Market attention has been riveted upon public debt levels in the US as Congress fights over spending cuts and tax hikes, and on Europe as more and more economies there plunge into crisis. But the announcement on August 24 by Moody’s, the rating agency, that it was again downgrading Japan’s sovereign debt rating was a reminder of how precarious its situation is too.
Moody’s downgraded Japan’s public debt by one notch to Aa3, citing Japan’s continued large budget deficits and a further build-up of public debt in the wake of the 2009 global recession. Moody’s move brings its rating on Japan into line with that from Standard & Poor’s.
A Japanese public debt crisis could be closer than many market players imagine, according to some informed observers. “In the end the market will pick up on Japan’s weak public finances,” former senior Japanese finance ministry official Shigemitsu Sugisaki tells Emerging Markets, and a “crisis could be more a matter of when rather than if”.
Japan’s public finances “are in bad shape, and I would say that they are the worst among all the World’s leading economies,” says Sugisaki, who is also a former deputy managing director of the IMF.
“It is quite obvious that we in Japan need to take drastic measures both on expenditure as well as in taxation to reverse the continued erosion of public finances and to avert a crisis,” he says.
The IMF warned after consultations with Japanese authorities this July that any rise in long-term interest rates could precipitate a fiscal crisis in Japan which, it suggested, could have destabilizing effects beyond Japan’s own shores.
But not everyone is convinced that Japan is at risk of such a crisis. “Japan’s fiscal condition is not as bad as many people think it is,” Eisuke Sakakibara, a former vice finance minister for international affairs, tells Emerging Markets.
“The accumulated debt of the Japanese government is huge – the largest among developed countries,” he says, referring to the fact that the ratio of gross central and local government medium- and long-term debt in Japan is approaching 200% of GDP – by far the highest within the OECD.
“But accumulated household savings are also the largest among developed countries, so that 95% of our national debt is owned by Japanese,” says Sakakibara. “We are not in a crisis situation. We are unlike Greece or even the US: we are financing ourselves.”
It is not the immediate fiscal situation that worries others, however, so much as what lies down the road.
The IMF has warned that Japan’s current public debt trajectory is unsustainable, with a rapidly growing social security burden in an ageing society, and that hikes in consumption and other taxes are essential. The OECD has issued similar warnings to Japan.
These concerns are shared by Sugisaki: “The volume of Japanese government bonds (JGBs) outstanding, including short-term debt, is coming close to total personal savings of some ¥1,400 trillion,” he says. (The usually quoted amount of outstanding JGBs at around ¥860 trillion does not include short-term debt.)
“Even though we rely on domestic financing we will eventually reach the limit, and then we will have to ask foreign investors to invest and increase their share of holdings of JGBs beyond the current level of 5%,” says Sugisaki.
“It’s not so much a question of the current position of the Japanese public finances but whether there is a credible path toward consolidation and whether the needed fiscal measures will be taken,” he says.
The Japanese government recently published a medium-term fiscal framework, with the best-case scenario based on a projection of 3% nominal growth or 2% real growth over the current decade, and a worst-case scenario somewhat less than that.
“These growth assumptions seem to me to be rather optimistic,” says Sugisaki. “Even if they do materialize and even assuming a consumption tax hike in the middle of this decade of up to 10% (compared to the current 5%), the primary budget deficit will still be 3% plus, and without any further measures that percentage will stay more or less flat in the second half of the decade.
“There will be more effort needed to improve the primary balance,” says Sugisaki. “Therefore, it is quite obvious to me that we need to take very drastic measures both on expenditure as well as in taxation.” He believes this would put the nation’s fiscal house in order and avert some kind of crisis.
All this is without taking into account the costs for reconstructing Japan after the massive earthquake and tsunami that struck the country on March 11. These costs could run to ¥20 trillion or more, equal to 25% of the Japanese government’s annual budget. Funding routes have yet to be fully explored.