Friday, September 17, 2010

The Plot Thickens: How Will Japan's Largest Pension Fund Find Room To Maneuver?

The WSJ is out with a short piece about new rumblings coming from Japan's $1.43T public pension fund, Japan's Public Pension Weighs New Investments. If I may be so bold as to impersonate the Japan deflation-blogger Mish for a moment, let's take a look at a few of the dynamics at play as reported by the WSJ. I'll provide some commentary along the way:
Japan's public pension fund—the world's largest with assets totaling 123 trillion yen ($1.43 trillion)—is weighing the controversial idea of investing in emerging-market economies as a way to gain higher returns as it faces a tsunami of payout obligations over the next several years.

The conservative Government Pension Investment Fund, which alone is larger than India's economy, has a staggering 67.5% of its assets tied up in low-yielding domestic bonds. The fund plans to sell off a record four trillion yen in assets by the end of March 2011 to free up funds for payouts to Japan's rapidly aging population. By the year 2055, 40% of Japan's population is expected to be over the age of 65.
There's a lot to discuss but before I do I want to clarify an error I believe the journalists who wrote this piece made.

The comparison between the size of the GPIF and the size of India's "economy" is not a meaningful one because the GPIF is a "stock" while the aspect of India's economy being referred to, GDP, is a "flow". At $1.235T (2009 estimate, Wiki), India's GDP is supposed to measure the total monetary value of output of all goods and services for a particular period of time, in this case one year. Meanwhile, GPIF's asset base is a static measurement of current asset valuation. I'll avoid the bath tub analogy and instead refer to public company financial accounting: GPIF's asset size is like examining an entry on the asset side of a company's balance sheet; India's economic "size" is like examining an income statement for the revenue or earnings generated in the period in question.

One other minor quibble-- the "2055" statistic is completely irrelevant to telling this story because the GPIF is not going to last that long, at least not in its present form and at its current levels of funding.

With the fur out of the way, let's dig into the flesh of the matter. First things first: the GPIF is another Ponzi-finance scheme, much like the US Social Security Administration system. I think Takahiro Mitani, president of the GPIF, explained the predicament all Ponzi-finance schemes eventually find themselves in best in this recent WSJ interview:
Mr. Mitani: Baby boomers are now 60 years old or older, and have started receiving pension. In the meantime, the number of people who pay a pension premium is smaller. What's more, pension premium is determined by wage, which has been on decline. So, pension special account overseen by the health ministry is having a tough time.… More outlay than income in the pension system means that they need to tap into the reserve we have. [emphasis added]
Long-term, the GPIF and SSA will always be running up against a potential demographic problem like this, where the amount promised to past generations of present retirees is greater than the amount being contributed by present workers. Therefore, there will come a time in every Ponzi-pension fund's life during which the managers of the fund will be forced to go out on the risk curve in a search for yield. And as luck would have it -- or rather, as generations of inflationary central planning schemes would have it -- the very time these demographic trends reach an apex, so, too, do long-running financial trends on which the fund's internal rate of return projections have been built. In other words, the perfect financial storm, a "liquidity event" of colossal proportions, metaphorically and literally-speaking.

Unfortunately for Mr. Mitani and his loyal horde of investment management professionals (you did know that scams like the GPIF also serve as lucrative government-sponsored subsidies to investment banks like BlackRock, Morgan Stanley and State Street, Mitsubishi UFJ Financial Group and Mizhuo Financial Group, didn't you?) there's more than just wind and noise coming out of those storm clouds in the form of macro demographic and economic trends, though they are all related in a way. Another problem facing the GPIF is political and is tied up in the composition of the GPIF's portfolio:
The GPIF holds the lion's share of its assets in low-yielding Japanese government bonds. (The yield on the 10-year JGB is currently a paltry 1.07%.) Roughly 67.5% of its assets are parked in domestic bonds, including government and corporate bonds; the rest are spread among Japanese stocks, overseas shares and foreign bonds.
The GPIF is a Ponzi, wrapped in a Ponzi, inside an enigma. If you take a look at the investment results for the first quarter of fiscal 2010[PDF] provided by the GPIF, you'll see that the "domestic bonds" portion is split roughly 76% into "market investments" (JGBs of varying maturities) and the remaining 24% into "FILP bonds".

