Tuesday, August 31, 2010

Japan - Are the three "D's" going to kill its economy?

Update January 27th, 2011

Standard & Poors has downgraded Japan’s long-term credit rating from AA to AA minus with a stable outlook.  S&P downgraded the country based on the fact that its “fiscal deficits (are likely to) remain high in the next few years”.  Is the United States next in line for a downgrade?

Update October 8th, 2010

Japan's Cabinet approved a $61 billion economic stimulus package designed to stimulate the country's rather lethargic economy.  The government hopes that the package will add 0.6 percentage points to the country's GDP and create or save up to 500,000 jobs.

Update October 5th, 2010

The Bank of Japan announced today that they have reverted to a zero interest rate because there are signs that the very strong yen is hurting a fragile economic recovery in Japan.  Overnight rates will now range from zero to 0.1 percent and will be kept in that range until prices are stable.

Update - September 8th, 2010

Japanese ruling party powerbroker Ichiro Ozawa, who is challenging Prime Minister Naoto Kan for leadership of the country, stated today that the government of Japan may need to issue more debt to fund its economy if conditions worsen. There is a possibility that Japan will have to reverse Prime Minister Kan's efforts to reign in the country's massive public debt. Japan is increasingly boxing itself into an economic corner because of the size of the country's debt in relation to the size of its overall economy. The Japanese economy is facing additional pressures because of the rapid rise in the yen to its current 15 year highs; this results in decreased international demand for Japanese goods creating further growth issues for the Japanese manufacturing industries.

Original Posting

In light of Moody's recent commentary on potential downgrades to the sovereign debt of both Great Britain and the United States, I thought I'd take a look at a G8 nation that has already had its debt downgraded.

Back in May 2009, Moody's Investor Service downgraded Japan's sovereign debt by two notches from Aaa (Triple-A) to Aa2. Again in February 2010, Moody's threatened to change its outlook on Japan to negative unless the country got its debt under control. In its May downgrade, Moody's cited challenges that face the Japanese economy because of their increase in debt issuance to fund a massive $159 billion stimulus spending program to combat the recession of 2008 - 2009. Japan issued huge amounts of debt during the last 2 decades to combat deflationary pressures in their economy. Other than the threat of deflation, the parallels to the United States economy with its massive debt growth is rather interesting.

While the Japanese government is massively in debt, the same cannot be said for the country as a whole. The nation as a whole has a pool of around $15 trillion in savings, thanks in large part to its frugal populace which have always been encouraged to save.

According to the Wall Street Journal, Japan's nominal GDP dropped 0.9% in the second quarter of 2010 to $1.288 trillion, falling to third place in the world after China whose nominal GDP came in at $1.337 trillion. Last year, Japan's annual GDP came in at $5.108 trillion compared to China's which came in at $4.98 trillion, however, recent growth patterns show that China's economy could well end up being larger than Japan's on a long term basis by the end of 2010.

There are 3 factors working against the Japanese economy; demography, debt and deflation.

First I'll deal with Japan's changing demography.

From the CIA World Factbook 2010, Japan has a total population of 126.8 million people, the 10th most populous nation in the world. They have one of the lowest birthrates in the world at only 7.41 births per 1000 people (222nd in the world putting them in second last place) and with population growth of -0.242%, they also have one of the lowest population growth rates in the world (216th in the world). One of the issues facing Japan is their extremely low fertility rate; only 1.2 children are born to an average Japanese woman (219th in the world putting them in fifth last place), well below the normally accepted replacement rate of 2.1 children per woman in developed nations.

The three factors of a lowered birthrate, a raised life expectancy (the longest in the world) and a very low historic immigration rate are working their magic against the long term viability of the Japanese economy. Basically, Japan is the first nation in the world giving us first hand evidence of a demographic shift that could lead to a marked decline in its population by 2050; from their experience, we will get a taste of what it will be like as the North American and Western European baby boomer populations age.

Here's a quote from the Japanese Statistics Bureau explaining the demographic shift that is expected:

"The population pyramid of 1950 shows that Japan had a standard-shaped pyramid marked by a broad base. The shape of the pyramid, however, has changed dramatically as both the birth rate and death rate have declined. In 2008, the population of elderly citizens (65 years and over) was 28.22 million, constituting 22.1 percent of the total population and marking record highs both in terms of number and percentage. The speed of aging of Japan's population is much faster than in advanced Western European countries or the U.S.A. Although the population of the elderly in Japan accounted for only 7.1 percent of the total population in 1970, 24 years later in 1994, it had almost doubled in scale to 14.1 percent. In other countries with an aged population, it took 61 years in Italy, 85 years in Sweden, and 115 years in France for the percentage of the elderly to increase from 7 percent to 14 percent of the population. These comparisons clearly highlight the rapid progress of demographic aging in Japan."

