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07/11/2006 | Global Market Brief

Stratfor Staff

Japan's Local Debt Problem:Japan's Council on Economic and Fiscal Policy suggested Oct. 25 ending Tokyo's implicit guarantee of municipal debt. Chaired by Prime Minister Shinzo Abe, the council is meant to advise Japan's Ministry of Internal Affairs. This proposal resulted from discussions the council has had since August on how to prevent local governments from running up unsustainable levels of debt.

 

Debt is not a new problem in Japan. After the Japanese economy hit a wall in the early 1990s when its financial system unraveled, the "solution" was to use deficit spending to spark growth -- under the theory that a swift injection of cash would jump-start the economy. Fifteen years later, that strategy is still in use. As of 2005, the budget deficit is about 6.5 percent of gross domestic product (GDP) and the economy has not yet demonstrated an ability to grow without such debt-sourced spending. Japan's national debt -- excluding pension arrears and locally issued debt -- is now about 150 percent of GDP, more than $6 trillion. Add in those other categories and the number is probably around $10 trillion, making Japan the most indebted country on a per capita basis in history.

Abe's laudable goal is simple: to start addressing at least pieces of this debt; and he is starting with the place at which it is the worst. Local governments within Japan's 47 prefectures currently have outstanding debt of approximately 200 trillion yen ($1.7 trillion), or 34 percent of GDP. This compares with local debt levels of 5 percent of GDP in Germany and 13 percent in the United States. After the downturn of Japan's economy in the early 1990s, local government budget balances have been just as consistently negative as the national government's, with the total debt stock of local governments showing a steady and continuing upward trend to the present.

Excessive local borrowing is the product of the government's need to spend more than it collects in tax revenue in order to keep economic growth moving. Under the Japanese system, municipalities have significant responsibility for providing public goods and benefits, but their take of tax revenues is disproportionately small compared to that of the national government. The ratio of national taxes to local taxes is 3:2, while the ratio of national fiscal expenditure to local fiscal expenditure is 2:3. To compensate for this gap, revenues are transferred from the national level to the local level. In addition to various fund-transfer mechanisms, localities have a long history of supplementing their revenues with the issuance of bonds. The central government's implicit guarantee of that debt effectively allows subsidized lending, as the municipalities enjoy far lower interest rates and far greater access to capital than they would otherwise.

This system has created an incentive for local governments to grab as much money as they can, both from transfers and from their subsidized borrowing. That municipalities can raise funds beyond what the market would normally allow has led to significant waste and overinvestment. This local government borrowing has primarily been used to finance infrastructure projects. However, much of this public works spending has no economic rationale, and the rate of return has been low. (Examples of this, such as roads to nowhere and unused stadiums, abound.) The ability of many local governments to repay their debts, even if their borrowing costs were to remain the same, is therefore questionable.

If the national government's implicit guarantee of local debt were to end, localities would find themselves exposed to the harsh realities of the market. Currently, local borrowing costs are often only 13-15 basis points (0.13 percent to 0.15 percent) above Japanese sovereign bonds. Market rates for local bonds would be much higher. Depending on the size and creditworthiness of the municipality, rates would likely increase an average of 200-300 basis points (2.00 percent to 3.00 percent). Municipalities in extremely bad financial shape might even find themselves cut off from capital markets entirely if lenders judged their credit risk to be too high. Though exposing municipal borrowing to market forces is necessary in the long run, it could have disastrous consequences in the short run.

There is a significant risk that the elimination of the national government's guarantee would lead to the bankruptcy of many municipalities. There have been 884 such bankruptcies since records began, largely because current laws do not provide localities with any real means to deal with debt problems before declaring bankruptcy, and there has never been any debt forgiveness. The latest example is Yubari, a former mining town with a population of about 65,000 in the northern prefecture of Hokkaido. The town recently filed for bankruptcy after accumulating debts of 63 billion yen ($500 million), 14 times its annual average revenues.

Therefore, mechanisms would have to be put into place that would allow the localities to restructure their debt load should they be in danger of default. But any version of such a plan would, by definition, lead to a drastic drop in public spending at the local level. That would most likely trigger a recession were it not balanced by increased spending at the national level. Unfortunately, as noted earlier, the national government faces a financial burden similar to that of the localities. After 15 years of spending beyond their collective means, the Japanese have to find a way to constrict spending to the tune of between 7.5 percent and 9 percent of GDP without impacting tax revenues just to stay even. And that is even before the mounting pension arrears from Japan's demographic crunch are taken into account.

There is another angle that needs to be considered before the doom-and-gloom (and wholly realistic) possibility of an outright financial collapse. Debt defaults by local governments would harm both private banks and the national government. Local government bonds are almost entirely domestically held. The private sector holds approximately 30 percent of all this locally issued debt. The majority of the privately held bonds are owned by local and regional banks. Stripping away the national government's explicit credit guarantees from the local authorities would trigger significant defaults by the localities, severely damaging the banking sector and forcing some such institutions into bankruptcy.

