Last week the Bank of Japan (BOJ) more than doubled their Swap borrowings from the Fed to a total of $20.4 billion. Though this is a quarter of the $82.3 billion the European Central Bank (ECB) has taken out since the Fed lowered its swap rates back in December, it may be more alarming.
With all the turmoil in Europe, few have paid attention to the situation in Japan. Japan currently has a 230% debt to GDP ratio and is borrowing close to 55 percent of every dollar (yen) it spends. Consistent current account surpluses have allowed them to stay solvent by funding their debt through domestic banks and insurance companies, government pensions, and Japanese savers. Just 5 percent of its debt is owned by foreigners. It’s largely a Ponzi scheme, but because of their huge exports and saving, it has perpetuated.
But this is beginning to change.
Since the start of the financial crisis in the summer of 2007, the Yen has appreciated nearly 40 percent against the dollar, and slightly more against the Euro, a result of the massive easing by the Fed and the ECB. As a result, Japan’s exports have become more expensive, declining over the entire period. Then the Fukushima Daiichi nuclear earthquake disaster last March crippled export volumes further.
Japan’s current account has fluctuated violently since the beginning of the Yen appreciation over the past five years, but all the while has been in decline. 2012 may very well mark the first year of current account deficits in Japan following decades of annual surpluses.
If that should prove to be true, the last place Americans want their dollars to be going is the BOJ. Without current account surpluses, domestic buyers of Japanese debt will have no source of money with which to fund the Japanese government. Foreigners surely won’t pick up the slack with Japanese 10-year yields at 1 percent when they can get Treasuries and Bunds at 2 percent.
The only possible outcome would be for Japan’s borrowing costs to at least double or massive inflation by BOJ printing. Debt service is currently half of government tax revenue, so if borrowing costs double, and all else equal, debt service will be 100 percent of revenue. Of course that cannot happen, so something catastrophic would occur prior, namely the latter option of BOJ printing and hyperinflation.
That’s not a situation we should be throwing dollars at in blind hope. However, the one thing the current Fed loves to do is throw money at any situation regardless of the cause and potential downside outcomes. So the questions are, what factors will lead Japan to current account deficits, and as a follow-up, what happens when BOJ swap operations with the Fed soar as a result?
Demand for Japan’s exports will be at the heart of determining a deficit or surplus for Japan’s current account. A weakening Europe, and stagnating U.S. will drag on demand, and the subsequent easing by the ECB and Fed will drive the Yen higher crushing exports and continuing the slide to current account deficits.
Another factor will be growth in Japan’s imports, namely that of commodities. A stronger Yen will contribute to this, but a fundamental shift is also on the rise. There now is a greater demand for energy generation from fossil fuels like coal and liquefied natural gas (LNG) because of the earthquake. Japan generates nearly a third of its electricity from nuclear, and in an island nation of limited natural resources, commodities imports are likely to boom.
Transfer payments too are beginning to exert pressure. Japan has a top-heavy aging population and the younger generations are not saving like the generations that preceded them. Social welfare will drastically increase net transfers. This is an inevitable drag on the current account even if the former scenarios do not play out.
Thus the situation looks grim. But it should not come as a surprise because the writing has been on the walls for decades and the recent trend towards current account deficits has been in place for nearly five years. Nevertheless, the Fed is addressing the issue with its usual band-aid of free money.
I suppose one can’t blame the Fed, however, because the solution for Japan in this situation would be to sell their nearly $1 trillion in U.S. treasuries held in reserves. At a time when the Fed has just binged on U.S. debt and the future of the dollar and the U.S. economy now hinge on the ability of our government to borrow cheaply, our debt-laden controllers can ill afford any foreigner dumping our paper, let alone the second largest creditor.
So, as our Fed works to bailout Japan, we must address the follow-up question of what happens when BOJ swap operations with the Fed soar as a result. The answer unfortunately is uncertain.
The Fed enters the swaps via a fixed exchange rate with the counterparty central bank, so arguably the Fed is insulated from any risk because any central bank can simply print money if the banks that are ultimately lent to collapse and cannot repay. But if the swaps soar to something like $500 billion or more, and banks do collapse, what central banker is really going to print the money necessary to make good on their end of the swaps? All holders of Yen (in this case) would get crushed. Likewise, the Fed would tell U.S. citizens that it’s in their best interest not to demand repayment and share the pain so as not to initiate a global slowdown, world financial crisis, or whatever the scare tactic phrase du jour may be.
Again, the problem is that nothing is being done to address the fundamental issues laid out here. Rather it’s more of the same printing money, providing liquidity, and dealing with “surprise” crises as they occur.
The Fed’s swap operations can be found here. They’re currently above $100 billion and climbing. We’ll write again on these swaps when that figure becomes a pittance.