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Sunday, March 13, 2011
Gnome-o-gram: The Japanese Earthquake--Financial Aftershocks?
I have hesitated writing about the financial implications of the earthquake and tsunami in Japan because the human tragedy is so much more clamant and barely appreciated since there are large areas devastated by this disaster which have not yet been reached by rescuers or reporters with the ability to uplink images. That said, I am really worried about the financial markets next week. Japan has a public debt burden twice that of the U.S., and most of that is owed to domestic creditors. These same investors, directly or indirectly, have been buying a large amount of U.S. Treasury debt, financing the deficits run by the U.S. government. As Japan seeks to recover from this natural catastrophe, Japanese investors and institutions will seek to redeem their investments in Japanese sovereign debt to meet insurance obligations to rebuild the areas devastated by the earthquake and tsunami. This will naturally increase the interest rate the Japanese central bank will have to pay to roll over its debt, and this can easily lead to a “debt spiral”, where rising interest rates increase debt service expenditures, which expand budget deficits, which require more borrowing, which further reduces credit ratings and increases debt service expenditures...lather, rinse, repeat. Everybody talks about China, but Japan plays a comparable role in financing the U.S. budget deficit. If, in the aftermath of this calamity, Japan necessarily turns inward and directs its savings toward investments in recovery from this natural disaster, then it will be far less likely to be a buyer of U.S. Treasury debt. With Japan focussing its investment on domestic recovery, demand for U.S. Treasuries will be reduced at the same time supply burgeons, and a runaway debt service spiral in U.S. sovereign debt could be a consequence. All of the projections you see (however dire or apocalyptic) for U.S. Treasury debt generally assume an interest rate on the long bond of at most 5%. Try working those numbers assuming 8% and see what you get. Hunker down in the bunker and run them for 12% and look at how that plays out. These unexpected interest rates and their consequences could obtain in the next two weeks should events in Japan go badly and the world's financial markets react rationally to those events. We should further look closely at the exposure of financial institutions to insurance and reinsurance of the damages sustained in Japan. If you're the counterparty to a contract with an institution which is rendered insolvent by recent events in Japan, and you're counting on a payment at the conclusion of the contract, you can be wiped out by the failure of the institution taking the other side of the deal. Are you prepared?Posted at March 13, 2011 04:03