Is Kyle Bass Wrong on the Japan Trade?

Kyle Bass may be one of the best-known hedge-fund investors in the world. His bets against subprime made him wealthy, and as close as you can come to being a celebrity while managing a hedge fund.

These days, he is probably best known for his prediction that Japan is headed for a “bond crisis.”

The principle rationale for his thesis is demographic. Japan has an aging population with more people leaving the work force than entering. He predicts that soon they will have more people dis-saving than saving and begin accumulating a trade deficit with the rest of the world, breaking “the funding mechanism” that has supported low interest rates in Japan for decades.

“Their ability to fund themselves internally is coming to an end,” Bass wrote to investors in a letter last November.

This narrative of a country needing internal, private savings to fund its government spending and public-sector debt accumulation is familiar to a lot of people and has the ring of truth.

If the government cannot keep borrowing from its people, won’t it have to borrow from outsiders? When the country starts paying out more to the rest of the world than it takes in, doesn’t it become dependent on the credit of the rest of the world? And what if outsiders won't tolerate lending at near zero-rates against a public sector balance sheet with a “debt burden” as high as Japan’s? 

That’s certainly the way it would work for a household. As revenues contract, the ability of a household to “fund” itself contracts as well. An aging household—that is, one in which grandpa and grandma retire—had better have some savings. If they are dependent on credit, they will soon find themselves paying exorbitant interest rates.

Sure, they could do a reverse mortgage, but eventually that too will run dry. When they run out of equity to mortgage, bankruptcy will loom.

Joe Weisenthal at Business Insider thinks that this resemblance is an illusion. Japan, he argues, is not going bust. Bass’ logic is “badly flawed,” he writes. As a result, the Japanese trade is “never going to pay off for him.”

Weisenthal makes a number of points in his argument. First of all, he says that the dependence of foreign creditors is an irrelevancy.

“There's no connection between rate sustainability and domestic/foreign borrowing,” Wesienthal writes.

The reason why is fascinating, because in order to get your mind around it you have to understand that for Japan, government debt accumulation is nothing like debt accumulation by private households, municipalities, corporations or even European governments. You have to step through the looking glass and apply Alice-in-Government-Land logic.

Weisenthal explains:

Foreign ownership of debt is not a function of the country going cap in hand all around the world, looking for investors to buy their bonds. It's a function of trade. When a country runs a trade deficit, it basically means it's spending more on goods from the rest of the world than the rest of the world is spending on goods from said country.

So it stands to reason that if Japan is buying a lot from the rest of the world, then there are a lot of yen floating around the world: More yen wind up in places like China, the Mideast, the US, Europe, etc.

What happens to those yen? Well, some will get spent on other things, but in the end, they'll all wind up in bank accounts somewhere, and somehow they'll find their way into a Japanese Government Bond, so that the holder of said yen might get some yield. Now theoretically if someone had a bunch of yen, they might prefer to buy German bonds or US bonds, and that's fine, but then there's another private holder of yen who has to make a decision about where they're going to place their currency. Eventually, that currency will find its way home, and the cycle is complete.

But if Japan doesn’t have to worry that high levels of debt will drive interest rates higher, what is going on in Europe?

The very question points toward its own answer. Japan has much higher levels of debt compared to its GDP than any European country. If that metric were what mattered, Japan would already be in a debt crisis.

Indeed, it would have preceded Greece into default and political mayhem. Greece, Italy, Spain, Ireland and Portugal all have more attractive “balance sheets” on this measure.

So obviously, something else is going on. Part of the answer is the currency union. As Weisenthal explains, Japan’s excess spending inevitably winds up as yen-denominated savings in Japanese government bonds. But when the government of Spain deficit-spends, there’s no guarantee that the euros wind up being used to buy Spanish government bonds. In fact, right now, much of the deficit funds of countries like Spain and Greece are being used to buy German bonds.

“This is the key idea that Bass is missing, and why his trade is never going to pay off. For a country that borrows in its own currency, government spending finances borrowing! If Japan spends 100 billion yen on something, that's 100 billion yen out there in the world that will eventually wind up in a financial institution, where ultimately 100 billion yen worth of JGB will be purchased,” Weisenthal writes.

In other words, Bass has the “funding mechanism” that supports Japanese government bonds backwards.

I’d argue that Weisenthal potentially misses one possible source of a crisis—a loss in global demand for yen.

For a country like Japan, there is no risk at all of interest rates rising—except in accordance with public policy. So long as the Bank of Japan desires rates to stay low, they will stay low. Even if all the foreigners with excess yen holdings decided to bury their yen in the ground, rates would stay low because Japan’s central bank can support rates at whatever level it wishes by simply buying the bonds at the target rate.