Friday, August 12, 2011

How to make monkeys out of rating agencies

Sovereign downgrade? Been there, done that ... such is likely to be the response of any investor in Japan to the news that Standard & Poor’s has removed its triple A rating on US debt.

Japanese government bonds lost their stamp of premium quality in 2002. Early this year S&P took a second shot, with another downgrade to double A minus. The result? In last week’s turmoil the yield on Japan’s 10-year bond briefly dipped below 1 per cent. If Sidney Homer’s classic History of Interest Rates is any guide, this represents the lowest level of interest rates anywhere since Babylonian times.

No less a person than Kaoru Yosano, minister of economic and fiscal affairs, warned in a Financial Times interview that “Japan faced a dreadful dream”. On the face of it the numbers appear to back him up. Japan’s net debt to gross domestic product ratio comfortably exceeds 100 per cent and primary deficits stretch out as far as the eye can see. Yet the markets themselves are saying something quite different – that the supply of Japanese government bonds, far from being excessive, is actually insufficient.

This is no aberration. For the past decade the Japanese bond market has been making monkeys out of not just the credit rating agencies, but also academics, trigger-happy short sellers and politicians and bureaucrats who see fiscal austerity as a virtue in its own right. All have been proclaiming that out-of-control public debt had set Japan on the road to fiscal perdition.

To call this a disconnect is putting it far too mildly. The markets and conventional opinion are on different planets. Until recently this was a Japan-only affair, but now the implications are too important to ignore. Public debt has become the hottest topic across the Organisation for Economic Co-operation and Development. No assertion about the sustainability of public finances can be convincing unless it accounts for the Japanese paradox.

It is possible, of course, that the market is simply wrong or, in a different formulation, rigged. Possible, but unlikely. The Japanese government bond market is the second largest in the world. It cannot be dismissed like some crazy aunt in the attic. Yields have exhibited an unbubble-like stability, holding between 1 per cent and 2 per cent since the late 1990s. Nobody, not even Japan’s financial bureaucrats, can muster the wherewithal to pull off manipulation on that scale.

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