, all of this is about risk management but futures can move like an epileptic belly dancer and hurt you really quickly. Most people dabbling with them use WAY too much leverage. You don’t want to be the guy that got such an exciting trade right and managed to wipe himself out along the way.

Appreciate your comments. Until next week…


“The art of life lies in a constant readjustment to our surroundings.” ― Okakura Kakuzō, The Book of Tea



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