But even more damning would be the effect on the national government itself, as institutions such as the Bank of Japan (the central bank) and the postal savings program hold approximately 70 percent of the total debt. Those bonds -- roughly $1 trillion worth -- would go bad should the government unilaterally cut off the local governments. Those bonds are a core asset on the national account; without them Japan's credit rating, already at an abysmally low level for a developed economy, would have nowhere to go but down, and sharply down at that.

This would hurt the holders of Japanese sovereign bonds. As with the local bonds, a reduction in the value of the sovereign bonds would primarily negatively impact the national government -- overseas investors hold only about 5 percent of outstanding sovereign bonds, and Japan's own government institutions hold most of the rest. Lower credit ratings mean higher borrowing costs, which would only increase the difficulty of the task -- at both the local and national level -- of rectifying the Japanese financial crisis.

With stronger economic growth, the hope is that the debt crisis can be addressed without triggering a recession, or more likely, depression. For the past year Japan seemed it might be poised for a recovery on the back of stronger consumer and business spending. But one year into this recovery the local and national government's penchant for debt-funding spending has not significantly budged, and there are new signs of weakness. Recent statistics indicate that household consumption fell by 6.0 percent in September compared to a year earlier -- the sharpest drop in five years. Consumer spending is the backbone of the Japanese economy and any weakness there will quickly resurrect the country's deflation crisis
.

The current Council on Economic and Fiscal Policy proposal is only at a very early stage, with the council yet to make any specific recommendations. One such recommendation would be to continue to guarantee old debt, but not new debt. This way localities would get the point without having it shoved down their throats.

But even putting aside the myriad potential dangers, and assuming that Abe proceeds with intelligent caution, any meaningful structural reforms will prove extremely difficult -- politically, financially and
culturally. Regional spending has been fundamental to Japanese politics in the post-war period, and the ability of politicians to get elected rides heavily on their ability to bring in government money to their localities, even more so than in most other developed economies. Such reform could even prove more difficult than the privatization of
Japan Post -- the country's hybrid postal system/state-run bank -- that began in 2004, more than a decade after privatization was first discussed.

But regardless of the time frame, out-of-control local debt is a $1.7 trillion problem that will have to be dealt with in a way that does not throw the economy into disarray. It is a crucial step on the path toward fiscal responsibility that Japan will have to tread if it is to recover from its past decade of stagnation and return to economic normality. The trick is how to do that without triggering the very calamity Japan is so desperately trying to avoid.

RUSSIA: Russian state natural gas firm Gazprom said Oct. 30 that it has delayed from 2011 until at least 2013 the expected first shipments of liquefied natural gas (LNG) from its yet-unstarted Shtokman project in the Barents Sea. Moscow is dangling the project as a carrot in front of Western governments in order to extract concessions on other issues. However, the terms it has offered -- foreign consortia would have only minority control, would have to provide all the capital and technology and would need to teach Gazprom offshore and LNG technology in order to participate -- are so poor that no firm wishes to become involved. The new plan is to have no foreign participation in ownership, but for Gazprom to hire foreign firms as contractors. This would require Gazprom actually putting up several billion dollars for such contracts, something that it has never done. Shtokman is, in effect, dead.

CHILE: Chilean energy distribution companies finished receiving bids from suppliers Oct. 31 and will announce Nov. 13 which electric generation companies won the bid. The new contracts are also for development of the Chilean energy sector, which is trying to become less dependent on imports. Chile is in the midst of a broad energy reorganization that will include liquefied natural gas import terminals and nuclear power plants. The goal is to enable Chile to completely end its energy imports from all the neighbors Santiago has decided are too unreliable.

PAKISTAN: Pakistan has approved the United Arab Emirates' (UAE) International Petroleum Investment Co. proposal to construct a $5 billion oil refinery in Balochistan capable of refining 200,000 to 300,000 barrels per day (bpd), the Pakistani government said Nov. 1. Pakistan imports approximately 85 percent of its oil consumption of 350,000 bpd, of which almost more than half is imported in the form of more expensive refined products. The Pakistani government is hoping that locking itself into a long-term supply agreement with the UAE and getting a refinery built in-country will lower its long-term energy bill. Additionally Pakistan hopes that having a UAE economic interest in Pakistan -- the UAE is a strong U.S. ally -- will encourage the United States to consider Pakistan more favorably.

CHINA: China announced new anti-money-laundering legislation Nov. 1 that expands the definition of "money laundering" to include financial crimes such as loan fraud, embezzlement and bribe taking. The old law focused on more traditional criminal activities such as the processing of drug money. Such financial crimes are endemic to the Chinese system -- loans are regularly granted by state-owned banks because of political connections rife with conflicts of interest, with minimal evaluation of business plans or regard for payback. This economic system is particularly deeply entrenched within the "Shanghai clique" of oligarchs and government officials who owe their power to former Chinese President Jiang Zemin. The intent of the new law is simple: to grant the government a new tool with which to root out the influence of Jiang and his allies.
China's National Administration of Copyright just launched a new campaign to crack down on illegal downloads of films, music, software and textbooks, Xinhua news agency reported Oct. 31. The campaign is slated to run for three months. This comes after news that the United States will file charges against China in the World Trade Organization for not doing enough to protect intellectual property rights.

Stratfor (Estados Unidos)

 



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