Sounding the Alarm About Japan

Frayed nerves over the debt crisis in Europe will calm over time. But next up is Japan, potentially a more dangerous sleeping giant.
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Europe has captivated the headlines the past six weeks with concerns about whether Greece will be able to pay back its debts given the required austerity measures it has been forced to take and its already slow-growing economy. Investors also have worried about the ramifications this thorny situation could have on richer countries in the European Union like Germany and France if they decide they no longer want to be on the hook to bail out Greece or another weak sister country such as Portugal, Spain, or Italy.

We know this situation has been brewing in Europe for some time. We've known about the fiscal situations in these southern European countries, yet the problems have always been off in the future so that we could ignore them. It wasn't really until there were riots in the streets of Athens that the markets really got awakened to the gravity of the situation.

The drop in the euro has been so severe that the other members of the EU have been forced to look into the abyss which those of us in America did in September 2008. Nothing focuses a man's mind like knowing he's going to be hung in the morning, said Samuel Johnson. That's exactly right. The situation in 2008 forced America to act and Europe is now forced to do the same.

I suspect the rescue package, which still has to be formally ratified by all the countries, will take hold. Frayed nerves will calm over Europe with time, just as they did following the Troubled Assets Relief Program in the U.S. and the

Federal Reserve's

quantitative easing campaign. The can of Europe's problems has been effectively kicked down the road so that we'll be able to go back to collectively forgetting about Greece for a while.

However, there is potentially a bigger and more dangerous sleeping giant out there for world markets: Japan. Despite a few hedge fund managers sounding the alarm about Japan last year, little attention has been paid to it of late because -- just as with Greece -- nothing bad or newsworthy (like violent street riots) have occurred there yet.

But the numbers are very grim when you start to dig into Japan. Rather than the "land of the rising sun," Japan appears to be the "land of the setting sun."

Here are some quick facts about Japan to sober you up:

  • Japan's debt-to-gross domestic product ratio is now over 200% and approaching 250%, putting it far ahead of its G8 and developing-country peers.
  • Japan will issue $500 billion in new bond sales in this fiscal year and $600 billion and $650 billion in the next two years, respectively.
  • Its population is aging faster than any other country in the world. Ten years ago, it was estimated there would be less than two workers for every retiree in Japan. The current government numbers suggest the ratio is actually 1.3 workers for every retiree today.
  • Japan's population is expected to shrink by 30% to 90 million from 2007 to 2055.
  • By 2014, all the baby-boomers will have hit the retirement age of 65 and begin drawing down their savings.
  • Japanese debt service as a percentage of its tax revenue is now 60%, up from 32% 10 years ago. As the population shrinks, however, tax revenue will decrease. A rise in interest rates on servicing the debt could also be a major problem for the country.
  • With low interest rates, the Japanese are able to meet their steep debt service obligations. However, when interest rates on the 10-year Japanese bond go above 3.5% (rates are currently at 1.5%), the Japanese government will have major problems.

So what are the catalysts that could spark a crisis in Japan?

  • A failed Japanese bond auction.
  • A sharp drop in tax revenue.
  • A failure to implement tough fiscal and budgetary standards.
  • A sharp contraction in Japanese GDP.
  • A downgrade in sovereign debt by the ratings agencies.

Of all these possibilities, the downgrade is likely the spark that will set off this fire. The other risks can all be mitigated to a greater or lesser extent by the Japanese government. The government has shown a remarkable ability to push off the day of reckoning. When there is a downgrade, or even a threatened downgrade, it will be the signal to the capital markets that the time to worry is now.

Such an action by the ratings agencies, such as



Standard & Poor's

is not that far-fetched. An announcement from the agencies -- in my opinion - possibly is likely by the end of the summer.

Japan will be an enormous risk to the global market system, much more than Greece. Unlike the EU, Japan has no steward. This is a country that must govern itself and not rely on edicts from the Germans who are telling it what to do. This self-governance has enabled Japan to get in much worse financial shape than Greece would have been allowed to.

When the day of reckoning comes for Japan, it will be a doozy.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. You can follow Jackson on Twitter at or @ericjackson