A hard look at Japan’s debt problem

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Yesterday in this space, I asked if investors would come to reassess the riskiness of developed economies and usher in a “sea change” in how money is allocated around the world. Could Japan, the most indebted of all industrialized countries, be the trigger to start that dramatic process? Since the devastating earthquake and tsunami that ravaged northeastern Japan last month, the pitiful financial state of Japan’s government has come into ever greater focus. The reconstruction could place an extra burden on an already strained budget, while it could be difficult for policymakers to undertake the badly needed retrenchment in deficits and spending with the economy slowing and disaster victims still in need of aid, nudging the country closer to a possible debt crisis.

But how vulnerable is Japan to such a crisis? The answer is amazingly complicated.

First, let’s look at how the natural disaster could weaken the government’s financial position. Christian Carrillo, head of Asia-Pacific interest rate strategy at Societe Generale in Tokyo estimates that the government will likely have to issue an additional 5 trillion yen in bonds this fiscal year due to the costs of the quake. At nearly $60 billion, that’s no pocket change. But Carrillo points out that it is also less than 1% of Japan’s total outstanding debt. So in the end, the direct increase of debt from the quake is something of a drop in a big bucket of liabilities. “The magnitude of the increase in funding requirements is minimal in regard to the public debt,” Carrillo says. The quake may slightly heighten the risk of a debt problem, but only “on the margin,” he adds.

Economist Ken Courtis, founding partner of private-equity firm Themes Investment Management, thinks the impact could be a bit more severe. He estimates that all of the related costs of the quake – rebuilding and extra social welfare expenses, lost tax revenue, slower economic growth – will add about 10 percentage points onto the country’s already astronomical government debt to GDP ratio, which at 200% is the highest in the industrialized world. But Courtis also adds that that doesn’t necessarily mean Japan will have a debt crisis. First, he, like many others, believes Japan, the third-largest economy in the world, most likely has the resources to finance the costs of the quake on its own. And that would perpetuate a highly unusual situation in Japan that allows the country to go on building a mountain of debt without suffering the usual punishment of the marketplace. Japan finances its debt almost entirely within Japan. Some 95% of Japan’s government bonds are held by locals. These loyal Japanese investors have continually bought government debt at low yields, allowing the state to finance its deficits at extremely tiny cost. “In a sense, this thing can continue forever,” Courtis says. The only way this situation could change is if Japan is forced to borrow more from outsiders. That would make Japan’s position more akin to Greece’s or Ireland’s, which rely on foreign funds to finance their government’s needs, and force something of a “mark to market” for Japanese debt – which means borrowing costs will likely go up. “If Japan has to borrow from the rest of the world, then you’ll have the focus on the debt issue,” Courtis says.

What would cause that to happen? One scenario is that Japan’s consistent current account surpluses turn to deficits, causing the country to look beyond its shores for money. Another is that the Japanese themselves lose faith in the nation’s financial position and take their money out of the country. In other words, Japan can have a debt crisis only if the Japanese start one. Neither of those scenarios seems anything close to a possibility in the near or even medium term.

But does that mean that Japan will never have a debt crisis? The problem with the debt problem is that, left unresolved, it will just inevitably get worse, making it more and more likely over time that investor confidence, even Japanese confidence, could get shaken. David Rea, an economist at Capital Economics, points out that nearly half of the budget is bond issuance, and 25% of revenues is debt service. More debt means more pressure on the budget, taking the nation on a downward spiral. “It could get to the point where they do face tough choices,” Rea says.

Perhaps Takahira Ogawa, director of sovereign and international public finance ratings at Standard & Poor’s explained the situation the best. S&P has been warning about the fragile state of Japan’s national finances for some time. The agency downgraded Japan’s credit rating in January. But since the quake, S&P has been relatively quiet, taking a wait and see approach to how the natural disaster will impact its fiscal situation. Ogawa says that it is just too difficult at this point to assess how heavily the costs of reconstruction will weigh on the government budget. Yet he warns that Japan’s deficit and debt problem still needs to be taken very seriously. He compares the debt situation to the tsunami that hit Japan. Everyone knew Japan was vulnerable to such a disaster, he says, but it was difficult to realize and understand the true extent of the danger until the disaster actually happened. The same could be true with Japan’s fiscal woes. “Everyone knows the danger of delay,” Ogawa says. “But people don’t have a realistic view of the danger. Tomorrow may not be the same as today.”