FILP bonds, issued by the Japanese Ministry of Finance's Fiscal Investment Loan Program, are similar to agency debt and municipal/public works bonds floated by US state and federal government agencies (think FRE/FNM, FHLB, New York MTA bonds, DOT/highway bonds, public school and university bonds, etc.). According to the Japanese MoF's own online resource page, which I encourage you to click and skim-read in its entirety for yourself, FILP bonds can be issued to fund nearly anything the Japanese government might deem worthy of funding, including "housing construction, small and medium-sized businesses, roads, railways and subways, airports, water and sewerage [sic], education, medical care and social welfare, agriculture, forestry and fisheries, industry and technological development, regional development" and let's not forget "international cooperation."

Like I said, nearly anything. And with Japan's bubble-fueled reputation for being a corrupt, greasy-handed place to get business done, you can bet that at least one of almost everything in Japan's economy (and other countries' economies!) has been funded exactly this way. The FILP is like a giant government-sponsored slush fund for amakudari, Japan's version of the "golden parachute" for its fascistic, entitled union bosses-cum-career public servants[PDF].

Back to the Ponzi within a Ponzi. One reason that Japan's central government has been able to issue so much debt ($10.55T and rising as of the end of June) without blowing yields sky-high is due to the phenomenon of captive finance, an ugly cousin of vendor financing, of which government managed pension funds like GPIF are a facilitator. It works like this: the Japanese government issues debt, the Japanese worker is forced to contribute to a government pension fund such as GPIF, and the GPIF buys the Japanese government's debt because it's "safe". Hopefully you can see it now. The Japanese government must keep rolling over debt into new debt just to stay afloat which is purchased by the GPIF, while the GPIF must keep milking workers to pay off the retirees. Ponzi within a Ponzi.

Something's gotta give. But there's the rub-- it can't. According to the WSJ article, 67.5% of GPIF's funds are committed to JGBs and FILP bonds (the allocation as of the Q1 investment results[PDF] linked to above was 68.14%) with the remaining portion divided up approximately 9% international stocks, 8% international bonds and 11% domestic stocks. It can't easily touch that 67.5% allocation without experiencing stern consternation from Japanese politicians who see their Ponzi-scheme unravelling before their very eyes.

That means the search for yield will have to come from elsewhere in the portfolio, and anywhere else it might come from means potential pain for the supplier. Think the Nikkei can't go lower? Think the US Treasury has enough problems? Think the S&P 500 has been beat up enough already? Think again. Meanwhile, wherever the GPIF potentially re-places the funds could see a nice little second-wind. Good-bye SPY, hello EWZ!

I'm being facetious but hopefully my point is clear. Of course, where government is concerned, "can't" doesn't always mean "won't":
Regarding its four-trillion-yen selloff this year, Mr. Mitani said: "We won't only target [selling] domestic bonds. It could be [Japanese] stocks or foreign-currency-denominated securities or stocks," depending on market conditions.
At the end of the day, Japanese politicians can kick and scream but the GPIF has to meet its liquidity needs and one way to do that is to suck it up and kick some JGBs and FILPs out the door. Again, this is a problem and it will be chronic until it is terminal. Pay attention those of you long JGBs.
John Vail, chief global strategist at Nikko Asset Management, echoed that sentiment. "They need to take on more risk. As a long-term investment, equities will nearly always outperform JGBs," he said "Global equities are a wise investment for the GPIF—especially with equities being so inexpensive."

Mr. Mitani said he is aware of such opinions, but his mandate is to invest in "safe" assets with a long-term view. "In 2008 after the collapse of Lehman, while we posted a negative result we were relatively better than overseas pension funds thanks to our conservative, cautious stance. We posted only single-digit [percentage] loss while others posted double-digit loss," he says.

In the U.S., the California Public Employees' Retirement System, known as Calpers, is the nation's largest with assets of $200 billion. Calpers reported a 23% slump in the year ended June 30, 2009, marking its worst year ever. Some of the biggest hits were from private or alternative investments such as real estate. Calpers has since begun pulling back on such exposure. In comparison, the GPIF reported only a 7.6% slump in the fiscal year ended March 31, 2009.
That list bit about comparative slumps should clue you in as to where the GPIF is going to want to go to first when it comes to meeting liquidity needs. Why sell volatile equity securities and potentially lock-in another loss when you can sell some ultra low-yield JGBs and FILPs, perhaps even turning that ROI-frown, upside-down in the process?

