Japan's Debt Problem - How it Affects the Nikkei 225
In 2012 Japan's debt was approximately 997 Trillion Yen. That is more than 200% of GDP or more than $80,000 per capita.
There is little chance this gets paid off. Unfortunately things are about to get a whole lot worse.
How does the government create debt?
Each year the government gets revenue from taxes and other streams. Then they government spends the money in public services. If it has to spend more than it takes in from revenues including taxes then it has to issue IOUs or bonds. Investors buy them. The government gets the money and investors receive interest. But when the outstanding debt gets too large, investors start to get worried that they won't get their money back.
The central bank would then print more money to lower interest rates.As a result investors will feel reassured that their debt will be paid. That way the government can keep spending as they please.
What happens when the debt keeps increasing?
Normally, a portion of the government's existing debt will be paid from taxes collected and another portion would come from new debt. When the central bank lowers interest rates, the government pays less in interest to bond holders, which makes it easier for the government to meet its interest expense.
Eventually, the government keeps spending more money and interest expenses increase. The interest expense increases so much that even a small increase in interest rates would result in a large increase in interest expenses. As a result, all tax revenues end up going to pay interest expense. This leaves little to no money to pay for other expenses, which would force the government to take on more debt and issue more bonds to fund those other expenses.
Investors catch on and sell bonds to account for inflation, which increases interest rates. Sooner or later the tax revenue would only cover a fraction of the interest expense. When the government can't pay its interest expenses, the country will default.
Where Does Japan's Debt Situation Fit?
Japan's debt is 23 times revenues. This means that a 1% increase in interest expense rate results in an increase of interest expense by 23% of tax revenues. 23% of tax revenues is already being spent on taxes every year. So another 3% increase in interest expense would result in having to use nearly all of tax revenues to pay just the interest expense.
Can the government keep debt interest rates below 4%?
The last 20 years, Japan's prices have been falling except for Japanese government bonds. This means a lot of the Japanese already have their money in bonds. New funds would have to come from foreign investors. But, they are more used to higher rates of return. In addition, Bank of Japan started to target 2% inflation. Japanese investors saw deflation of 1% and got a nominal yield of 1%, so they saw a real yield of 2%. But with the new target, they would recognize a real yield of -1%.
To get back to where they were before, bonds interest rates would need to be 4%. Once this happens its game over.
Compare the debt situation with that of the United States. Not all that different is it?
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