- Japan has a lot of government debt totaling 1.1 quadrillion JPY (about 85% is Japanese Government Bonds), with debt to GDP ratio at around 240% which is high compared to other developed countries. - The debt accumulated starting in the early 1990s after the economic bubble burst as tax revenues declined while government spending increased. - Domestic financial institutions, including banks and insurance companies, hold about 66% of JGBs, while foreign investors only hold around 10%, differentiating Japan from countries heavily reliant on foreign investors.

1. BH Report: Japanese Government Debt 2013/6/3

2. Context
•How long have we been hearing the statement 'Japan is in deep trouble with so much debt?' ... entirely too long ...
–Politicians, journalists and economists are constantly making the argument on media
–I distinctively remember hearing about the scenario of Japan going bankrupt in a matter of a few years back in 1999 – I totally bought the argument at the time... but it didn't happen
•The frustration I had was the fact that everyone has/had access to the same abundant data, and yet each person comes up with different interpretation and story – I would hear both optimistic and pessimistic arguments, and I could not really tell which one to trust
•In preparation of writing this report, I looked across wide set of opinions of people who have tackled the problem and delivered good insights- I put together what I believe to be the right set of analyses to answer key questions
–Some of the sources I found to be interesting are listed at the end of the report
•In this report, I intend to answer following key questions
–Does Japanese government really have a lot of debt? if so, how did it get there?
–Who is holding Japanese Government Bond (JGB)?
–How likely is it for Japanese government to go bankrupt in the next 5 years?
–What is Japanese government doing about this? Is it effective?
–What does this all mean to people who have assets in Japan, or Japanese Yen?
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3. Summary of findings (1/3)
Yes, a lot
–1.1 quadrillion JPY worth of debt, ~85% of it is government bond
–The ratio of debt to GDP is at ~240%, whereas the 'normal' rate for developed countries is in ~80-100% range
It started in early 1990's post economic bubble
Japanese government has been relaying on Japanese Government Bond (JGB) to bridge the gap between declining tax revenue and increasing spend
–Tax revenue peaked in 1990 and since then continued to decline: -2% CAGR through 2010
–Spend1: +1.5% CAGR for the same period
Direct owners: domestic financial institutions
–Domestic financial institutions (Banks + Insurance Co's) account for ~66% of JGB balance
–Foreign investors only account for ~10% of JGB balance... this is incredibly low (UK ~30%, France ~35%, USA~45%)
•This differentiates Japan from countries like Greece/ Argentina who had financial crisis driven by FX
Indirect owners: Japanese citizens and companies
–One can argue that it is Japanese citizens/companies who are the ultimate owners (because 75% of banks/insurance co's liabilities come from retail + wholesale deposit)
Does Japanese Government really have a lot of debt?
How did it get there?
Who is holding Japanese Government Bond (JGB)?
1. Exclude special account
2

4. Summary of findings (2/3)
Very low likelihood of going default in the next 5 years
–FX risk is non-issue as exposure to foreign investors is fairly low (i.e., not the same situation as Argentina/Greece in crisis)
–Enough room for Central banks to print money & buy JGBs
–Banks/ insurance co's have enough asset to continue buying JGBs (and they have enough incentives to support JGB market)
There is another potential 'disaster scenario' (serious inflation), but this is also unlikely to happen in next 5 years
–It would start with banks/Insurance Co's stop buying JGB, and then below sequence of events follow (order may move around)
•Interest rates go up -> prices of outstanding JGBs drop -> domestic FIs post huge loss -> Central Bank print lots of yen -> out-of-control inflation / yen loses all the credibility -> major imports (e.g., food/ oils) suffer
–Low probability in near term because of two main reasons:
•1. Even with 5% blended average rate hike – bank balance sheet will only get damaged by ~6-7%1 (also it will be somewhat offset by stock market going up) which is manageable
•2. Government/Central Bank would do anything they can to avoid it, incl. supplying banks with money, changing or adjusting guidelines/rules on ALM (Asset Liability Management) and accounting rules for evaluation loss
How likely is it for Japanese government to go 'bankrupt' in the next 5 years?
1. Assumed that the current JGB on banks balance sheets have average maturity of 5 years
3

