‘Next Greece’ Search Is on as Hedge Funds Circle: William Pesek

Commentary by William Pesek
Feb. 22 (Bloomberg) -- The search for the next Greece is finding its way to an unlikely place: Japan.
Few here gave much weight to warnings by analysts like Makoto Noji of Mizuho Securities Co. about the second-biggest economy facing "next-Greece" speculation. That was until Japan’s central bank chief hinted at a similar risk.
Governor Masaaki Shirakawa last week called on Prime Minister Yukio Hatoyama to contain the world’s largest debt with a warning that investor trust won’t be assured in the aftermath of Greece’s budget woes. It was an extraordinary comment.
Politicians routinely slap the Bank of Japan around; it’s jaw- dropping to see the BOJ return the favor.
The BOJ head is right to put a spotlight on the fiscal train wreck that could be Japan’s $4.9 trillion economy. That’s especially so now that the Federal Reserve is on the move. Its discount-rate increase last week telegraphed what Japan has been
dreading: rising global bond yields that exponentially boost debt-servicing costs.
Unlike Greece, Japan prints its own currency, controls its own monetary policy, has a current-account surplus and roughly
$15 trillion of household savings it can tap when things get dicey. More than 90 percent of government bonds are held domestically, eliminating capital-flight risks.

Worrisome Trifecta

Yet Japan faces a worrisome trifecta of challenges in the years ahead: Deflation, lopsided demographics, and ratings companies casting a wary eye its way.
Deflation is worsening, as evidenced by the 3 percent drop in the gross domestic product deflator in the fourth quarter. It was the biggest drop since records began in 1955, and showed the extent to which 2010 will be a bumpy year.
The steady drumbeat of damaging news about Toyota Motor Corp. and Japan Airlines Corp. is already wreaking havoc with the Japanese psyche. Now, headlines about deepening deflation are likely to further depress household spending.
While Japan’s rapidly aging population is a concern in the long run, credit raters are paying ever more attention to the dynamic. Last month, Standard and Poor’s warned that it may cut the nation’s AA rating. An actual downgrade can’t be far off.
Hatoyama has yet to outline any plans to repair Japan’s finances. The risk is that closer scrutiny of Europe’s debt woes increasingly shifts attention to Japan. The government, after all, is preparing to sell a record amount of bonds to fund its largest budget ever for the year starting April 1.

Market Collapse

Japanese officials may be tempted to seek Goldman Sachs Group Inc.’s help in hiding debt off the balance sheet, as did the Greeks. Yet the news is out on that Enron-like tactic.
There’s little time to waste in figuring out how to maintain a high level of borrowing without spooking markets. As officials in Tokyo weigh their options, hedge-fund managers like David Einhorn of Greenlight Capital Inc. are betting on a Japanese bond-market collapse.
Some rise in Japanese yields is a given. Ten-year bonds yield all of 1.32 percent, compared with 3.77 percent in the U.S.
and 4.17 in the U.K. Yet when your outstanding debt load is double the size of your economy, even a modest spike in rates will hurt.
The yen is a wild card here. Will waning confidence in Japan’s finances lead to a plunging yen? Manufacturers would love a weaker exchange rate, yet a run on the currency could destabilize Japan as it would any economy.

Deflation Risks

"Japan has essentially said deflation will be a feature of the economy for at least a couple more years," says Glenn Maguire, chief Asia-Pacific economist at Societe Generale SA in Hong Kong. "That means rates aren’t going higher and the yen will be weaker. The only question is how weak."
The Fed’s move to raise the rate charged to banks for direct loans by a quarter-point to 0.75 percent boosted the dollar. As the Fed and BOJ move in opposite directions -- the Fed removing liquidity, the BOJ adding it -- then yen will slide.
The key is to keep the trend orderly and manageable.
The yen could also take some hits as tensions rise between the BOJ and the government. Last week, Finance Minister Naoto Kan turned up the heat, urging the central bank to adopt an inflation target to stabilize falling prices. Shirakawa shot back with his call for fiscal responsibility.
It would be better, of course, to fight things out behind closed doors. More likely, this tit-for-tat match between fiscal and monetary policy makers will intensify as the year unfolds.
And that’s a very telling state of affairs.

Grim News

Truth is, Japan still has no strategy for growing without the help of massive borrowing and near-zero rates. Hopes that Hatoyama’s election win in August would bring new thinking to old problems have been dashed.
The upshot is more of the same -- debt sales and a return to the quantitative easing policies the BOJ scrapped in 2006.
All the while, reforms needed to raise Japan’s competitiveness amid China’s rise are being put off. Expect ever more debt, higher yields and less growth.
Even if Japan isn’t the next Greece, its debt trajectory is anything but pretty. That’s grim news for investors.