How is Japan swimming in debt, but still able to stay afloat? Is their smooth sailing coming to an end?
By Avi Gupta
Debt is the one of biggest limiting factors for governments to create extensive social programs, further innovation, and protect its citizens, all at the same time. Debt accumulation is a normal byproduct of government work, but when debt reaches absurd amounts, investors have solvency concerns for government debt, and the risk of default is great. In the United States and around the world, there is fear of rising debt burdens created by long-lived deficits and emergency measures, but one country has survived and even thrived with over a 200% debt to GDP burden: Japan.
Japan after World War II regrew its economy and became an economic powerhouse. After many decades of prominent economic growth, a real-estate and stock-market price bubble popped in 1992, leading to an economic recession. Many Japanese banks and companies needed a bailout, so the Bank of Japan (BOJ) and Japanese government started buying bad debt. This measure was not enough and many companies were combined and nationalized, furthering the expense on the government. From there on, the BOJ and the Japanese Ministry of Finance have been pumping money into the economy through quantitative easing and fiscal stimulus spending, leading to one of the largest national debts in history.
That being said, Japan is also the third largest economy by GDP, the world’s biggest creditor nation, and one of the most trusted bond sellers in the world. Japan breaks expectations in many ways. It does so through smart monetary policies and good circumstances:
First, unlike most Central Banks, Japan not only works closely with the government, but is a non-independent government entity.. This makes the Central Bank more integrated with fiscal policy, while also allowing for a direct avenue for monetizing debt. The BOJ buys Government bonds, which keeps interest yields low by raising the price, lowering the cost of borrowing for the government.
Second, 90% of Japanese Government debt is owned by its citizens. The Japanese population is aging and prefers stability over interest yield, which allows the Government to continue to sell bonds at low yields. Furthermore, it can be argued that the Japanese population buys these bonds out of patriotism which reduces the importance of yield even more.
Third, the Japanese Economy has not come close to hitting its inflation targets of 2%, which allows the BOJ to print money with almost no impact on the economy, creating an almost unlimited account of funds to buy bonds.
Fourth, as the world’s largest creditor, Japan holds over $3.1 trillion dollars worth in foreign assets and currencies. Thus, the Japanese Government can create liquidity to pay off debts if necessary, which increases the trust in the Government’s bonds.
Although at first glance it seems the unorthodox Japanese debt financing machine will be able to handle any shocks and eventually pay off its debts, this is not true with the current situation. With the economic shock from Coronavirus, Japan has increased its Quantitative Easing programs, raising the debt level to new highs and causing the S&P to raise the risk profile of Japanese Government bonds. That being said, even if Coronavirus had not created an economic downturn, Japan would still have been limited by the amount of debt the country can hold. This limit is based on the ability for the government to finance its debt.
The only way to finance the debt is to have people buy it. The Japanese population is expected to decline in the next decade, forcing the Government to look outside the country for bond holders. This will raise the interest yields of the debt as foreign investors need to be compensated for the risk, costing the Government much more in interest payments. These interest payments are the true limiting factor of the debt. They are already currently the second greatest expense of the Government’s budget, and with tax revenues decreasing in the future from the declining population, the budget deficit will increase. With such a disastrous cycle forming, the Government is being forced to take debt to pay off current investors, which will increase interest payments in the future. Unless the Japanese Government provides a radical solution, this budget deficit will only increase and possibly lead to a debt crisis.
The good news is there are many macro solutions. The Japanese government can decrease the deficit by reducing spending, increasing tax revenue, raising GDP by a corresponding amount, or increasing inflation. Although it may sound simple, the government cannot reduce spending or increase tax revenue because of Japan’s aging population; the tax revenue will decrease in the future, and Japan spends most of its budget on social programs for the elderly. On the other hand, Increasing real GDP growth by a greater amount than the interest rate is possible. The challenge is driving economic growth with a declining population that already relies on massive quantitative easing programs for growth. Another possible solution is for Japan to increase inflation. This would erode the value of the interest payments, decreasing the real amount the Government owes. The issue is that the BOJ is mandated for price stability or to prevent inflation above the 2% target.
The final solution is for the BOJ to write off the debt held by the BOJ. Writing off the debt held by the BOJ, 30% of total national debt, would have no practical impact and would eliminate a significant portion of the debt. The issue is that it would violate the independence of the BOJ, and create investor concerns for future Bond holders. Also it is a bandage on a deeper wound: the write off will be able to reduce debt in the short-run, but unless other measures are taken, it will just push the inevitable. Thus, new solutions need to be found, and rather quickly.
Overall, Japan has shocked the world through its unprecedented economic policies and large debt accumulation. Japan is vital in the world economy and its economic policies may lead to one of the greatest economic disasters ever. Only time will tell what will happen, but even with the glum picture that is described above, there is hope: Japan has revolutionized monetary policy in the last century and pushed what was possible in economics to its limits, maybe it can do it again. □
- Image source
- Balmer, Etienne. “Japan’s Debt Mountain: How Is It Sustainable?” Accessed July 16, 2020. https://www.barrons.com/news/japan-s-debt-mountain-how-is-it-sustainable-01591775409.
- East Asia Forum. “Is Japan’s Mountain of Public Debt a Threat to Financial Stability?,” August 6, 2018. https://www.eastasiaforum.org/2018/08/06/is-japans-mountain-of-public-debt-a-threat-to-financial-stability/.
- Commodity.com. “Japan Debt Clock: What Is A Rolling Liquidity Strategy Doing To Economic Health?” Accessed July 16, 2020. https://commodity.com/debt-clock/japan/.
- Narioka, Megumi Fujikawa and Kosaku. “For Some in Japan, Another Day Older and Deeper in Debt Doesn’t Sound So Bad.” Wall Street Journal, March 30, 2019, sec. Economy. https://www.wsj.com/articles/for-some-in-japan-another-day-older-and-deeper-in-debt-doesnt-sound-so-bad-11553947202.
- Oh, Sunny. “Here’s a Lesson from Japan about the Threat of a U.S. Debt Crisis.” MarketWatch. Accessed July 16, 2020. https://www.marketwatch.com/story/heres-a-lesson-from-japan-about-the-threat-of-a-us-debt-crisis-2018-05-14.
- Pesek, William. “Japan’s Debt Passes 250% of GDP.” Asia Times, March 18, 2019. https://asiatimes.com/2019/03/japans-debt-passes-250-of-gdp/.
- Pham, Peter. “When Will Japan’s Debt Crisis Implode?” Forbes. Accessed July 16, 2020. https://www.forbes.com/sites/peterpham/2017/12/11/when-will-japans-debt-crisis-implode/.
- “S&P Cuts Japan’s Debt Outlook as Spending Surges during Pandemic.” Reuters, June 9, 2020. https://www.reuters.com/article/us-japan-rating-s-p-idUSKBN23G15E.