"On the other hand, the percentage of the younger age population in Japan (0-14 years) has been shrinking since 1982. In 2008, the younger age population amounted to 17.18 million, accounting for 13.5 percent of the total population, the lowest level on record since the Population Estimates began. The working-age population (15-64 years) totaled 82.30 million, continuing its decline since 1996. In share terms, it accounted for 64.5 percent of the entire population. As a result, the ratio of the dependent population (the sum of the elderly and younger age population divided by the working-age population) was 55.2 percent. In terms of their proportion of the total population, the elderly have surpassed the younger age group since 1997."

Here's a chart showing the demographic shift from the same report:

By 2050, basically less than half of the population (those between 20 and 65 years of age) will be working to support nearly 40% of the population. As we well know, with age comes increased reliance on the social network of any country. Poorer health requires more frequent visits to the doctor and increased hospital admissions. From these statistical estimates, we can see that a smaller proportion of the population will be responsible for funding the increased need for health care of a greater proportion of the population.

Apparently, the Japanese have very efficiently and thoroughly studied this issue. The National Institute of Population and Social Security Research has posted this study on their website showing their population projections for the future. Here is a chart summarizing their findings:

Here's a quote from the text of the study:

"According to the 2000 population census, the base year of this projection, the total population of Japan was 126.93 million. Based on the results of the medium variant projection, the population is expected to gradually increase in subsequent years, reaching its peak of 127.74 million in 2006, then enter a longstanding depopulation process. The population is expected to drop to the current size by 2013, then decrease to about 100.6 million in 2050
Based on the results of the high variant projection, the gross population is expected to reach its peak in 2009 at 128.15 million, a little later than the medium variant projection. A downward turn is expected subsequently, reaching 108.25 million in 2050.
Based on the results of the low variant projection, the total population is expected to reach its peak of 127.48 million in 2004, then subsequently decrease to 92.03 million in 2050.
These projections show that Japan will soon enter into the era of population decline, bringing the trend of population increase to an end. The fact that the fertility rate has been far below the level required to maintain the stationary population (population replacement level, total fertility rate requires approximately 2.08) since the mid-70s, together with the low-fertility rate trend continuing for a quarter-century, make the depopulation which start at the beginning of this century almost inevitable.

Secondly, let's take a look at Japan's debt situation.

Japan has a gross public debt estimated to be 862 trillion yen ($10.14 trillion US) by the end of fiscal 2010 which is estimated to be 197.2% of their GDP, the second highest debt-to-GDP ratio in the world after that pillar of fiscal strength, Zimbabwe. Please note that I have used a conversion rate of 85 yen to the USD throughout this analysis.

From their 2009 Fiscal Condition document, they show the following chart and graph. Note the rapid climb in their debt-to-GDP ratio since 1995 when their ratio was not that much worse than that seen in other developed nations:

The document also contains the following chart showing their growing debt level over the past three years:

As well, Japan's external debt (owed to outsiders) totals $2.132 trillion, eighth highest in the world.

According to their 2010 fiscal year Budget, 22.4% of the total 2010 fiscal year budget will be spent on National Debt Service. This amounts to 20,649 billion yen or $243 billion dollars, still quite a bit lower than the United States which is currently spending around $400 billion annually on interest payments. Here's the chart from Japan's 2010 budget showing the expenditure breakdown:

Fortunately for Japan, their interest rates have been very low since 1993; according to the Bank of Japan website, their discount rate has ranged from a high of 2.5% in 1993, dropping to 1% in 1995 and remaining between 0.75% and 0.10% from September 1995 to the present. While world-wide central bank rates are now in the sub-single digit range, that has only been a relatively recent phenomena. Japan's protracted period of low interest rates have helped their economy by adding a smaller interest component to their overall government debt.

In July 2010, even the International Monetary Fund warned Japan that they must rein in their high public debt-to-GDP ratio as soon as possible. Their recommendation is that Japan gradually in crease their consumption tax to reduce the risk to their sovereign debt.

Lastly, let's take a brief look at deflation in Japan.

