A rare wave of optimism about Japan’s economy has swept over financial markets this year as the Nikkei stock index has soared and the yen plunged. The policies of newly elected President Shinzo Abe’s government have been hailed as Japan’s savior from decades of stagnation, winning plaudits at home and abroad.
Meanwhile, Japan’s national debt has quietly crept past the quadrillion yen mark – that’s 12 zeroes, or approximately $10 trillion – and some analysts fear the very success of a pillar of the government’s “Abenomics” could tip the country’s finances into a crisis that would reverberate through the global economy.
“If the government does get out of deflation, this could lead to a very serious situation for Japan’s finances,” says Yuichi Kodama, chief economist at Meiji Yasuda Life Insurance and a critic of ‘Abenomics,’ who believes the government has to radically reform the nation’s finances “in order to avoid a tragic collapse.”
Consumer price index figures released Friday showed that the government and central bank may be finally making progress in their battle against the deflation that has stubbornly dogged the economy for the past 15 years. Prices of consumer goods didn't drop in May, the first time they haven't fallen since Abe took office in December. While prices have yet to rise, it is the combination of inflation and debt that poses the risk.
Successive Japanese administrations have been able to rack up huge levels of debt – which is now 2-1/2 times the size of the economy and equivalent to more than $165,000 for each working person in the country – largely thanks to domestic investors willing to buy government bonds paying near-zero interest rates. However, one of the main targets of Abe’s growth plan is to raise inflation to 2 percent. That should in turn push up interest rates, including those on Japanese Government Bonds (JGBs), as investors seek higher returns.
The options appear severely limited.
Almost half of government tax revenues are already consumed just by servicing the debt, and that is at current low interest rates. If they were to rise more than a couple of percent, the costs of debt-servicing would escalate to critical levels. Supporters of the government’s policies argue that the increased economic activity that would accompany inflation will lead to higher tax revenues, helping to keep the debt manageable. Critics point out that while a doubling of debt costs is far from impossible, tax revenues growing by 100 percent would be close to miraculous.
“It will then be a kind of race between inflation and increased tax revenues. If you don't believe that tax revenues can win, then you have to think Japan is doomed,” says Paul Sheard, chief global economist at Standard and Poor's ratings agency, who describes himself as “cheerleading but skeptical” on a positive outcome.
Even outright supporters of Abe’s policies, such as Masayuki Kichikawa, the chief Japan economist at Bank of America Merrill Lynch in Tokyo, acknowledge the danger of the debt. He believes the cost of debt servicing is already too high for the Japanese economy, which he estimates has, “a potential growth rate of less than 1 percent.”
The fact that nearly all of Japan’s debt has been held domestically, has so far shielded it from the outside pressures that brought turmoil to countries like Greece and Spain. That is slowly changing, too.
The elephant in the room
“Foreign ownership of government debt has gone from 5 percent two years ago to 9 percent now. The only net buyers now are the Bank of Japan and foreign investors,” says Jesper Koll, managing director at JP Morgan Japan and a self-proclaimed flag-waver for the country.
“Government debt is the elephant in the room that nobody likes to talk about,” adds Mr. Koll.
Although the crucial yield rate on JGBs remains low, at around 0.85 percent, it has more than doubled in recent months.
“If they succeed with inflation and yields got to 2.8 percent, that would start to eat up all of government tax revenue and the bond market will likely blow up. And if they fail, then they're back in a deflationary spiral,” says James Gruber of Asia Confidential investment newsletter and a former analyst and fund manager. “I just don't see how there can be a happy ending for Japan. But I hope I'm wrong, for Japan's sake.”
If Japan did become unable to pay its debts, the only realistic options would be default or attempting to hyperinflate its way out of trouble by printing ever more money. The shock waves that would be sent through the global financial system would likely dwarf those felt after the Lehman Bros. collapse and the eurozone crisis.
Perhaps appropriately, a group of Japanese lawmakers intend to introduce a bill later this year to legalize casinos in an attempt to boost tax revenues.