It's a rule that even fledgling bond traders have memorized: Bond prices fall and long-term interest rates rise as a slow or no-growth economy begins to recover. That's precisely what's happening in Japan, which grew at an annualized rate of 6% in the first quarter. After years of stagnation, there's merriment among Prime Minister Junichiro Koizumi's political advisers heading into an Upper House election in the Japanese Diet in July, and among millions of families across the archipelago. And, as happens in recovering economies, Japan has seen a rise from 1.2% to 1.9% in benchmark 10-year government bond yields. It's a modest increase -- yet it scares the daylights out of anyone familiar with the government's runaway debt dynamics.
RAPIDLY AGING SOCIETY
Japan may be back, but so are worries about its accumulated government debt, which has climbed to a record 144% of gross domestic product, by far the highest in the developed world. Rising social security and medical costs in a rapidly aging society, declining tax revenues from fewer working citizens, widespread tax evasion, and, until recently, low tax receipts from the struggling corporate sector have all created a cavernous gap in the budget. To hold things together, the government has been issuing $300 billion-plus annually in new paper since 1998 while relying on ultraloose rates to keep interest payments low. Still, some 21% of Japan's annual budget is devoured by retiring older bonds and paying some $80 billion in interest. Fiscal hawks at Japan's Finance Ministry point out that if the debt were stacked up in 10,000-yen notes, the heap would be 1,300 times higher than Mt. Fuji and 500 times higher than Mt. Everest.
Japan needed that debt binge to keep the economy from falling into outright depression during a decade of bank failures and anemic growth. But now that the country is growing again and rates are rising, serious minds in Japanese finance see a major-league fiscal crisis in store. Every 100-basis-point rise in debt yield adds about $40 billion in debt-servicing costs, according to the Ministry of Finance. Says Keio University professor Eisuke Sakakibara, the Ministry's top financial diplomat in the mid-1990s: "If interest rates [rise] to 3% to 4%, there would be a major problem."
So far, predictions of a crash in the Japanese bond market triggered by rising long-term rates haven't been borne out. One reason is that Japan has a deep domestic savings pool and a massive current-account surplus. And Japanese banks and life insurers have been rapacious buyers of Japanese government debt, which they view as a safe, liquid investment despite low returns. What's more, the Bank of Japan under Governor Toshihiko Fukui has jumped into the act by buying bonds outright from the government as they are issued by the Ministry of Finance. "The BOJ is monetizing 40% of MOF's JGB issuances," notes Merrill Lynch Japan Inc. (MER) economist Jesper Koll in Tokyo. That's up from an historical average of 15% in the postwar period.
The government continues to think up creative ways to keep Japanese savers in the game, even recruiting celebrities such as Kabuki actor Koshiro Matsumoto to promote bonds to average Japanese. As long as domestic demand holds up, optimists argue, the government should be able to keep spending more than it takes in. Unlike the U.S. bond market, where foreigners, led by Japan and China, own some 50% of tradable Treasury bonds, only 5% of Japanese paper is owned by overseas investors. So Japan doesn't have to worry about an exodus of foreign owners that would crush demand and send yields soaring. Indeed, back in 1995 and '96, when Japan had a growth spurt and long-term rates rose above 3%, the bond market didn't crash.
What could stir up trouble this time, paradoxically, is Japan's vastly improved economic outlook. Most forecasters see the economy growing 2% to 3% over the next couple of years, and deflation, a serious problem since 1998, ending next year. At some point, the Bank of Japan, with all that liquidity sloshing around the system, will have to start worrying about inflation. Already there is talk of an "exit strategy" from Japan's near-zero interest-rate policy. But if the BOJ has to hike rates dramatically -- something it has a poor track record of handling -- chances are other interest rates, such as the banks' prime lending rate and long-term bond rates, would climb. More important, the price the government has to pay to refinance its debt load would skyrocket.
Thus everybody agrees that Japan needs to get on a serious fiscal diet -- and quickly. "At some point, the economy will not be able to provide enough resources for it to service its debt and avoid default," notes Thomas J. Byrne, vice-president and senior credit officer for sovereign risk at credit-rating agency Moody's Investors Service (MCO)
Prime Minister Koizumi, who came into office three years ago as a fiscal conservative, has held the line on general expenditures over the past two years. And he is pushing for pension reforms to cut promised benefits and raise premiums. The rub is that tax revenues have fallen from a peak of $555 billion in 1990 to an expected $385 billion in 2004, according to MOF data. That's why the government's reliance on bonds to fund its operations has jumped from 7.3% to 41% of the budget over the same period. And with Japan's graying demographic profile -- due to a low birth rate, minimal immigration, and a declining workforce -- Koizumi and his successors will have to take more dramatic action to rein in spending. Cutting payments and services is sure to be unpopular with voters, which is why the government has delayed all but the most basic reforms until now.
AN UNPALATABLE MOVE
Although Koizumi has pledged not to raise Japan's 5% nationwide sales tax, for example, he may have to break that promise before his term ends in 2006. "The only available means of cutting the budget deficit quickly looks like a rise in the consumption tax," says Richard Jerram, an economist at ING Baring Securities (Japan) Ltd. (ING) in Tokyo. He thinks it will eventually have to double, to 10%. To make that more palatable, Koizumi could slightly cut corporate taxes at the same time. Then again, a modest hike in the consumption tax (from 3% to 5%) in 1997 helped push Japan into recession and cost then-Prime Minister Ryutaro Hashimoto his job. Some think the BOJ might be forced at some point to simply tolerate high inflation, which would allow the government to pay off its bonds with cheaper yen. That, however, is regarded as a radical solution, since it would erode the value of savings and amount to a huge transfer of wealth to borrowers.
Make no mistake: There are plenty of good things going on in Japan's economy right now. Trade with China is booming, the high-tech and auto sectors are humming, and consumer spending has pulled out of a long slump. Yet the cold reality is that Japan is in a debt trap. It's a problem that will take years of steady growth and fiscal restraint to remedy. Until that process is well under way, even a hiccup in Japan's bloated bond market could have grave implications for the government's finances.
By Brian Bremner in Tokyo