The Tokyo Foundation for Policy Research


The Tokyo Foundation for Policy Research

The Long Road to Fiscal Stabilization

May 20, 2010

While the ballooning fiscal deficit is not an immediate threat to the Japanese economy, the continued issuance of bonds to finance revenue shortfalls could tie the hands of future generations, especially as the bond market become more susceptible to trends in the global economy.

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Japan’s fiscal 2010 budget is the largest ever, and there are growing concerns that long-term government bond prices could crash, sending long-term interest rates soaring. Are such fears about Japan’s public finance warranted?

The chances of a fiscal collapse or a crash in the bond market are probably quite low over the next few years—and no doubt over the next decade as well unless there is a fundamental breakdown in Japan’s industrial structure. But there will surely come a time four or five decades hence when instability in the bond market will impact quite negatively on the Japanese economy.

There are bond-related concerns over the short, medium, and long term. I will deal with each of them in turn.

As for the short term, the likelihood of a crash in the bond market is closely linked with trends in the foreign exchange rate. Should investors lose confidence in Japanese bonds, faith in the yen will also falter. As the yen grows progressively weaker, investors may opt out of yen-backed bonds in favor of more profitable foreign assets. Should such a situation continue, the bond market could very well nosedive.

Cyclical Mechanism

The yen, though, is unlikely to remain weak for long. A slight depreciation will make Japanese exports cheaper, leading to a bigger trade surplus. This will cause the yen to appreciate and subsequently make yen-denominated assets more attractive again. Investors will be more inclined to purchase Japanese government bonds (JGBs), pushing up their prices. It is thanks to such a cyclical mechanism that the JGB market should remain stable for at least the next several years.

This assumes that Japan’s export industry will remain competitive. Should it begin to totter in the future, prompting both domestic and foreign investors to project perennial trade deficits for the country, the market will come to assume that the yen will depreciate and stay weak. This will make foreign assets more attractive than yen-denominated ones, and investors will begin dumping JGBs. This will cause bond prices to tumble and significantly diminish the value of the yen.

This assumes, of course, a structural weakening of Japan’s export industry, as indicated, for instance, by several consecutive years of negative economic growth. Such a turn of events could trigger a collapse of the bond market.

It is inconceivable that the economy would become that feeble, though. Even if growth slows down, there would surely be at least some growth, so a financial collapse and a bond market crash are probably not very likely.

This is not to say, however, that there is no need for concern. Even if the economy continues to grow, the bond market would remain precarious. The government is so heavily in debt today that raising taxes would do little to reduce such debts right away, as interest payments would continue to snowball. Achieving fiscal stability will take around two to three generations.

A condition where expenditures equal revenues is called primary balance. An estimate made a few years ago by Keio University Professor Takero Doi at the Research Institute of Economy, Trade, and Industry shows that even if fiscal discipline was implemented so that revenues exceeded spending by a significant margin for over 40 years, it would still take about 100 years for government bonds to stabilize.

This is because the primary balance does not include expenditures for the amortization of bonds. Even after the achievement of primary balance, therefore, huge interest payments would still have to be made, so revenue shortfalls would continue, and government debt would keep accumulating for several more decades. Even if the government cuts back its programs and starts living within its means, it already has so much accumulated debt that it will keep running up deficits.

In this scenario, the government’s net liabilities—calculated by subtracting total assets from outstanding debt—will continue to grow through the first half of this century, ballooning to three times the country’s gross domestic product around 2060 before beginning to contract. It will be about 2100 when total government debt will finally diminish to an equivalent of the country’s GDP.

Burdening Future Generations

The total financial assets held by Japanese people in bank deposits and other instruments are only around three times GDP. This means that should the government’s net liabilities exceed this level, then it will become impossible for the Japanese people alone to finance the debt; foreign investors will inevitably come to make up a substantial share of JGB holders.

One reason that Japan’s stock market is so sensitive to trends in US stock exchanges today is because foreign investors account for a big share of the transactions on Japanese bourses. Should foreign ownership of Japanese government bonds rise, trends in the bond market will likewise come to rely heavily on the decisions of foreign investors.

What this suggests is that a minor rumor could have a major impact on market psychology, and the dumping of government bonds would become commonplace. Bond values would fluctuate wildly, resulting in the destabilization of both long-term interest rates and inflation and impacting negatively on both the corporate and household sectors. It may even lead to a vicious circle that could enfeeble the Japanese economy. Such economic and fiscal precariousness would expose the next generation of Japanese—and the one after that—to the kind of economic crises that afflicted Argentina and is now threatening Greece.

It is important to take heed of our responsibilities toward future generations and chart a long-term course toward fiscal rehabilitation.

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