Japan is the world's third largest economy and below is a report...

Japan is the world's third largest economy and below is a report from Hayman Capital, well worth reading:

"Japan’s debt to GDP ratio is the worst in the world yet the country’s interest rates are the lowest in the world, excluding Switzerland.

The primary reason is that for the past 15 years we’ve seen an excess of Japanese savings and a deficit of demand for those savings. So the Japanese government was able to issue debt without any competition from the private sector. But the Japanese demographic profile means that more workers are withdrawing from the workplace and drawing down their retirement savings.

The Japanese government is running a fiscal deficit of 10 to 11 per cent of GDP. Spending on social security accounts for ¥27 trillion out against total revenues of approximately ¥45 trillion. In addition, the Japanese government has interest expense of ¥10 trillion. Add them both together, and the Japanese government is spending 90 per cent of its total revenue on these two items.

We think that we are in the midst of an inflexion point, where there’s not enough Japanese savings to finance Japanese government debt. That means that the Japanese government will have to borrow in international capital markets. Given Japan’s risk profile – its debt to GDP ratio is 230 per cent – Japan may have to pay, say, 3 to 3.5 per cent to borrow. But that would push Japan’s interest expense to ¥30-35 trillion. We believe that is a recipe for disaster.

The Bank of Japan has announced that it will start buying a lot of Japanese government debt, which will temporarily allay the problem. But if the market starts thinking that Japanese inflation will pick up, interest rates will be pushed higher.

One other thing that has provided stability in Japan and solace for investors in Japanese bonds has been Japan's consistent current account surplus. However beginning before, but obviously accelerating after the earthquake, tsunami and accident at Fukushima, Japan has seen its trade balance decline sharply. The reactor meltdowns and subsequent closure of the vast majority of nuclear plants has forced Japan to aggressively shift away from nuclear base load power. But that has meant it has had to pay a lot for LNG, oil and coal for its power generators.

Last year, Japan’s ran a full-year trade deficit for the first time since 1980. The just released data for January show that Japan also ran the largest single month full current account deficit (in unadjusted terms) since the oil shocks of the 1970's. In addition preliminary data show Japan on track for another trade deficit in February, despite it being traditionally the strongest month for trade performance.

Now, one of the things that the market relies on for Japan is that it is a net saver because it runs a current account surplus – take that support away and the market's sentiment on Japanese debt sustainability could change very quickly and very aggressively."

Yes indeed, Japan is , by definition, the world's biggest, fluffiest black swan. One day, and very quickly, the world markets will react. Again it's the interest on massive debt as a budgetary expense that will kill.