Fund banking on wider trade deficit

by Masaki Kondo

Bloomberg

Japan’s worsening trade gap will make it harder to service the world’s largest debt, fulfilling part of the doomsday scenario that Hayman Capital Management LP is betting on.

The nation’s 10-year note yield may rise toward 10 percent from the world’s third-lowest of 0.79 percent, while the yen weakens, said Richard Howard, who oversees Hayman’s Japan-focused fund with J. Kyle Bass. That would represent the developed world’s second-highest borrowing costs after Greece, and a surge to that level by the end of 2013 would cause losses of 42 percent for investors purchasing the securities now, data compiled by Bloomberg show.

Data on Monday showed Japan had its biggest half-year trade deficit on record. Hayman, which manages about $1 billion, made $500 million by predicting the U.S. housing market collapse, and Bass has said since at least 2010 that Japan’s $12 trillion bond market is heading for a crash. So far, the debt has returned 3.1 percent in the past two years, Bank of America Merrill Lynch data show, while yields touched nine-year lows.

“It all came down to this idea that there was an internal self-funding mechanism in Japan, that essentially the Japanese economy and interest-rate environment could exist separate to the rest of the world,” Howard, 32, said in an interview last week in Singapore. “It wasn’t going to last forever, and in fact it is rapidly approaching a turning point.”

Japan’s imports exceeded exports by ¥3.22 trillion in the six months ended Sept. 30, the biggest trade deficit for a fiscal half-year period, according to Finance Ministry data going back to 1979. The nation posted a shortfall in September for a third-consecutive month.

The country has public debt equivalent to 237 percent of gross domestic product this year, the biggest debt-to-GDP ratio globally, estimates by the International Monetary Fund show. The ratio for the U.S. is 107 percent.

Ten-year Japanese government bond yields are less than half that of similar-maturity Treasury bonds and reached 0.72 percent in July, the least since June 2003. Japan’s current account, the broadest measure of trade, has been in the black on an annual basis since at least 1985, according to government figures, helping the country finance a budget deficit domestically for lower borrowing costs.

When Japan’s current account turns to deficit, “the marketplace is going to realize that it requires international capital, either repatriated Japanese capital or fresh new international capital, to buy Japanese government debt in order to keep funding the government,” said Howard. “That is the beginning of a cycle to put upward pressure on yields.”

On a monthly level, Japan reported a record deficit in its current account in January, showing the impact of rising energy imports following last year’s record earthquake that triggered the shuttering of nuclear plants.

The yen strengthened against most of its 16 major peers in the past six months as the euro region’s debt crisis boosted demand for the currency as a refuge. It touched 80.01 per dollar Tuesday, the weakest since July 6, before trading at 79.96 as of 9:51 a.m. in Tokyo, compared with its record high of 75.35 reached Oct. 31.

The stronger yen makes Japanese products costlier overseas and weighs on exports while encouraging domestic companies to acquire assets abroad. Softbank Corp., the country’s No. 3 mobile phone career, agreed this month to buy a 70 percent stake in U.S.-based Sprint Nextel Corp. for $20.1 billion.

Proceeds from overseas investments have grown ninefold since 1985 through last year, helping alleviate a slump in exports. Japan had its first annual trade deficit last year in at least 27 years, Finance Ministry data showed.

Slower growth and more than a decade of deflation have prompted Japan’s banks to channel deposits into JGBs rather than loans. Domestic investors account for 91 percent of the total ownership of the nation’s debt, according to data from the Bank of Japan.

Households held a total of ¥1.515 quadrillion of assets at the end of June, more than half of which were bank deposits, BOJ figures showed. That’s bigger than the U.S.’s annual economic output in dollar terms and compares with ¥1.124 quadrillion of general Japanese government debt.

Standard & Poor’s said in a report that Japan’s deficits are likely to remain high for several years and it runs the risk of a credit downgrade if its “debt trajectory were to remain on its current course.” S&P rates the sovereign AA- with a “negative” outlook.

A tumble in JGBs may happen in two steps, where a selloff pushes yields a couple hundred basis points higher, triggering concerns about the government’s ability to refinance its debt, said Howard. That could push yields “a lot, lot higher” toward double digits, he said.

The risk to Hayman’s scenario is that concern about the rest of the world will sustain demand for Japanese assets as a haven, he said.