02/13/2015 05:40 EST | Updated 04/15/2015 05:59 EDT

What the Sheer Volume of Japan's Debt Really Means

Thrill-seekers have had a seven-year heyday. The global economy's gyrations have provided ups and downs that have tested the strongest stomachs, and the ride is not over. Among the current exhibits are the fiscal high-wire acts that grew out of the crisis. The most popular have been the Southern European variety, with their penchant for teetering impossibly, before magically regaining their footing. Far less dramatic has been the act half a world away. Japan's show has been primarily for a closed, domestic audience. This has given the appearance of a more staid, controlled situation. Is it, or have we ignored this particular act at the risk of miscalculating its consequent perils?

Europe's fiscal fiascos were highlighted by the 2008 economic and financial crisis. Maastricht rules were for the most part reining in even the region's worst fiscal sinners. But Japan's story began much earlier. Back in 1990, on the strength of a long post-war growth cycle, Japan's fiscal picture was exemplary. Its debt-to-GDP ratio was 69 per cent, close enough to Europe's guidelines for sustainability, and net government debt was about as close to zero as possible. Others worried about Japan's ascendancy, and its rising global financial clout. The late 1980s saw Japan gobbling up prime assets across the planet, with no apparent end. It seemed Japan could do no wrong.

Recession jolted the good times. Japanese property -- seen by most as a no-lose investment strategy -- suddenly faced plunging prices. Lower demand shocked the globally-efficient multi-nationals and revealed a far-less-efficient layer of smaller businesses in the domestic and export supply space. This mix of events sent the financial sector reeling into a series of largely unsuccessful stop-gap measures. Meanwhile, the economy had to absorb the effects of an ageing population, a phenomenon that few developed economies had yet encountered.

As a result, Japan ventured into the ultra-low interest rate world, and is still there. A second response was wave after wave of fiscal stimulus. A quarter century on, this strategy has taken Japan from a model of fiscal management to a global Achilles' heel. The national debt-to-GDP ratio has ballooned to 245 per cent, and rising. By contrast, Greece's debt, at 175 per cent, is now in retreat, thanks to strict austerity measures.

Japan's net financial liabilities used to take it off the hook. However, they too have soared, and now stand well above Greece's, at 140 per cent, and rising. Many will argue that although these ratios seem impossibly high, the debt is mostly domestically owned, and thus not vulnerable to jittery foreign financial markets, currency fluctuations and the like. Analysts will also point to Japan's foreign net creditor position as an important source of capital. These arguments are credible, but debt levels this high still have significant effects.

First, the sheer volume of the debt consumes a disproportionate amount of available savings. Put another way, the need to service public debts is crowding out funds that might otherwise be used for private investments. It also calls into question future availability of funds. Eventually, according to IMF estimates, Japan's debt will rise to the level of total available savings -- suggesting a needed new foray into international markets.

Second, the debt mountain creates a huge vulnerability to the prospect of higher future interest rates. Low borrowing costs have long been the norm, but recently the spread on Japan's 10-year bonds against 10-year bunds has closed -- and it's not because bunds are falling. Something is happening at the long end of the market that could be suggesting a rising risk premium.

The scenario is precarious. Anything that interrupts current rhythm could distract the tightrope-walker, with serious consequences. So far, Japan has been able to skillfully manage its predicament, but it appears to be running out of time.

The bottom line? Revived global growth may be just in time to avert a high-wire accident. Growth helps -- but is no substitute for the structural changes that have turned things around in Southern Europe. This is one we'll be keeping our eyes on.


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