The Japanese economy has suffered from deflation off and on since 1995 and pretty much consistently with occasional positive monthly inflation numbers since 1999. Monthly inflation rates have been as low as -2.53% as recently as October 2009. While dropping prices seem like a dream come true to consumers, they are considered a nightmare by economists. When consumers assume that prices will drop in the future, they tend to put off purchasing items because they know that the same item will likely be cheaper in the future. This results in a drop in economic indicators, especially in the case of Japan where 60% of GDP is related to consumer spending. Indirect evidence of deflation can be seen in the Bank of Japan discount rates over the past 15 years as noted above. Japan has deliberately tried to reflate its economy by maintaining a protracted period of very low interest rates.

Here's a chart showing Japan's inflation rate over the past from the indexmundi website:

From these statistics, we can see how well entrenched deflation is in the Japanese economy.

From this posting, I hope that you can see that Japan's economy faces a rather unique "perfect storm". Many other OECD nations will face similar issues with demography, debt or deflation, however, Japan is in the unique situation of facing all three issues at the same time.


  1. I wonder what exactly they are really up to - numbers send a message, and tell others what you want them to see...

  2. Interesting and thorough article; thank you for putting it up, complete with graphs!

    I have to say that I find the demographic issue somewhat questionable and potentially over-discussed in the Japanese media (and overseas). In terms of numbers, no one can really say how many people can a country the size of California can "comfortably" support. 2.1 children per parent might be a comfortable number to keep population levels steady, but I don't know if anyone has argued whether before, Japan was "over populated" and the "just right" value is lower than the current 120 million.

    There is no doubt that the pension system will break...but if Japan survives that period (by prolonging the retirement age, just as what France has just done?), maybe things will be fine. The Japanese media talks about the need to increase the birth rate and increase immigration, but sometimes I wonder if this is driving up the nations' fears. i.e., "the sky is falling"

    One thing is for sure...whatever Japan will face, the combination of the 3 D's should be of interest to economists in other countries. Any industrialized country can follow the same path; I think Germany also has a ratio of less than 2.1 per family.

    And it is Japan ... any shortfall in population will be made up for by robots! :-)

  3. Based on the above it makes sense for Japan to begin printing more money and selling yen in the open market. This will help counter the deflation and increase exports and drive improvement in the economony. In regards to the high levels of debt outstanding, Japan can again print money to pay of this debt so long as there is not issue with inflation. We've been in an interesting paradigm the last two years where stable countries have been able to print large amounts of money without triggering inflation, thus the concerns about debt in the U.S. and Japan are overstated.

  4. Thanks for your comments. I agree that Japan could be in a unique situation; the Japanese have always been very good savers and that will stand them in good stead if rough waters should be encountered. Their debt to GDP level still concerns me and as an investor who is concerned about fiat currencies, the idea of firing up the printing presses is frightening but that is what is most likely to happen. Whether there is a price to pay in the long run, no one knows....yet.

  5. If you run the numbers, with a birth rate of 1.2 children per woman, 8 grandparents will have about 5 children and 3 grandchildren. This kind of demographic collapse is inherently deflationary. To fight the deflation, Japan went into serious debt.

    It seems to me that of the 3 D's, demographics is at the center of it all.

  6. I am new to your blog, but I enjoy your topics. I believe that when one looks at the Japanese debt, one must look at both the net and the gross government debt-to-GDP ratios.

    Yes Japan's Gross Debt-to-GDP is extremely high and stands far out from the rest of the G8 crowd. Yet Japan's Net Debt-to-GDP is rather comparable to Italy's. Yes it is high and undesirable, but it is not as bad of a problem portrayed.

    Please see this site for a comparison between net debt-to-gdp for the G7:


  7. Japan continues to destroy wealth. Their Nikkei Dow peaked in 1989 at 39,000 now around 12,000 and real estate peaked in 1990 and is down 50 to 70%. The savings of the Japanese people is being wasted by the government and the government will not be able to fund Social Security and Medical care because of their demographics. The financial institutions own a lot of JGB's that will decline dramatically in value as Japan searches for foreign buyers at higher rates, as financial institutions turn to net JGB sellers. The savings rate is now zero (was 16%). Retirees, that hold most of the huge bank deposits are withdrawing deposits to fund retirement. CD's only pay .2%--retirees must withdraw principal. Interest consumes 22.4% of government revenues at a blended 1.4% interest cost. If the interest rate moved to 2%; the loss on JGB's would damage capital at most all the financial institutions. Japan's options are limited.

  8. Debt/GDP is a meaningless measure. See: http://rodgermmitchell.wordpress.com/2009/11/08/federal-debtgdp-a-useless-ratio/

    Rodger Malcolm Mitchell