With their declining household-saving rate, Japanese consumers are no longer both financing government deficits and sustaining their nation’s current-account surpluses. How is the gap being filled?
The current-account balance can be expressed as the difference between gross national saving by consumers, business and government, and total gross investment by those sectors. In this context, gross refers to measures before the subtraction of capital consumption or depreciation. If the balance is positive, as in Japan, saving exceeds investment needs and the rest must be exported. If it is negative, as in the U.S., saving is insufficient to finance domestic investment and funds need to be imported.
In Japan, household gross saving in excess of gross capital spending is slipping as the saving rate falls. That trend is likely to continue as a result of the aging population and other forces, as discussed in yesterday’s column. The government persists with its deficit because its gross saving is negative and gross investment is positive. That leaves the corporate sector to make up for the shortfall.
Normally, the business sector is a net borrower as capital spending exceeds cash flow from depreciation and retained earnings. Yet Japanese business capital spending has been falling since the mid-1990s while export-driven cash flow has climbed. Since then, the business sector has been a saver on balance, and most of that increase in gross saving has come from capital-consumption allowances in the nonfinancial corporate sector. Businesses, then, have seamlessly replaced consumers in financing chronic government deficits and in sustaining current-account surpluses.
The falling trend in corporate capital spending and its decline as a share of gross domestic product coincide with rising exports. In recent years, Japan has increasingly exported capital goods to China and other Asian lands, where they are used to produce U.S.-bound consumer products. That’s an oversimplification, yet it gets to the essence of the process. This has made Japanese business very efficient in producing capital goods to export without increasing capital spending. Indeed, core machinery orders fell 2.8 percent in March 2012 compared with February.
In contrast, in the U.S., there is a negative spread between gross national saving and investment, which last year ran at $435 billion, or 3.1 percent of GDP. The household sector, with a 4.7 percent saving rate last year, had a $446 billion surplus of saving over investment. The U.S. business sector’s net surplus was $498 billion. The combined total of $944 billion was overwhelmed by the government deficit of $1.38 trillion.
As U.S. consumers continue to retrench and delay imports, China will cut its growth in already excessive industrial capacity, and that will include capital equipment and other Japanese exports. Absent strong domestic demand, weak exports, in turn, will keep capital spending subdued and, in time, Japanese gross corporate saving in the form of capital consumption and retained earnings will weaken. The net effect will be to depress the country’s current account, unless the economy revives thanks to a large increase in consumer spending and the related disappearance of government incentives to run big deficits by providing fiscal stimulus.
Japan’s current account was 2 percent of GDP in 2011, and fell 8.6 percent in March 2012 from a year earlier. Low global interest rates during what is likely to be five to seven more years of worldwide deleveraging will depress earnings of Japanese foreign assets, which have supported the current-account surplus. Furthermore, from 2007 to 2011, Japan cut holdings of high-yielding euro-area assets by $309 billion, and probably by much more in the past year.
Except for government spending, exports have been the only area of strength in the Japanese economy for years. And there has been a close link between exports and GDP growth since 1990. That’s why the government in early 2010 began a campaign to spur exports of infrastructure goods such as bullet trains and nuclear reactors.
A current-account deficit in Japan would have serious consequences because the country would be importing money, instead of exporting. And since this would probably occur in a moribund economy, few investment opportunities would attract foreign capital or encourage Japanese with foreign assets to sell them to bring the money home. So interest rates would need to rise appreciably from current low levels of less than 1 percent for 10-year Japanese government bonds.
Furthermore, debt-rating companies are growing weary of Japan’s huge government deficits and mounting sovereign debt. That means Standard & Poor’s and Moody’s Investors Service may follow Fitch Ratings’ recent downgrades. This would lead to further increases in Japanese interest rates and bond yields. Higher rates would also end the yen’s status as a funding currency for the carry trade that allows investors to borrow in yen and invest in higher-interest-rate countries.
Then, Japan’s immense government debt, even if almost entirely domestically owned, would be much more expensive for the government to finance. The International Monetary Fund estimated that in 2010, Japanese government interest payments amounted to 2 percent of GDP. An interest rate that is one percentage point higher would add 2 percent of GDP to the government’s interest costs. Then as confidence eroded, the IMF wrote, “Authorities could face an adverse feedback loop between rising yields, falling market confidence, a more vulnerable financial system, diminishing fiscal policy space and a contracting real economy.” In other words, a government-debt death spiral.
Japanese domestic investors may be satisfied with low nominal interest rates as real returns are much higher because of domestic deflation, but foreign investors probably compare yields in Japan with their own price indexes, which are still rising. That also could initiate a self-feeding debt spiral unless other government spending is slashed. But that action might so weaken the economy that the government deficit, excluding interest costs, would end up widening, not shrinking.
Upward pressure on government bond yields will also ensue as institutional holders such as the Government Pension Investment Fund, which has two-thirds of its assets in government debt, and Japan Post Holdings Co. sell their holdings to pay old-age-related entitlements in coming years. And rising interest rates will lower the value of those pension assets. To be sure, the Bank of Japan, with government approval, could offset some of the pressure on interest rates with a flood of money, but in the long run, that could push the yen down so much as to jeopardize Japan’s international credibility. The central bank pursued that policy after the 2011 earthquake and tsunami, but for a limited period.
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the fourth in a five-part series. Read Part 1, Part 2 and Part 3.)
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