Will Japan have a financial crisis anytime soon?

The odds are against this, and most market prices are well-behaved, noting that the yen was hitting 160 to the dollar.  More importantly, Japanese stocks have bounced back over the last two years, over the same time period that the yen has been weakening.  That is one marker that this is a needed adjustment, rather than a pending collapse.  Noah has a good post on the whole topic.  Here are a few related observations:

1. When it comes to a mature, functional economy, do not bet on a financial crisis.  Such crises are the exceptions.  Furthermore, financial crises, by their very nature, are nearly impossible to predict in economies with functioning financial markets.  If the prediction were a good one, the crisis already would be here.

2. That said, crises do occur, and economies can have hidden sources of leverage.  The 1990s Asian financial crisis was not obvious in advance, and throughout South Korea had a strong long-run fiscal position, due to growing export potential.  So talking about this is not a waste of time.

3. The real question is what Japan will do with all of its government debt, combined with a shrinking population.  Note that the debt to gdp ratio is sometimes estimated at 260%, though much of this (half?) is held by the Bank of Japan.  That said, I am not sure the relevance of the BOJ-held debt should be dismissed entirely.  It still means the Bank is less solvent, and whether debt monetization/money printing is an automatic way to overcome that dilemma I consider in #4. Institutional barriers still do matter somewhat.

4. Japanese short-term interest rates are again very close to zero.  So it is hard to inflate the debt away by an asset swap, as the “new money” might simply be saved and prove irrelevant.  It is true that the Japanese central bank could try to credibly promise to keep inflating the actual paper currency until price inflation went up.  But that kind of inflation is hard to predict and control, so perhaps such a promise would be a) not credible, and b) unwise.  “We’re going to goose up the printing presses (literally, not metaphorically) until price inflation breaks double digits!” does not do wonders for a country’s credibility, fiscal or otherwise.

4b. It is hard to raise real interest rates, because the long-term fiscal position of the government is so difficult.

5. Japan as a whole has a very strong external position and foreign asset portfolio.  Nonetheless the extent to which any of that can help Japan address its long-term solvency problem is an open question.  Is the Japanese treasury going to start confiscating the Toyota plant in Kentucky?

In this regard I am somewhat less sanguine than are many of the optimists.  A falling yen redistributes wealth from the Japanese consumers who buy imported food (directly), and energy (indirectly), and to Japanese MNEs holding dollars.  But how much do one-time boosts in “corporate stock solvency” protect against longer-run growth unsustainabilities?  I would not bet the house on that one.

6. Similarly, I am not so impressed by the strong dollar holdings of the Bank of Japan.  In times of currency crisis, such reserves can be burned through quickly, as evidenced by South Korea right before the 1990s Asian financial crisis.  Let’s say your total government debt is about $9 trillion, and the BOJ holds a trillion in USD.  That is a nice cushion, but it is not going to save the day, especially since Japanese government debt will accumulate further with unfavorable demographics.

7. If you think about the political economy of the status quo, it is a bit worse than is being recognized.  Inducing “austerity” through the exchange rate movement means that the redistribution from citizens goes to Japanese corporations, rather than to the government coffers, to pay off or retire debt.  That makes tax hikes all the harder later on.  You might rather have had the direct government austerity now in lieu of the exchange rate adjustment.  How good a political message is the following?: “We know you’ve been hammered by higher prices for imported energy and food, but don’t worry, we’re going to take care of everything with a big tax hike.”

8. When push comes to shove, do markets believe that the Japanese government could see through a big tax hike?  With the tax take currently at about 34% of gdp, well below western European levels, I’m still going to say yes.  And if markets believe such a tax hike is possible, perhaps it is not anytime soon required.  That is a core reason why I would bet against a financial crisis here.

9. Perhaps the true wild card is China, and the risk of contagion, no matter in which direction the contagion might run.  Who really knows what is going on in the Chinese economy right now?  I certainly don’t.  It would however be a nightmare scenario if the world’s #2 and #3 economies, at the same time, had major financial troubles, including those of capital outflow.