When Japan's debt bubble bursts – watch out

When it does, it will face a rude shock in the form of higher interest payments. Japanese 10-year Treasuries now yielding 1.0 percent will not stand a chance against US or German bonds of the same maturities that yield 2.89 percent and 2.59 percent, respectively.

Interest-rate dilemma

To attract investors, Japan will have to offer much higher rates. Though they have their own fiscal problems, the US and Germany still have much lower indebtedness and superior demographic growth profiles.

Japan's stimulative, low-interest policy put the country in its debt trap: It cannot afford higher interest rates, and low interest rates are no longer stimulative to the economy.

In 2009, over a quarter of its tax revenue went toward interest payments. If the cost of its borrowing were to double (which it may soon), the increase in the cost of debt would equal the Japanese budgets for education and science and defense combined. Higher interest rates will probably trigger debt downgrades, which will drive borrowing costs up even more.

Higher taxes and the austerity measures that will undoubtedly follow, combined with higher interest rates, will slow down the economy further and drive Japan toward insolvency.

Unlike European countries that socialized their currencies and cannot on their own print euros, Japan has complete control over its printing press. Also, unlike Greece, which, due to its small size, could be bailed out by Germany and other European friends (and a bit of help from the ever-willing International Monetary Fund), Japan is too big to be bailed out.

Defaulting on its own debt, especially when the majority of it is owned by its own citizens, is a political impossibility. This is why governments that have control over their currencies don't default – they print. And print they will, in Japan! Decades of deflation will turn into hyperinflation, which will destroy the purchasing power of citizens' savings and collapse the yen.

Consequences for America

The consequences of what is slowly but surely unraveling in Japan is important to US investors, as it will not stay in Japan but will spill into the US and rest of the world.

Along with China, Japan is the one of the largest holders of US government debt, and its demand for our fine paper will decline. Most likely, Japan will start selling Treasuries. And to make things worse, Japan will start competing with the US, not just in cars and electronics, but for buyers of sovereign government debt. Japan will export inflation, inflation will rise globally, and so will interest rates.

Had I written a similar article five years ago, I would have been "wrong," as today the Japanese economy is still ticking. Timing bubbles – and Japan is in the late stages of an enormous debt bubble – is very difficult, as bubbles tend to last longer than rational observers expect. But every year that the Japanese bubble doesn't burst and debt swells, the eventual pop just grows more catastrophic.

Japan is past the point of no return; its fiscal and demographic problems were created over decades and will take decades to be resolved. In the meantime, its citizens will pay the painful price. Japan is proof that a country cannot borrow itself to prosperity. The US and other developed nations still have a chance to make the politically difficult but right decision to cut government spending and stop looking for government to be the source of sustainable growth, which it never is.

Vitaliy N. Katsenelson is a portfolio manager/director of research at Investment Management Associates in Denver. He is the author of "Active Value Investing: Making Money in Range-Bound Markets." A version of this article originally appeared in Institutional Investor magazine.

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