June 26 (Bloomberg) -- It's been a while since Japan offered good news from the debt front. For the past 15 years, it's been little else but new record highs for bond issuance.

Change may be at hand. In the first quarter, Japan's national debt increased 5.9 percent from a year ago. That may not seem like reason for optimism; after all, debt continued to rise. Yet the rate of increase was down sharply from 11.2 percent in early 2005.

Examining Japan's national balance sheet is like trying to make heads or tails of an M.C. Escher drawing. It does seem, however, that the tide is turning for a nation that carries a lower debt rating than Botswana, and investors should watch the trend closely.

The breakdown of Japan's latest debt statistics tells the story. For example, the first-quarter increase for the financing bills that smooth out fluctuations in government revenues was 8.4 percent from a year earlier, when the increase was 11.8 percent.

All this suggests that the increased government revenues consistent with a growing economy are having a positive effect on Japan's debt outlook. If the trend continues, Japan's debt- to-gross-domestic-product ratio of about 151 percent could edge lower and result in a higher credit rating.

Improvement on the debt side is a key element that's been missing from Japan's most convincing recovery in a decade and a half. While the progress is incremental at best, these things tend to happen in baby steps before they really take hold.

To-Do List

How can Japan accelerate the trend? Well, the government could start by devising a credible plan to trim outstanding debt -- something it has yet to do. All the excitement over Prime Minister Junichiro Koizumi's efforts to revive the No. 2 economy ignores the fact that Japan remains addicted to financing growth with debt.

In his five-plus years overseeing the economy, Koizumi set out a plan to reduce Japan's public works spending. This year, for example, the government will cut public works expenditures by 4.4 percent.

Far less progress has been made to reduce the amount of debt outstanding, and this poses challenges for Japan's private sector. Companies here may want to take their rehabilitated balance sheets out for a ride and issue fresh debt to expand operations and compete globally. It's hard to sell debt with the government hogging so much of the market.

Crowded Market

While this so-called ``crowding out'' dynamic isn't new, eliminating it would produce a more vibrant economy in the long run. Giving companies more room to issue debt would help Japan develop the internationally recognized corporate, municipal or asset-backed security markets Asia's biggest economy should already have by now.

It would also help the country earn a higher credit rating. Moody's Investors Service Inc. gave Japan a hint that an upgrade may be forthcoming in 12 to 18 months as the economy expands and the government cuts its debt burden.

Investors should be encouraged that Moody's is eyeing Japan's debt position. After all, the company's last move was to cut the rating two notches to a sixth-highest A2 in 2002. On June 1, Moody's changed its long-term credit outlook for Japan to positive.

``Future budget deficits may track along a lower path,'' Thomas Byrne, a New York-based senior credit analyst at Moody's. ``Moody's expects improvement in macroeconomic and fiscal performance will continue next year.''

Stability

There are two more reasons why it's crucial for Japan to use today's 3 percent growth -- the fastest in 15 years -- to trim debt: financial stability and demographics.

The Bank of Japan has been trying to create inflation after seven years of falling consumer prices. Yet what happens if it gets it?

Japan may have the same local-currency bond rating as Kuwait, Latvia and Mauritius, but its 10-year bonds yield a mere 1.86 percent. That's less than half what the triple-A-rated U.S. pays 10-year investors. Australia, which boasts a budget surplus, pays 10-year investors 5.82 percent.

Until now, investors have been willing to accept yields below 2 percent from Japan. That may change if inflation begins to accelerate without a corresponding reduction in outstanding debt. Too much supply and not enough demand amid rising consumer prices could shoulder-check Japan's bond market. To avoid that risk, Japan needs to issue less debt.

Demographics

Another reason to do so is demographics. Japan's birth rate dropped to a record low of 1.25 children per woman of childbearing age in 2005. Quite rightly, the government is concerned an aging population will overburden the national pension system because there won't be enough working-age people to support payments for the retired.

As Japan mulls what to do, it will need all the policy flexibility it can muster. Its ability to issue new debt to fund the pension system down the road will be limited if Japan doesn't get serious about its current debt burden.

Koizumi will step down in September, and his successor will have little time to waste. It's imperative that the next prime minister act decisively and aggressively. Otherwise, hints that Japan's debt woes are improving will die a quick death.

(William Pesek Jr. is a columnist for Bloomberg News. The opinions expressed are his own.)

To contact the writer of this column: William Pesek Jr. in Tokyo at wpesek@bloomberg.net

Last Updated: June 25, 2006 21:09 EDT