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Is Japan next?

February 16, 2012: 5:00 AM ET

Japan's debt levels have ballooned to a level that makes Greece look like a steward of capital. Wall Street has noticed, and it's placing its bets.

By Cyrus Sanati, contributor

japan_economyFORTUNE -- With the European sovereign debt imbroglio taking a breather for the moment, there is increasing concern on Wall Street that Japan could be the next major flashpoint in the ongoing global financial crisis. It appears that the country's economic reckoning, some 20 years in the making, could finally be coming to a head in the near future as the economy weakens and its debt, relative to its economic output, balloons to a level that makes Greece look like a responsible steward of capital.

Wall Street is buying protection in the form of credit default swaps to prepare for that day Japan implodes. Trading of swaps on Japanese sovereigns has been highly volatile in the past year -- they are currently being sold at around 135 basis points, 100 basis points above Japan's debt yield, credit traders in New York and London tell Fortune. Credit default swaps provide a way for investors to make money in the event of a default.

While the Japanese debt bomb isn't expected to go off tomorrow, Japanese CDS is now 50% higher than where it was a year ago. Wall Street involvement in the Japanese debt market has grown in the last few years, which could bring increased pressure on the government to try and solve its debt dilemma. Eventually, though, the Wall Street bond vigilantes could drag Japanese bond yields up to levels that could cripple the government's ability to pay off its debts, setting the stage for one of the most prolific sovereign debt defaults in history.

It seems crazy to think that Japan, a country known for its efficiency and educated population, could have dug itself into such a dire debt hole. But Japan's total debt compared to its GDP is topping 235% and getting larger by the day. As a point of reference, the U.S. has a debt to GDP ratio of around 98%, while the worst off eurozone members, Greece and Portugal, have ratios of around 159% and 110%, respectively.

But Japan has been able to continue racking up the debt because of some notable debt defenses. Those defenses include the nation's strong export industry, as it allows Japan to be a net importer of capital, and the nation's loyal population, which tends to invest and spend money at home. And unlike other advanced economies, the bulk of Japan's debt is held by its own citizens, so it hasn't faced the full wrath of Wall Street's bond investors.

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But the nation announced some startling economic news this week that has exposed some chinks in Japan's debt defenses. In addition to announcing a much larger-than-expected 2.3% contraction in the country's GDP in the fourth quarter, Japan, the exporting powerhouse, said it ran its first annual trade deficit since 1980. The Ministry of Finance blamed the trade deficit on the high price of energy and the disruption in exports caused by last year's devastating earthquake. While both events did contribute to the trade deficit, the main issue here seems to be Japan's currency.

The yen is now extremely strong versus the U.S. dollar and the euro, making Japan's exports appear more expensive than ever before on the international market. Some of the nation's largest export-driven companies are reporting record losses as a result of reduced outflows. For example, Panasonic recently said that it was forecasting a $10 billion loss for the fiscal year, while Sony (SNE) announced that it was doubling its net loss to around $2.8 billion for the fiscal year, the largest loss in the company's history. The losses at Japan's biggest firms translate to reduced economic growth and a big decrease in government revenue. That forces Tokyo to borrow more money from its citizens to stay afloat.

Meanwhile, the loyal Japanese consumer has started to stray a bit as the strong yen has made foreign goods look relatively cheap compared to domestic products, further exacerbating the nation's trade deficit. Real imports into Japan in December exceeded expectations of a 1.4% contraction to a 4.1% increase. This trend is expected to continue as the yen strengthens and Japanese consumers become more comfortable buying foreign goods.

The strong yen and prolonged weak interest rates are also affecting the loyal Japanese investor. While the vast majority of Japanese assets still remain parked at the bank and in government bonds yielding little interest, there has been a shift in the past two years to invest in higher-yielding international securities offered through mutual funds. At the same time, foreign ownership of Japanese debt is on the rise, going from 5% last year to around 8%, according to Goldman Sachs. The share of short-term debt held by foreigners has now doubled in the last decade to just below 20%.

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The Japanese government has tried to weaken the yen for a decade to no avail. It has incessantly engaged in multiple rounds of quantitative easing, which is when the central bank buys back its bonds from the banks with freshly printed cash, thus inflating the money supply. The BOJ engaged in three rounds of QE last year, but the yen kept strengthening. On Tuesday, the BOJ surprised the markets and announced an expansion of its QE program, injecting an additional $130 billion into the banking system. The yen weakened a bit, but the additional QE  isn't expected to have a lasting effect on its value.

With Japan's traditional debt defenses damaged and the yen increasing in value, the stage is set for the Wall Street bond vigilantes to make their mark as they did in Europe last year. The difference in yields between Japanese interest rates and Japanese CDS implies that foreigners are growing concerned as to the creditworthiness of the Japanese government. That's understandable given that the government will bring in only 40% of what it needs this year in taxes to cover its budget.

Despite all the clear signs of trouble and the damage to its debt defenses, Japanese sovereign debt is still trading below 1%, making it easy for the government to continue borrowing. But the volatile trading in Japanese bonds and CDS in the last year implies a vulnerability where even a mild credit event could trigger a run on the sovereign by both foreign and domestic bondholders, sending government borrowing rates skyrocketing overnight - just as it did in Italy last year.

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There seems to be no easy way for Japan to escape this debt prison. It could try to inflate its way out of the mess by doubling or tripling the entire money supply, but that would effectively decimate the nation's savings. The government could implement some draconian austerity measures to rein in spending or hike up taxes to increase revenue, but both moves would have severe consequences on economic growth. The boldest move the government is proposing is to hike the nation's sales tax to 8% by 2014, which would increase to 10% in the following year, but that isn't enough to make a dent in the debt pile.

There is no way to know when Japan will finally succumb to its debts. Japan's aging population will be retiring in droves over the next few years, meaning that they will stop buying and start liquidating their bonds, eliminating the government's ability to fund itself. With Japan's debt defenses compromised, that day of reckoning could be coming up much sooner than anyone can imagine.

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