Japan — long the epitome of chronic deflation, weak growth, and policy paralysis — has become a much livelier place. Per MainFT:
Japan is now behaving like a country that has emerged from a malaise once considered incurable. Deflation now seems consigned to the past. The output gap has closed. Pricing power has returned to parts of the economy that have not known it for decades. [ . . . ]
“This is a structural transformation of Japan,” says Keiichiro Kobayashi, an economist at Keio University in Tokyo, who has tracked the country’s three-decade-long struggle to emerge from deflation. “It is a shift from being a demand-shortage economy to a supply-shortage economy.”
Good news! A more “normal” macroeconomic backdrop should contribute to rising corporate dynamism and investment, among other things. There will be growing pains, of course. This would nonetheless be an almost entirely positive outcome for Japan, if it were not for the small matter of a pile of public debt of more than 200 per cent of GDP.
Now, it must be acknowledged that financial writers have spent entire careers warning, wrongly, of an impending Japanese debt disaster. Betting against Japanese government bonds has been a widowmaker trade since Sony was selling the Walkman. This time is never different. And yet, in some clear respects, this time is different.
Take the trajectory of bond yields, for example:
Perhaps this doesn’t mean anything; after all, bond yields around the world have been rising over the past few years. Japanese long-term yields aren’t merely rising, however; they are converging toward those of other rich countries. The spread between US and Japanese 10-year yields has fallen from nearly 400bps in 2023 to under 200bps today, for example.
In addition, Japan’s commitment to fiscal support for the economy seems ever more enduring. Just this past week, the cabinet of Prime Minister Sanae Takaichi approved her plan to mobilise some $2.3tn in public and private spending through 2040, intended to more than double the economy’s structural growth rate. The government argues that this is fine, as a doubling or tripling of productivity growth will bring down the ratio of debt to GDP even if government spending jumps. File under: Maybe!
Then there is the precipitous and ongoing decline of the yen, which has sunk below ¥163 to the dollar for the first time in more than 40 years, after trading at just over ¥100 only five years ago. Together, these factors seem to indicate that there could be actual fire, where for three decades there has only been smoke.
I can feel commenters mentally drafting their lists of objections, so let’s grapple with the case for nonchalance. Japanese debt looks far less concerning on a net as opposed to gross basis, because the central bank owns such a massive share of outstanding bonds (about half).
What the Bank of Japan doesn’t own is mostly held domestically, with large piles in the hands of Japanese banks, insurers, and pension funds. Over $1tn in official foreign exchange reserves gives Japan ample room to defend its currency, and a hulking net international investment position of $3.5tn provides further protection against a chaotic depreciation of the yen. All in all, it is difficult to envision a scenario in which selling pressure from foreign vigilante investors sparks a fiscal crisis.
But if Japan can do lots of things to keep itself out of trouble, those actions inevitably have consequences.
Suppose long-term rates continue to rise, adding to fiscal sustainability concerns. The BoJ has said that it will answer a rapid rise in long-term rates with “nimble responses”, through one-off purchases of government bonds or by pausing or reversing the tapering of its ongoing bond purchase programme. (Yes, the BoJ is still engaged in QE.) This, though, would place downward pressure on the yen and upward pressure on inflation.
Those problems could be addressed through increases in short-term interest rates. The BoJ raised its overnight rate to 1 per cent in June, and further increases are expected. Japan, though, has been moving to issue more debt at shorter maturities, precisely because long rates have been rising, so more hiking undercuts the effort to ameliorate the debt problem.
Japan could instead tackle the depreciation problem by selling down its holdings of foreign exchange. Unfortunately, this has already been tried, back in the spring, when the government spent $72bn to chase off yen bears. The effect was immediate but modest, and the yen tested new lows just two months later. The finance minister, Satsuki Katayama, is promising additional “bold” action. But the fundamentals are not helping — in addition to fiscal concerns, Japan’s import bill has been rising because of high oil prices — and further interventions are likely to drain FX resources without helping very much.
Still, time bought is time bought. So, stipulate that Japan can fend off market pressures for a good while yet: are we in the clear, crisis-wise? Well no, not really, because the actions Japan can take to help itself end up exporting pain, piling pressure on the bonds of other governments which are having their own rough time of things.
Higher interest rates in Japan attract investors (domestic and foreign) out of other government bonds, driving down their prices and pushing up their yields. So do sales of Japan’s holdings of foreign bonds, intended to raise foreign currency for the purchase of yen. There are very good reasons why rich-country bond yields tend to move together. And lately, the direction they’ve been moving together is up.
So here’s the thing: worries about Japan are really about much more than Japan. Governments spent the long era of falling interest rates accumulating debt. That era is now over, and the rising cost of financing that debt has investors demanding more of a premium to lend at long durations. Even as this is occurring, borrowing needs are increasing: because of current wars, and the need to be ready to fight future wars, and the imperative to develop a secure industrial base in case of future wars, and the intense capital appetite of an AI complex which will likely run those future wars, and so on.
For individual governments, it may be possible to tell stories about why a crisis isn’t imminent. But as bond-market pressure rises, a weak link may ultimately be exposed. It could be Japan, or France, or America, or Britain. If and when things kick off, the bonds of other governments might benefit from safe-haven flows. But there is some chance of contagion — and the vindication of the long-suffering ultra-perma-bond bears.