5. Summary of findings (3/3)
I don't have the answer (too complex of analysis needed... would require days) If you were to do it, you need to look at 3 different underlying drivers: (1) Government spend, (2) tax revenue driven by economic growth & tax rate, (3) bank balance sheet composition
Either way – it is unlikely for this to happen in next 5 years seeing banks' BS
–Enough assets in other categories that can be shifted to JGB
–Balance sheet still growing at ~15-30 trillion yen per year
Government , currently led by prime minister Abe in close collaboration with Central Bank, has been taking initiatives on monetary/fiscal policy known as 'Abenomics' which aims to achieve inflation target of 2% in 2 years
–(1) Quantitative easing: Central Bank to buy significant amount of JGBs -> keep rate down and facilitate lending/shift to stock market
–(2) Expansion of public Investment: Increase government spend E.g., earthquake relief, healthcare technology, regional investments
–(3) Economic growth: Evaluating ways to invest in private sector and drive economic growth (still in evaluation phase- the government planning to release more detailed views in June 2013)
This policy can either resolve the problem (i.e., increased tax revenue + modest inflation + gradual debt paydown) or it can completely mess up the economy (i.e., decreased tax revenue + hyper inflation + dramatic accumulation of debt driven by increased spend)
–Either scenario definitely takes more than 5 years to fully materialize
–Which way it is headed will be evidently clear by mid year 2015, seeing how consumption/tax revenue respond to sales tax hike
"When" will this happen (if ever)?
What is Japanese government doing about this?
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6. Implications (assuming that you have some assets in Japan or JPY)
Recommendation 1: Avoid owning large amount of JPY in cash/ bank deposit– instead, own hard assets (e.g., real estate in prime locations, gold, etc.)
–Good hedge against 'disaster scenario' (e.g., hyper inflation), and reasonable hedge against 'optimistic scenario' (e.g., controlled inflation)
Recommendation 2: Watch out for key leading indicators/events to detect early signs of 'disaster scenario'... here are couple of key warning sings:
–1. Not getting near the target inflation (2%) in '14 (e.g., if CPI growth remain below 0%)
–2. GDP growth slows down more than expected in '14 (e.g., below 0%)
•Critical for the government to prove its commitment by clearly articulating and delivering growth strategy (most likely by the way of deregulating previously protected key industries)
–3. Government deciding to postpone the sales tax hike seeing that 1. and 2. are not going well
–4. Rate of new bank deposit slows down to below 10 trillion yen per year
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7. Appendix 1: Current state & history of Japanese Government Debt
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8. How much debt does Japan have?
1.1 Quadrillion JPY as of year end 2012
(that's roughly 11 trillion USD)
Roughly 85% of the debt is through Japanese Government Bond (JGB)
Source: Cabinet Office of Japan
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9. How does it compare with other
countries?
80
60
40
20
0
-20
0 50 100 150 200 250
Government debt as % of GDP ('12)
Greece
India
Russia
Brazil
UK
France
Germany
Japan
China
USA
% GDP growth ('12)
Source: IMF
It looks VERY alarming – but this itself is not an issue because most
of debt is taken on by domestic investors (detail in later pages)
Each dot represents a country
(173 countries plotted)
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10. How did it get there? (1)
150
500
0
250
1,000
200
100
0
1,500
50
2002
2001
2000
1987
1986
1996
1995
1994
Government debt (JPY Trillion)
1990
1989
Government debt as % of GDP
1988
1999
1998
1997
2005
2004
2003
1985
1984
1983
1982
1981
1980
2009
2010
2011
2012
2007
2006
2008
1992
1993
1991
The trend is nothing new...
Source: IMF 9

11. How did it get there? (2)
0
100
200
300
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1997
1996
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
Japan
Government debt as % of GDP
USA
Regan Bush Clinton Bush Obama
Nakasone Takeshita
Kaifu
Miyazawa
Hosokawa/
Hata
Murayama
Abe
Obuchi/Mori Koizumi ...too many to note
Hashimoto
Source: IMF
... Japan started going down the path of heavy leverage
beginning in early 1990's (post economic bubble)
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12. Why did/does Japan need so much debt?
(especially since early 90's)
125
100
75
50
25
0
Government revenue (JPY Trillion)
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1999
60
100
80
40
20
0
42
1998
39
1997
24
1996
28
1995
27
1994
22
1993
21
1992
14
1991
10
1990
10 10
1988
12
1987
16
1986
20
1989
23
1984
25
1983
26
1982
30
1985
% of Government revenue
37
1999
2010
45
2009
51
2008
38
2007
31
2006
34
2005
37
2004
41
2003
43
2002
41
2001
36
2000
Others Debt Tax
1. I will not go into much detail – but basically, there is another set of revenue/expense by the government that is not shown here that amounts to roughly
150 trillion JPY a year... it is a very unique and bizarre accounting scheme that Japan has... Source: Ministry of Finance Japan
Tax revenue hit the peak in 1990, but the spend continued to
increase... Japan decided to rely heavily on debt
Note – above
figures do not
include special
account1
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13. Appendix 2: Views on Japanese Government Bond (JGB)
12

