Government Defaults - Why is Japan Not Bankrupt?

In the previous post the fundamentals of government defaults were examined. Given the fundamentals, how is Japan not bankrupt? The debt level is over 2x GDP and there is no end of deficits in sight. Why isn't there a run on the Yen today?* One approach is look at the Japanese situation under the national accounting formula (see twin deficit theory), propensity to pay, and ability to monetize.
1) According to the national accounting formula, Budget deficit = Savings + Trade Deficit - Investment. Japanese savings rates are high, have not shown to decrease significantly despite an aging demographic, and the residents tend to keep their cash within the country. Japanese households not only save, but they save in Yen. There have been signs that high savings have recently begun to slacken.
2) Because of deflationary trends over the last twenty years, the Japanese government has been able to monetize its current debt through the central bank. The central bank has expanded its balance sheet significantly.
3) The Japanese government has been able to monetize its current debt from investors through negative real rates. Simply put, over the last eighteen months Japanese bonds have paid less than the inflation rate. This is similar to having someone pay you for the opportunity to lend you money.
4) The Japanese governments have shown political will to pay. There aren't rumors flying about minority parties saying that they will simply default.

That keeps things limping along. However, according to the fundamentals, Japan has no good options left. Escaping the present problem is not because of a fault of courage or competence, and it is not driven by government corruption. It is not like the movie "Dave," where if those in charge can just put their heads together and put special interests aside they can find the solution and come up with the money. Defining "survival" as "not defaulting, technically or otherwise," the historical survival rate for countries in similar situations is zero. The Japanese miracle would be navigating the next ten years without default. What are some potential options?
- Productivity improvements, which necessitates upending many aspects of the social and labor structure. This was supposed to be the "third arrow" of Abenomics (reforms named after the Prime Minister) but it is politically difficult and has yet to make its appearance. Mark as doubtful.
- Population growth, which necessitates either having more children or importing immigrants preferably at least a medium skilled or high potential. Incentivizing people to have more children is very difficult, and concerning immigration, those that are more familiar with the political conditions in Japan tell me this is a complete non-starter. Mark as doubtful.
- Narrow or zero out the current deficits, then thread the needle between nominal interest rates, inflation, and GDP growth. This is theoretically possible, especially because of the prefecture system. It is similar to the United States in that the federal government runs deficits and transfers money to smaller government sub-entities. The Japanese national government can dramatically lower the transfers to prefectures and run at least primary surpluses (revenue minus spending excluding interesting payments). Mark as possible.
- Monetize - Central bank threads the needle between hyperinflation and hitting the print key and gobbling up the debt. This is already occurring, as the central bank's balance sheet has nearly doubled over the last two years, but it will prove ever more difficult to implement.
- Asset/liability balancing - The Japanese government has a huge relative amount of assets on its balance sheet compared to other countries. If these assets are only tapped at critical junctures to navigate this process, it might be just enough lifeline to pull through.

It is a very difficult situation, and I would put even odds on a technical default in some form in the next ten years.

*For the sake of both simplicity and the fact that there are others leagues more knowledgeable than I, I won't delve into the complex banking/government financing structure and its corresponding risks

Government Defaults - Why is Venezuela Bankrupt?

Japan's debt to GDP is over 200%, while Venezuela's is around 50%. Why is it that Venezuela is in the middle of a cash crisis but Japan is not yet? A few facts on the Venezuelan economy:

- Accuracy: Exact numbers on debt, GDP, and inflation do not have high confidence. Negative impact.

- Debt to GDP: Estimates of debt to GDP put it around 50%-65%. This can be positive (low) or negative (high) depending on the other factors.

- Propensity: The government has defaulted five times in the last twenty-five years. Negative impact.

- Collateral: Overseas seizable assets. Positive impact.

- Budget deficit: Venezuela's budget deficit zeroes out only when oil is above $117.

- National Account Theory: Budget Deficit = Savings + Trade Deficit - Investment. Savings are low in a high inflation environment. Investments have been historically low as well. In order to run a trade deficit, a capital inflow is needed.

