Waking up from the dream of Japanese debt

Author: Toshiro Nishizawa, University of Tokyo

Affordability is important for public debt because the burden is ultimately passed on to current and future taxpayers through tax increases or inflation. Japan’s gross public debt stood at 263% of GDP at the end of 2021. Borrowing may seem affordable as long as the average yield is close to zero, but low interest rates are no longer sustainable as Japan lagging behind global monetary tightening trends.

Japan’s sovereign debt to GDP ratio is the highest among G7 countries since 1998. It is double that of the United States (133%) and well above that of Italy (151%). The Bank of Japan (BOJ) held 43% of Japanese government bonds (JGBs) at the end of March 2022, raising concerns about the genuine affordability of national debt.

JGBs accounted for 71% or 526 trillion yen (3.8 USD end of March 2022. The bank’s liabilities stood at 732 trillion yen ($5.3 trillion), including 563 trillion yen ($4.1 trillion) in short-term deposits—liabilities owed to depositors by through financial intermediaries.

In 2012, some argued that JGB rates could rise if the amount of debt exceeded domestic private sector financial assets. They simulated the cap overrun occurring over the next ten years. Based on fund flows at the end of 2021, net financial assets of the non-financial private sector amounted to 188% of GDP, while general government liabilities reached 218% of GDP.

The JGB landscape has changed dramatically, with BOJ assets now four times larger than in 2012. This suggests that the simulation would have materialized had it not been for the BOJ’s prolonged JGB purchase.

The current global monetary tightening environment has not altered the BOJ’s easing stance. Japan’s low interest rates continue to deviate from rising levels in the US, Europe and some emerging economies. The yen has fallen to its lowest level in 24 years, putting pressure on domestic prices already hurt by global increases in commodity prices.

Economics tells us that exchange rate management, monetary autonomy and the free mobility of capital are incompatible — “the impossible trinity”. Policy makers must give up one of these goals. Japan cannot maintain a stable yen, maintain low interest rates and simultaneously maintain free capital flows. A rise in interest rates will soon become inevitable unless people tolerate price increases or prefer capital controls.

In April 2022, the International Monetary Fund (IMF), in its annual Article IV consultation, warned of the risks associated with a long-term increase in public debt. The IMF has suggested that the current interest rate/growth differentials may not last without the BoJ’s accommodative monetary policy and the home bias of domestic investors.

Academic discussions of the implications of ending quantitative easing have long gone silent. Political motivations have weakened any sense of urgency and prolonged the illusion of affordability. Policymakers seem to be buying time either for fiscal consolidation or their long-awaited economic revitalization.

The Japanese government’s balance sheet shows a negative net worth of 592 trillion yen (US$4.3 trillion), with its power to collect taxes conceptually existing as an invisible asset. People’s ability to pay taxes depends on their wealth and income level. Japan’s national wealth was 3.669 trillion yen ($26.8 trillion) at the end of 2020 and nominal gross national income (GNI) was 563 trillion yen ($4.1 trillion) in 2021 .

Focusing on investing from savings can strengthen the country’s asset quality and its ability to generate long-term income. But changes in the investment-savings balance can have a short-term impact on borrowers’ financing costs. Japan’s aging demographics are also dampening income growth and narrowing the tax base, while health and pension spending is rising.

Tokyo is inclined to present an optimistic growth outlook. In 2013, the “Japan Revitalization Strategy” targeted an average nominal GDP growth of 3% over the next ten years to increase nominal GNI per capita by 1.5 million yen (US$10,949). Still, nominal GNI peaked at 580 trillion yen ($4.2 trillion) in 2019, a meager increase from 526 trillion yen ($3.8 trillion) in 2013.

By contrast, general government gross debt has nearly doubled since 2000, when it stood at 136% of GDP. Unrealized aspirations for economic revitalization have trapped policymakers in a time-wasting mode full of repetitive rhetoric. A political compromise removed the deadline for the primary balance target set out in the “Basic Policy” – the annual fiscal and economic policy guidelines released on June 7, 2022. Political narratives of extravagant spending dominated debates during the Upper House election campaign.

Japanese Prime Minister Fumio Kishida’s initiative to reform the Japanese economy through a “new form of capitalism” is another attempt at revitalization. But peer pressure dampened its redistributive policy and investor backlash sidelined the capital gains tax debate.

The national and international environments are now significantly less favorable than ten years ago, when limits for JGBs were suggested. Japan’s efforts to “defy gravity” are already turning into a steep decline.

Meanwhile, Kishida said on May 27, 2022 that his government continues to debate capital gains tax. He also said on June 19, 2022 that “we must continue to raise the banner of fiscal reconstruction”.

The landslide victory in the Upper House appears to have given the prime minister the political capital needed for a “golden three years” to revive Japan’s economy. But this will all be an illusion without a serious discussion of debt affordability and a resolute goal of fiscal health.

Toshiro Nishizawa is a professor at the Graduate School of Public Policy at the University of Tokyo.

Melvin B. Baillie