Meanwhile, the loyal Japanese consumer has started to stray a bit as the strong yen has made foreign goods look relatively cheap compared to domestic products, further exacerbating the nation's trade deficit. Real imports into Japan in December exceeded expectations of a 1.4% contraction to a 4.1% increase. This trend is expected to continue as the yen strengthens and Japanese consumers become more comfortable buying foreign goods.
The strong yen and prolonged weak interest rates are also affecting the loyal Japanese investor. While the vast majority of Japanese assets still remain parked at the bank and in government bonds yielding little interest, there has been a shift in the past two years to invest in higher-yielding international securities offered through mutual funds. At the same time, foreign ownership of Japanese debt is on the rise, going from 5% last year to around 8%, according to Goldman Sachs. The share of short-term debt held by foreigners has now doubled in the last decade to just below 20%.
The Japanese government has tried to weaken the yen for a decade to no avail. It has incessantly engaged in multiple rounds of quantitative easing, which is when the central bank buys back its bonds from the banks with freshly printed cash, thus inflating the money supply. The BOJ engaged in three rounds of QE last year, but the yen kept strengthening. On Tuesday, the BOJ surprised the markets and announced an expansion of its QE program, injecting an additional $130 billion into the banking system. The yen weakened a bit, but the additional QE isn't expected to have a lasting effect on its value.
With Japan's traditional debt defenses damaged and the yen increasing in value, the stage is set for the Wall Street bond vigilantes to make their mark as they did in Europe last year. The difference in yields between Japanese interest rates and Japanese CDS implies that foreigners are growing concerned as to the creditworthiness of the Japanese government. That's understandable given that the government will bring in only 40% of what it needs this year in taxes to cover its budget.
Despite all the clear signs of trouble and the damage to its debt defenses, Japanese sovereign debt is still trading below 1%, making it easy for the government to continue borrowing. But the volatile trading in Japanese bonds and CDS in the last year implies a vulnerability where even a mild credit event could trigger a run on the sovereign by both foreign and domestic bondholders, sending government borrowing rates skyrocketing overnight - just as it did in Italy last year.
There seems to be no easy way for Japan to escape this debt prison. It could try to inflate its way out of the mess by doubling or tripling the entire money supply, but that would effectively decimate the nation's savings. The government could implement some draconian austerity measures to rein in spending or hike up taxes to increase revenue, but both moves would have severe consequences on economic growth. The boldest move the government is proposing is to hike the nation's sales tax to 8% by 2014, which would increase to 10% in the following year, but that isn't enough to make a dent in the debt pile.
There is no way to know when Japan will finally succumb to its debts. Japan's aging population will be retiring in droves over the next few years, meaning that they will stop buying and start liquidating their bonds, eliminating the government's ability to fund itself. With Japan's debt defenses compromised, that day of reckoning could be coming up much sooner than anyone can imagine.
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