Adjustment scenarios for JGBs

Reuters reports Japan GPIF to withdraw $78 bln from assets.

The GPIF is likely to raise cash by selling JGBs and other assets in its portfolio as pension contributions and tax income continue to fall short of pension payouts which are growing as Japan's population ages, the newspaper said.

The largest buyer of JGBs, is not just reducing purchases, or failing to roll over maturing bonds, but will be a net seller this year. That is a watershed moment. The Japanese government, with astronomical debt-to-GDP over 200% may be a harbinger of things to come for western governments with heavy debt loads. We've seen bond market failures already for Greece, Ireland, and Portugal at much lower debt levels.

Japan has been given a great deal of slack because it has large net exports, and the unusual fact that it's government bonds are 90% funded internally through pension funds and private purchases. It appears the time is fast approaching when private purchases are no longer sufficient to fund bond issuance. I've been trying to think through possible ways Japan and/or market forces will adjust to this change. How will JGBs be funded in a future where private funding slows down?

Foreign purchases might surge

The shortfall could be met with increased foreign purchases of JGBs, from sovereign wealth funds, hedge funds, or central banks. At current interest rates, the lowest in the western world, it is hard to imagine any large buyer would think Japanese bonds were a good investment. It is possible that foreign central banks might agree to support Japan and purchase some with the goal of averting a global crisis. The Fed in particular has been accommodating of most any request for dollars.

Japanese bond issuance slows due to voluntary austerity

The government of Japan may decide to dramatically reduce spending and reduce deficits. Where spending cuts are made is likely to be a heated political battle, much as in the US.

The BoJ monetizes JGBs

Following a standard operating practice since the 1990s, the BoJ may increase their purchase of bonds in another round of quantitative easing. While events may include elements of each policy and market response to the JGB problem, I view BoJ QE as the most likely and to make up the bulk of any shortfall from private purchases.

The danger of unlimited QE is that the amount monetized becomes absurd at some point. Whether that is 250% debt to GDP, 400%, or when the total tax revenues no longer cover the interest due on outstanding bonds. Something will be a trigger point where either the Japanese people or Japan's trading partners lose faith in the yen. An extreme currency crisis can be only be met with extreme policy choices.

Extreme policy choices

Once a currency crisis has begun, Japan can choose to default on outstanding debt due and preserve some value in the currency, or print money to cover every bad debt leading to hyperinflation. Both choices are painful for the citizens and country and may lead to unknown political consequences. Despite all the advantages accrued to Japan, it may be the first major advanced economy to go over the Keynesian cliff.