“Negative interest rates are spreading like the Zika virus.”
— Bill Gross, co-founder of PIMCO
Bill Gross, a legendary fixed-income investor, recently expressed his alarm in his monthly newsletter over the increased use of negative interest rates in Europe and in Japan. He snidely commented that negative interest rates are an enigma to almost every investor on the planet and asked the question we all would like answered: “Why would someone lend money to a borrower with the certainty of getting less money back at a future date?”
“Even the most Einsteinian-like economics would not have imagined such a state, but now it seems like an everyday occurrence, as central banks plumb deeper and deeper depths like drilling rigs expected to strike oil, if only yields could be lowered another 10, 20, 50 basis points.”
Instead of hitting the mother lode, however, central banks might incur an oil spill of Deepwater Horizon proportions.
Japan’s use of negative interest rates for funding long-term debt — issuing a 10-year bond with negative yields — is an extreme measure. Other countries, from Sweden to Italy, have issued negative-yielding securities of short durations.
Japan has pushed the boundaries of using negative interest rates in more ways than duration, however. It also is using them more than any other country: Almost 70 percent of Japan’s government debt now trades with a negative yield.
Currently, Japan’s central bank holds roughly a third of the country’s outstanding debt, and its portion should rise if negative interest rates persist.
In layman’s terms, the Japanese government, instead of relying upon third parties, is selling debt to itself.
Historically, Japanese pension funds and life insurers have been big buyers of the country’s government debt. This is now changing. As yields have dropped, the pension funds and life insurers have acquired riskier investments by buying 20-year government bonds and foreign and corporate bonds.
If Japan returns to positive interest rates or the yen appreciates relative to other major currencies, these institutions could suffer dramatic losses.
Will Japan then experience a scenario of needing to save institutions that are too big to fail? According to data compiled by The Economist magazine, Japan’s fiscal status appears reckless. The economists Carmen Reinhart at the University of Maryland and Kenneth Rogoff of Harvard demonstrated in a scholarly treatise entitled “This Time is Different” that countries’ financial outlooks become perilous when their ratio of debt to gross domestic product exceeds one.
Some 2014 figures for government debt as a percent of GDP show that Japan’s is 230 percent; Greece’s is 180 percent; and the U.S. ratio is 109 percent.
Instead of engaging in continued major fiscal stimulus measures or taking extreme monetary measures, Japanese officials could be better off if they instead realistically examine their economic situation: They possess the world’s third-highest GDP with a relatively small population, some 127 million. Instead of just focusing on growing their economy, Japan should assess the enormous risks it is undertaking: Its national debt is monstrous, and undertaking a policy that ensures that most of its federal debt offers negative interest rates undermines its credibility.
Japan needs to recognize that a major part of its problem is its demographics: It suffers from an aging and declining population. To counter this trend, Japan needs to institute laws and practices that facilitate immigration of educated young workers. It needs to understand that the emergence of Singapore and countries such as China and South Korea will curb its exports and therefore limit one of the ingredients that propelled its miracle economic growth in the years following World War II.
Many years ago, a friend gave my father very good advice that now seems appropriate for Japan. He said: “Joe, it is not how much you can make, it is how much you can afford to lose.”
Originally published in the Sarasota Herald-Tribune