14. Who is holding JGB?
66%
22%
9%
100
0
20
60
80
40
% of Japanese Government Bond ownership
2012 Year End
4%
Domestict financial institutions
excl. Central Bank
Domestic Government/
Municipalities/
Social Security/Central Bank
Foreign Investors
Domestic household & corporate
Source: Bank of Japan
90%+ of Government bond is held by
domestic investors, large % of which
is owned by domestic financial
institutions
• Foreign investors only account for
~10% of JGB balance... this is
incredibly low (UK ~30%, France
~35%, USA~45%)
VERY limited dependency on foreign investors (much less
bonds in foreign currency)
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15. How big is JGB on Japanese banks/ insurance co's balance sheet?
Assets
454
Other
360
JGB
624
Retail +
Wholesale lending
199 Cash/deposit
Liabilities
406
Other
1,230
Retail +
Wholesale deposit
(~800 from
Japanese citizens +
~400 from compnanies)
1,637
1,637
Source: Bank of Japan
~22% of assets
Banks
Insurance Co's
Assets
214
JGB
Liabilities
429
Insurance +
Pension reserves
273
Other
100 Other
529
529
Japanese citizens
72 Other
429
Insurance + Pension
reserves
24 JGB
61 Mutual Fund
106 Equity
798
Deposit
56 Cash
Assets
1,547
supply
supply
Units: JPY Trillion
Japanese citizens' assets (e.g., deposit) is supplying the majority of banks/insurance co's balance sheet from which JGB is purchased/held (~22% of bank assets, ~41% of insurance co's assets)
~41% of assets
14

16. Can banks continue to buy more?
10 11 11 11 11 12
50 48 44 44 43 40 39 40 42 40 39 38
5
8 9 10 12 18 18 19
21 22 23 22
35 38 37 35 34 31 32 31 27 27 26 28
9 9 10 10 10 11
0
100
80
60
40
20
% of total assets
2012
2011
12
39
24
26
2010
2009
2008
2007
11
41
19
29
2006
2005
2004
2003
11
41
16
32
2002
2001
2000
1999
10
45
37
1998
5
1997
Cash/deposit
Retail/wholesale lending
JGB
Other
2,000
1,500
1,000
500
0
Total assets / Total liabilities of banks (JPY Trillion)
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
0.4%
Retail+Wholesale deposit (1.0% CAGR)
Other (-1.1% CAGR)
Deposit growing at ~1% CAGR (15 years);
~15-30 trillion yen each year for the last 5 years
Share of JGB in the assets has increased, but it
is still at ~22% range
Source: Bank of Japan
Yes – at least for next 5 years because (1) banks have enough assets in other categories
that can be shifted to JGB (2) getting ~15-30 trillion yen worth of new deposits each year
15

17. -
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
1980
1981
1982
1983
1984
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
1 year
10 years
How has JGB rate changed over time?
1. Since 1986 2. Plan is to extend average maturity of bonds purchased from 3 years today to 7 years
Source: Ministry of Finance Japan
Japanese Government Bond interest rate
1
Monetary tightening/ economic bubble burst in 1990
Long period of depression, stock market decline, increased JGB issuance
"Zero interest- policy" in '98-'00, '01-'06, '08-
April 4th 2013 - Central Bank declared large scale quantitative easing
•Buy JGBs at annual pace of ~50 trillion yen
•Buying JGBs with longer maturity2 ... naturally JPY dropped, stock market rose... interest rate surprisingly went up, but Central bank is determined to keep rates down in mid-term through continued purchasing (to encourage bank assets to flow into lending and/or stock market driving growth)
2013
16

18. Appendix 3: Interesting sources
17

19. Interesting sources
Bank of Mitsubishi Tokyo UFJ report (April 2010)
•http://www.bk.mufg.jp/report/ecorevi2010/review100428.pdf
•Analysis on "how long JGB can continue to be owned primarily within Japan" Chikirin's diary (March 2010)
•http://d.hatena.ne.jp/Chikirin/searchdiary?of=7&word=%B9%F1%BA%C4
•A blog entry on "what Japan should do if banks stop buying JGBS"
•It is half joking, half serious entry... the solutions suggested by Chikirin is pretty hilarious
•Entries on other topics by the same blogger is also pretty good Diamond interview with Kumagai (October 2012)
•http://diamond.jp/articles/-/26187
•A good summary of views by an economist/analyst from DIR
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20. Disclaimer
This document is provided for general information only and nothing contained in the material constitutes a recommendation for the purchase or sale of any security. Although the statements of fact in this report are obtained from sources that I consider reliable, I do not guarantee their accuracy and any such information may be incomplete or condensed. Views are subject to change on the basis of additional or new research, new facts or developments.
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