Wednesday, October 14, 2009

Japan's sovereign CDS indicates higher relative risk

The US government debt is clearly growing out of control and will present some unprecedented challenges for the nation in years to come. But the US debt problems are not even close to what Japan is facing. We've discussed the issue of Japan's growing debt problem before. A great deal of the government paper in Japan (95%) is placed domestically as a form of savings, particularly retirement savings. As Japan's population ages, the domestic holders will increasingly become net sellers of government paper (JGBs). The international market for JGBs is quite limited and central banks have only a limited appetite for the paper. On the other hand the government will need to issue more, because as the workforce shrinks (as more people retire), tax revenues will be pressured.

The chart below shows a comparison of government debt to GDP ratio (including a near-term projection from IMF) for the US and for Japan.

source: Bloomberg/IMF

While the chart above shows the government debt ratio, Japan's gross national debt (including private debt) is currently 217% of its GDP, while the US is at about 81%. Both are obviously projected to rise significantly. There seems to be little focus on this in the media. Part of the issue has been the yen strength. Japan continues to rely quite heavily on exports. And even if they set up manufacturing in the US or China, they still have to bring the profits back into yen. The strong currency continues to have a negative effect on Japan's GDP, raising the debt to GDP ratio further.

The debt markets have taken notice. The sovereign CDS spreads (historical 5-year CDS levels plotted below) are now showing an increased divergence between the default risk premium for the US and the Japanese government bonds.

source: Bloomberg/IMF

The disparity would have been even higher if it wasn't for Japan's massive foreign reserves of about $1 trillion.

As a technical note (thanks for bringing this up Phil), the Japanese and the European nations' sovereign CDS is usually set up to settle in dollars. The US CDS however would generally settle in Euros (at least most contracts have traded this way so far) and would most likely be executed by a non-US bank. If any of the US treasury paper actually defaults, getting paid in dollars is probably not that meaningful.
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