A special thanks, by the way, to John Vail of Nikko Asset Management, for providing some much-needed "useful idiot" stock-jobber equity permabull nonsense encouraging the GPIF to go out on the risk curve a bit more. Over the long-term, equities will "nearly-always" outperform JGBs... except for the past 30 years (image pulled from Mish):



Dang, looks like the long-term can be very long, indeed.

Meanwhile, Mr. Mitani seems fairly confident that the Ponzi-scheme will be kept up a bit longer:
Mr. Mitani expects the 10-year JGB yield to mostly stay below 1.5% for the next two to three years, though it may break above that point temporarily. He added that he isn't too concerned about the risk that JGB prices will plunge due to fears about increasing JGB supply, creating a Greek-style fiscal crisis.

"If financial firms keep receiving ample funds from [the Bank of Japan], if companies remain reluctant to borrow, and if individuals keep savings at banks, there's no choice but to purchase government bonds," Mr. Mitani said.
Maybe. Hayman Capital Advisors' Kyle Bass doesn't seem to think so. Either way, it's not a popularity contest. Just keep in mind that that's a lot of "Ifs". The other thing to remember is that the GPIF may be the biggest fund facing this kind of problem, but it is far from being the only one, in Japan and around the world. As discussed above with the Ponzi within the Ponzi, there are a lot of moving pieces in these deadly contraptions and this type of intertwined financial structure has been rigged, Rube Goldberg-style (you're going to have to click the link and watch the 2min vid to the end to see just how ironic a choice it was given the subject matter at hand), across the world's pension and financial systems as well as governments.

I know not when it will end, but I do know this-- when these things end, they don't end well.


More reading on the subject, in the event that the preceding was not enough:
  • WSJ.com interview with Takahiro Mitani, president of the GBIF
  • How does the Fiscal Investment and Loan Program work?, Ministry of Finance, Japan
  • Fiscal Investment and Loan Program (FILP) Plan: FY2009[PDF]
  • Explanation of monetary and fiscal policy of Japan, Wikipedia, referencing FILP as Japan's "second budget" (every country has one... or two... or four...)
  • Historical investment results for the GPIF (for trend-watcher aficionados)
  • Thematically-parallel article on the pension problem in the US, also posted today, WSJ.com, teaser to whet your appetite:
    Many of America's largest pension funds are sticking to expectations of fat returns on their investments even after a decade of paltry gains, which could leave U.S. retirement plans facing an even deeper funding hole and taxpayers on the hook for huge additional contributions.

    The median expected investment return for more than 100 U.S. public pension plans surveyed by the National Association of State Retirement Administrators remains 8%, the same level as in 2001, the association says.

    The country's 15 biggest public pension systems have an average expected return of 7.8%, and only a handful recently have changed or are reconsidering those return assumptions, according to a survey of those funds by The Wall Street Journal.

    [...]

    The rosy expectations persist despite the fact that the Dow Jones Industrial Average is back near the 10000 level it first breached in 1999. The 10-year Treasury note is yielding less than 3%, and inflation is running at only about 1%, making it tougher for plans to hit their return targets.
    Is this story starting to sound familiar or what?

2 comments:

  1. Very good and much needed analysis. The extent of corruption in Japan's financial/economic system has been virtually ignored in main stream discussion of their system.

    ReplyDelete
  2. rosethorn,

    Thank you for the comment. I agree with you. One of the things that has "shocked" me (in the sense that I wasn't aware of its extent, not that I was surprised by its existence) was the corruption and the "depth of the rabbit hole."

    I've done some unorthodox research on this topic, so to speak, including reading a book called "Yakuza" which explores the semi-legitimate criminal non-underworld of gangland Japan. The role these organizations play in facilitating or smoothing Japanese politics and finance is illuminating-- it's hard to believe similar things aren't done all around the world once you read about how its done.

    I think one thing that stood out to me is that these aspects of systemic corruption seem endemic to inflationary economics and that we don't really realize (or even care to pay attention to) how widespread they are until the inflation fails and the beast starts rolling over.

    ReplyDelete