July 23 (Bloomberg) -- So you're sitting in Hong Kong, London or New York wondering what you can do to end Japan's 12- year economic slump. Here's an idea: Buy its bonds.

Yes, Japan's bond bubble is a big risk to global markets. Tokyo's debt-to-gross-domestic-product ratio is a troubling 140 percent. And bond issuance continues apace amid deflation, which increases the inflation-adjusted value of debt.

But the market's structure is one of the key barriers to change in Japan. Roughly 97 percent of government bonds are owned domestically, meaning Tokyo doesn't need to worry about a massive capital flight no matter how iffy its economic policies. It suits Tokyo just fine and delays reforms to revive the economy.

If foreigners owned more of Japan's debt, Tokyo couldn't shrug off downgrades by rating companies. It would have a harder time keeping bond yields less than 1 percent. It also couldn't put off badly needed repairs to a banking system swimming in bad loans. Domestic investors may tolerate all this; foreigners won't.

Enter the global ``bond vigilantes,'' traders and investors who take matters into their own hands when they perceive policy mistakes. Now the vigilantes seem to be pouncing in the U.S., boosting bond yields amid fears the Federal Reserve is leaving interest rates too low and fueling inflation.

Financial Activism Needed

Wouldn't it be nice if these mavericks turned their sights on Japan? It's hard to think of an economy in more desperate need of a little financial activism on the part of fed up market folks. Since foreigners can't exactly sell the Japanese bonds they don't own -- well, the 3 percent or so of them holding the debt can -- they could begin buying the bonds.

It's not as crazy as it sounds. First, Japan's government will be issuing lots of debt in the years ahead. It has no choice at a time when short-term rates are at zero percent and large sectors of the economy are dependent on public spending. So there should be enough Japanese bonds to go around.

Second, Japanese bonds may be less volatile than U.S. ones as the year unfolds. Tokyo exerts a level of control over the bond market that the U.S. Treasury and Fed don't. At times, U.S.- based traders and investors defy policy makers, pushing yields where they think risks lie. Such insubordination among bond traders and investors is rare in Japan.

While there have been exceptions, bond houses here tend to be very compliant, bidding on debt and holding onto it. Behind it is the incestuous relationship between the government and Japan's banks. The intimacy manifests itself in negligible bond yields. The government wants low borrowing costs, while banks don't want to upset politicians by bidding up rates. And since banks own lots of bonds, it's hardly in their interest.

Only Game

That's not to say you can't lose in Japanese bonds. Risks abound, and 10-year yields -- currently 0.94 percent -- have more than doubled since July. But Japan's economy is in such dire shape that investors have nowhere else to put their money, making bonds the only game in town. Besides, the government is determined to keep yields from rising.

The Nikkei 225 Stock Average may be up more than 10 percent this year, but Japan's fundamentals don't support the rally. It's mostly an Alan Greenspan-inspired buying binge. Investors figure the Fed chairman's rate cuts will fuel a rebound in the U.S. that will lift Japan too.

More likely than not, the bond market will return to favor as the year unfolds, particularly if the stock rally loses steam. The government is quite adept at keeping bond yields from rising. It channels vast amounts of household wealth sitting in the nation's postal savings system into bonds and encourages insurance companies and pension funds to do the same.

Buying Debt

In reality, Japan's bond market isn't so much a market as a mechanism for transferring wealth from households to the government. Well aware of the bond market's pivotal role in the economy, the Bank of Japan is equally loath to let yields rise. The bond market is too big to fail, and the BOJ will turn its full efforts to supporting bonds.

Here, bond vigilantes could make a difference. Buying up more Japanese debt would make Japan's markets -- and its economy -- more susceptible to the forces of supply and demand. It would also wrestle some control of the bond market from Tokyo.

Last September we got a glimpse of what vigilantes could do. For the first time ever, Tokyo's sale of 10-year notes didn't attract enough bidders. It was a startling vote of no confidence on efforts to repair the financial system. It also had Tokyo wondering if domestic bond traders and investors were revolting.

Ten months later, we know that didn't happen. Maybe it's time for foreign bond vigilantes to take matters into their hands.

Last Updated: July 22, 2003 13:08 EDT