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Defying gravity

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Japan is almost up to its neck in debt.  And the local market just keeps swallowing it up.  But according to a recent IMF paper, it cannot go on forever.  Japan cannot continue defying gravity.  The chickens will soon come home to roost.

This year Japan’s gross public debt will hit 225 percent of GDP (110 percent of GDP in net terms).  In this, Japan is a world leader among advanced economies. 

Japan’s public debt started taking off in the 1990s.  Economic recession, caused by the bursting of the bubble, provoked a government spending spree to stoke up the economy.  The government has turned the fiscal tap on and off a few times over the past two decades.  But today, the tap is very much open as Japan has been suffering miserably from the global financial crisis.  So debt has kept creeping up.  Net public debt rose from 20 percent of GDP to 60 percent of GDP over the 1990s, before passing through the 100 per cent ceiling today.

For a long time now, economists have been saying that the day of reckoning is nigh.  That interest rates will have to start climbing up.  But even today, they remain low by historical standards, even though the general government deficit could stay around 10 percent of GDP this year.  In fact, looking back to the early 1990s, Japanese Government Bond yields do not seem to jump up with rises in the fiscal deficit and public debt.  During the 1990s the 10-year Japanese Government Bond (JGB) yields declined steadily from 7 percent to below 2 percent, while long term yields have remained fairly stable at below 2 percent.  Indeed, according to the IMF’s analysis the Japanese government has been getting off more lightly than other governments who suffer higher interest rates along with fiscal deficits and rising public debt. 

For how long can the Japanese government continue to get off “scot-free”?  According to the IMF, in the near time, they will get away with it.  A number of factors keep JGB yields low: Japan’s large and growing pool of household savings; recent large saving flows from the corporate sector; stable institutional investors (like The Japan Post Bank and the Government Pension Investment Fund); and strong home bias (JGBs have been almost entirely financed by domestic investors). 

Another factor could also be the argument that gross public debt has not increased over the past 10 years when taking account of reduced government liabilities under the Fiscal Investment and Loan Program.  FILP lending has shrunk, forcing these affected agencies to curtail their projects and rely more on private financing. 

But others argue that we are in a "JGB bubble", with investors blindly investing in assets whose real values are unsustainable and likely to crash in the future.

Indeed, looking further ahead, Japan will hit the wall as the market’s capacity to absorb public debt will likely diminish.  Population aging will reduce savings inflows, while financial reforms could enhance risk appetite (both the Government Pension Investment Fund and the Japan Post Bank are freer to invest in non-JGB investments).  So, interest rates will start jumping in the face of a risk premium.  “Sound public debt management” can help steady the boat for a while.  But there is no escaping reality.  Over the longer term, the government cannot continue to spend “willy-nilly”, they will have to tighten their belts, and cut their deficits.

The ultimate doomsday could be dramatic.  The IMF calculates that gross public debt (including FILP liabilities) in 2015 could exceed gross households’ financial assets, assuming the household saving rate remains at 2.2 percent.  And while economists tend to forecast smooth adjustments, when market sentiment swings, it is often vicious. 

And there is every reason for a vicious swing.  A lot of Japan’s fiscal deficits have been badly invested in useless infrastructure, bridges to nowhere, airports without flights and so on.  And as interest rates rise, interest payments will take up more and more government revenues.  Tightening the government’s fiscal belt will not be easy, as more and more government expenditure will going to health and social policies for Japan’s ageing population.

The future does not look good.  Even Mrs Watanabe told me that she is very worried about her pension.


“The Outlook for Financing Japan’s Public Debt”, by Kiichi Tokuoka.  IMF Working Paper.  WP/10/19