With the European sovereign debt imbroglio taking a breather for the moment, there is increasing concern on Wall Street that Japan could be the next major flashpoint in the ongoing global financial crisis. It appears that the country's economic reckoning, some 20 years in the making, could finally be coming to a head in the near future as the economy weakens and its debt, relative to its economic output, balloons to a level that makes Greece look like a responsible steward of capital.
Wall Street is buying protection in the form of credit default swaps to prepare for that day Japan implodes. Trading of swaps on Japanese sovereigns has been highly volatile in the past year -- they are currently being sold at around 135 basis points, 100 basis points above Japan's debt yield, credit traders in New York and London tell Fortune. Credit default swaps provide a way for investors to make money in the event of a default.
While the Japanese debt bomb isn't expected to go off tomorrow, Japanese CDS is now 50% higher than where it was a year ago. Wall Street involvement in the Japanese debt market has grown in the last few years, which could bring increased pressure on the government to try and solve its debt dilemma. Eventually, though, the Wall Street bond vigilantes could drag Japanese bond yields up to levels that could cripple the government's ability to pay off its debts, setting the stage for one of the most prolific sovereign debt defaults in history.
It seems crazy to think that Japan, a country known for its efficiency and educated population, could have dug itself into such a dire debt hole. But Japan's total debt compared to its GDP is topping 235% and getting larger by the day. As a point of reference, the U.S. has a debt to GDP ratio of around 98%, while the worst off eurozone members, Greece and Portugal, have ratios of around 159% and 110%, respectively.
But Japan has been able to continue racking up the debt because of some notable debt defenses. Those defenses include the nation's strong export industry, as it allows Japan to be a net importer of capital, and the nation's loyal population, which tends to invest and spend money at home. And unlike other advanced economies, the bulk of Japan's debt is held by its own citizens, so it hasn't faced the full wrath of Wall Street's bond investors.
But the nation announced some startling economic news this week that has exposed some chinks in Japan's debt defenses. In addition to announcing a much larger-than-expected 2.3% contraction in the country's GDP in the fourth quarter, Japan, the exporting powerhouse, said it ran its first annual trade deficit since 1980. The Ministry of Finance blamed the trade deficit on the high price of energy and the disruption in exports caused by last year's devastating earthquake. While both events did contribute to the trade deficit, the main issue here seems to be Japan's currency.
The yen is now extremely strong versus the U.S. dollar and the euro, making Japan's exports appear more expensive than ever before on the international market. Some of the nation's largest export-driven companies are reporting record losses as a result of reduced outflows. For example, Panasonic recently said that it was forecasting a $10 billion loss for the fiscal year, while Sony (SNE) announced that it was doubling its net loss to around $2.8 billion for the fiscal year, the largest loss in the company's history. The losses at Japan's biggest firms translate to reduced economic growth and a big decrease in government revenue. That forces Tokyo to borrow more money from its citizens to stay afloat.
