Japan's growing debt mountain: Crisis, what crisis?

Nikkei Aasia has published an analysis covering why the world's No. 3 economy stays afloat despite towering debt-GDP ratio. Caliber.Az reprints this article.

When the U.K. announced uncosted tax breaks last year, it triggered a run on the sterling, sent British government bond yields to their highest since the global financial crisis, and hastened the downfall of Prime Minister Liz Truss after just 44 days in office. This year, the U.K.'s ratio of debt to gross domestic product surpassed 100 per cent for the first time since the early 1960s.

Japan could only dream of a figure so low.

The International Monetary Fund estimates that the world's third-largest economy's ratio is around 260 per cent -- by far the highest among developed economies, exceeding the 204 per cent seen during World War II in 1944. The number is expected to continue creeping upward, according to projections by the Japan Center for Economic Research, a Nikkei-affiliated think tank.

Yet Tokyo remains relatively sanguine. In an optimistic scenario that sees a rise in Japan's potential growth rate, the government projects it will balance its books by fiscal 2026.

The cost of borrowing, however, is rising. A decision by the Bank of Japan on July 28 to allow yields on Japanese government bonds (JGBs) to rise above its previous cap of 0.5 per cent to 1 per cent has already triggered a spike in yields -- they rose above 0.6 per cent for the first time in nine years in trading on July 31.

In the meantime, Japan keeps on spending. Prime Minister Fumio Kishida has pledged to boost defence expenditure to 2 per cent of GDP by fiscal 2027 from around 1 per cent now, and to double the child care budget to an annual 3.5 trillion yen ($25 billion). He is also planning to issue 20 trillion yen of Green Transformation (GX) bonds over the next decade.

While the GX bonds are to be repaid through a carbon tax and carbon pricing scheme, Kishida's government has yet to settle on a plan to cover the defence and child-rearing outlays. Saddled with a super-aged society, the government projects Japan will have to spend nearly one quarter of GDP on social welfare such as nursing care and pensions in the fiscal year beginning April 2040.

So far, none of this has spooked global investors the way Truss' tax plan did.

Various factors are dampening the fuse on Japan's debt time bomb. Companies have large cash holdings and are not yet borrowing heavily. Japanese government bonds have a relatively long average maturity and are mostly held domestically. The country has a healthy current account surplus, and a rare period of inflation is also helping.

"It's difficult to imagine a debt crisis in Japan. But its A rating does imply that it is not completely risk-free," Krisjanis Krustins, director of sovereign ratings for the Asia-Pacific region at Fitch Ratings, told Nikkei Asia. "If growth and inflation return to weak levels, then that would result in the debt ratio trending up -- all else equal."

Perhaps the biggest factor supporting Japan's debt situation is what Tohru Sasaki, head of Japan macro research at JPMorgan Chase Bank, calls a "kind of addiction" to the BOJ's ultraloose policies.

Under previous Gov. Haruhiko Kuroda and continued under Kazuo Ueda, the central bank has guided interest rates in a band around or below zero and, under a massive asset purchase program, the BOJ now holds around half of all sovereign bonds.

"The central bank cannot get out of monetizing government debt," Sasaki said. "The Bank of Japan will probably buy debt if we run into trouble from here. I'm not saying this in an optimistic sense, but in a pessimistic sense."

Japan is projected to spend 22.1 per cent of its current fiscal year budget on interest payments and debt redemption. Aware of this, and the growing debt burden, Finance Minister Shunichi Suzuki warned in March that "Japan's public finances have increased in severity to an unprecedented degree."

Still, investor confidence in Japan's finances appears to be holding, according to Christian de Guzman, a sovereign risk analyst at Moody's Investors Service who covers Japan.

"There is this home bias, and correlated to that is the current account surplus, which gives safe-haven characteristics to the JGB market and the Japanese yen," de Guzman said. "It really boils down to trust."

While Japan can probably rest assured that its debt burden is not going to trigger major economic damage anytime soon, economists do see hazards.

Shigeto Nagai, head of Japan economics at U.K.-based Oxford Economics, says one potential shock could be an ill-timed return to more "normal" monetary policy.

"The exit process from the BOJ's quantitative easing will take years and it needs a guardrail," Nagai told Nikkei Asia. "Done poorly, it could trigger JGB turmoil."

Kazumasa Oguro, a former Finance Ministry official who is now a professor of economics at Hosei University in Tokyo, told Nikkei Asia the BOJ is holding down long-term interest rates through its yield curve control program, "but when it is no longer able to do so, that is the time when the problem will become most apparent."

Kim Eng Tan, a senior director at S&P Global Ratings, warned that if the central bank were to suddenly increase rates or tighten monetary policy, it would untomb a "lot of skeletons in the closet."

Low growth as Japan's population ages and falls is also a major risk. Without a significant productivity boost, a smaller working-age population would make it very difficult for Japan to maintain or boost growth, which would help to bring down the debt-to-GDP ratio.

"For Japan, the biggest social risk factor has been demographics," de Guzman said on July 31.

Inflation, while unpopular with many residents of Japan as wage growth is not keeping up, could be a panacea for the debt position. Consumer prices picked up again in June to exceed the BOJ's 2 per cent target for the 15th straight month. Despite rates around zero, Japan now has faster inflation than the US, where the Federal Reserve on July 26 raised rates for the 11th time in 12 meetings, reaching a range of 5.25 per cent-5.50 per cent.

If sustained inflation materializes in Japan, "that will have a positive impact on GDP, the denominator and debt-to-GDP, that tends to be positive for government revenue as well," said Krustins at Fitch.

At some point, however, Japan will have to reinforce its debt position and cap spending even as the population grows older, economists say.

"A credible fiscal consolidation containing age-related spending and mobilizing tax revenues is warranted to put debt on a downward path and reduce risks," the IMF said in its March Article IV consultation on Japan.

Tokyo faces a choice between tax hikes and spending cuts, warned Ranil Salgado, the IMF's mission chief to Japan and author of the report.

Salgado said that a (politically unpopular) further hike in the consumption tax rate is the best solution given important spending needs. "In a country like Japan, where there's a substantial elderly population, the best way to tax permanent income or permanent consumption is the consumption tax."

Ultimately the task of preventing a debt crisis may fall to the role of the BOJ, and whether Japan's private sector can innovate to boost growth, said Richard Koo, chief economist at the Nomura Research Institute and author of "Balance Sheet Recession: Japan's Struggle with Uncharted Economics and Its Global Implications."

"The only borrower left is the government," Koo told Nikkei Asia. "I'd prefer seeing the Bank of Japan exit QE and gradually transfer those holdings to the private sector investors."