Felix Zulauf on the Japanese government's massive debt problem

Zulauf: The Japanese government is in a difficult position, with the country's debt running at 230% of GDP. Japan is in a recession. The budget deficit exceeds 8% of GDP, and could top 10% this year and next. The deficit was easy to finance as long as Japan was running a structural current-account surplus and the domestic pool of savings was large enough to do so. In recent times the country's external accounts have deteriorated, and that could continue.

Japanese institutions have always been the largest and steadiest buyers of Japanese government bonds, or JGBs. They recently announced they lack the funding sources to keep buying on the same scale. Japan Post Bank is an example. It formerly was a government institution in which individuals held savings of more than $2 trillion. It was a big buyer of government debt, as were pension funds and life insurers. All said recently they can't keep buying. The moment has arrived where the Bank of Japan needs to bridge the gap and buy more JGBs with newly printed yen. In other words, the supply of yen will increase dramatically. Japanese inflation will be pushed from slightly below zero to 2%, and the yen will be weakened. This is a major change for Japan, because the yen has been one of the world's strongest currencies for a long time, right behind the Swiss franc.

Q: There is definitely a trend here.

Zulauf: Japan's big life insurers are pension-fund-style entities for the Japanese public. They are big investors overseas, and because of the yen's strength, have hedged part of their exposure to the currency. What would happen if they unwound 10% of their hedges? The four largest life insurers would have to buy $25 billion worth of dollars and sell yen. Many pension funds and industrial companies are in a similar position. The potential purchase of dollars and sale of yen is gigantic. Of course, Japanese bond yields would rise under this scenario, which is another problem, as Japanese banks have 900% of their Tier 1 equity capital in JGBs. To prevent the bond yield from rising, the Bank of Japan will have to buy even more bonds, and print more yen. They will keep things under control for a while, but eventually this plan will fail.

~ Felix Zulauf, Barron's Roundtable, January 21, 2013