- Oil: Oil has accounted for 96% of its export revenue, and the price of oil has dropped by nearly half over the last year. Negative impact.

- Cutting spending: There are a few options, many of which have historically led to coups and unrest. Negative impact.

On net, this is why Venezuela's government is in dire straits. There are some holding out, believing that the upside is there, but the consensus is heavily in the default camp barring a dramatic increase in oil prices in the near-term.

Understanding Government Defaults

With the recent fall in oil prices, the analysis and rumors have been flying about the government default by oil revenue-dependent nations. Also, there has been a resurgence of prediction of the imminent demise of the Japanese government's finances by its mind-boggling debt ball. Now is an opportune time to review the fundamentals of government defaults, and why they are not nearly as simple as many believe.

Assuming that a nation's government will continue to exist and will attempt to make interest payments on debt in good faith, there are fundamental economic and demographic variables to predicting a government default. Below are six of the primary fundamentals that analysts utilize to evaluate the near to medium-term viability of government debt. While others exist, the below six hit the primary categories.

Current load - The ratio of the government's debt to GDP. This is similar to the proxy for the gross debt to revenue used to analyze the default risk of companies. At a certain point, it does not matter how good the product or service is, there is simply too much debt to service and stay solvent.

Current trajectory - The current and near-term forecast of deficit spending.

Cut/Tax your way out I: Ratio of government spending to GDP. In theory, the higher the level of government spending, the easier it would be to find non-critical services to cut. In reality, many countries with high level of spending would have civil unrest even with minor cuts. However, the theoretical basis remains, and to a certain degree it is practical. Conversely, if spending to GDP is low, there should be ways to close some of the gap with types of taxation that do not result in massive deadweight social losses that strangle the private sector (e.g., Laffer curve).

Cut/Tax your way out II: Deficit / Spending. If a government is relatively close on a percentage basis to its total spend, it is more likely that a mixture of tax and spend policies can close the gap. Closing the gap on a 40% spend with a 25% tax base is going to prove politically difficult to impossible. However, closing 60% spend with a 45% tax base is extremely difficult, yet plausible.

Populate your way out - At a basic level, it is more credible for 100 people to pay off a given debt than 50. Debt risk is evaluated on streams of future payments. If there are few people to produce those future payments, the risk rises. Also, even if per capita GDP is constant, it is politically easier to freeze government spending and grow population than to cut spending on a falling population.

Market confidence - 10 Year Bond Yields. This is a bit of circular reasoning, but if others believe that the bonds are sound, then the bonds are sound and the debt will roll over. If others do not believe that the bonds are sound, then it will be difficult to roll the debts over. If it's difficult to roll the debts over, interest rates will go up. If interest rates go up, more debt will need to be borrowed.

With this framework in mind, examine the table below, which includes a few countries that have a high level of "chatter" on their debt levels.

Type	Variable	Japan	Greece	Italy	Spain	US
Load	Gov Debt to GDP, 2013	227%	175%	133%	92.1%	102%
Trajectory	Federal Deficit, % GDP, 2013	-7.6%	-12%	-3%	-6.8%	-2.8%
Cut/Tax I	Total Gov Spend / GDP, 2013	42%	52%	50%	45%	42%
Cut/Tax II	Fed Deficit / Spend	-53%	-26%	-6%	-18%	-19%
Grow	GDP Annual Growth, 2014	-1.9%	1.9%	-0.5%	1.6%	2.4%
Populate	Population 5 year CAGR	-0.1%	-0.2%	0.4%	0.2%	0.7%
Market	Bond 10Y, Dec 2014	0.4%	7.3%	2.0%	1.8%	2.3%

(Source: tradingeconomics.com)

While the framework does give an idea of the medium-term fiscal health of the entity, its primary use is to act as a launching board to ask additional questions. How is Japan not in default with a debt to GDP of 230%? Why does Italy pay a lower yield than the US? This second level of analysis then takes us into the near-term variables with more qualitative aspects, namely, current access to capital, currency effects, and perception of the propensity to pay. The next two posts will examine the narrative around two extreme cases that seem to defy the fundamentals, but for much different reasons -- Japan and Venezuela.