Japan is the most indebted country in the world, with public debt representing 213% of its GDP in 2012 (compared to 176% for Greece). Under these circumstances, one might wonder why the country is not being suffocated by its creditors.
Three characteristics that justify the sustainability of the public debt-to-GDP ratio
Firstly, Japan’s net financial assets represent only 85% of GDP. This is due to the large reserves set aside to finance citizens’ pensions.
Second, 95% of the debt is held by residents of Japan, compared with 70% in the United Kingdom, 47% in the United States, and 35% in Germany. Excess domestic savings are invested long-term in domestic assets, particularly government bonds (a preference for domestic securities commonly referred to as domestic bias). Furthermore, currency risk discourages non-resident investors from investing heavily in government bonds. Finally, private deleveraging (households and businesses) over the past 15 years has created a non-competitive situation between corporate and government bonds. As a result, the apparent interest rate (average annual interest divided by the amount loaned) is 0.8%.
Thirdly, the Japanese central bank has greater room for maneuver as it can more easily inject liquidity into the economy without fear of high inflation due to the deflationary situation of the economy. This point distinguishes it from the European Central Bank, for example.
These three characteristics make Japanese public debt solvent, but is it sustainable? Two constraints need to be examined.
First constraint: deflation
Japan is structurally subject to major deflationary problems, with negative inflation in 2010 (-0.7%), 2011 (-0.3%) and zero inflation in 2012 (0%). The central bank’s intervention rate is 0.1 percentage points.
In a difficult environment, the central bank can stimulate the economy by increasing the money supply. This increase is achieved by lowering the central bank’s key interest rate in order to encourage economic agents to invest their financial wealth. However, when rates are too low, economic agents will speculate and hold on to their monetary assets in anticipation of a rate increase (improving their returns). This mechanism, known as the liquidity trap, makes the demand for money perfectly inelastic and limits the increase in inflation.
Thus, excessively low interest rates in Japan have led to a deflationary spiral that has reduced the value of the currency and made it more difficult to repay debt at face value. The mechanism described here corresponds to the concept of « debt deflation » proposed by Irving Fisher. This deflationary mechanism increases the likelihood that Japan’s public debt will become unsustainable.
Second constraint: demographics
Even though the country has more than 127 million inhabitants, demographic issues are significant. The fertility rate is very low (1.39 children per woman) and the birth rate of 8.39 births per 1,000 inhabitants has fallen below the mortality rate (9.75 deaths per 1,000 inhabitants). Combined with very low immigration (only 1.75% of the population is foreign, compared to 5.7% in France, for example), Japan’s population is aging. At this rate, the country could lose more than 30% of its population by 2050 (all other things being equal).
The economic impact would be a decline in the savings rate, which has already fallen by 50% since the 2000s to 6% in 2012. Such a decline would likely increase the use of foreign assets by retirees and thus reduce the current account surplus.
In reality, this decline in household savings is offset by a decline in the investment rate and an increase in corporate savings. This increase should improve their profitability and thus maintain a current account surplus of 1% in 2013, thereby prolonging the rollover of public debt by resident investors.
The impact of the stimulus plan on Japanese public debt: higher inflation reducing real public debt
In this difficult context, Shinzo Abe, Japan’s new prime minister, has decided to implement an €87 billion stimulus plan. This project should stimulate inflation through planned investments and could lead to a reduction in public debt in real terms.
In addition, the BoJ (Bank of Japan) has revised its inflation target to 2% and has committed to an unlimited asset purchase program until this target is reached. The current program, worth more than €800 billion, will end in 2014. The BoJ has committed to continuing these purchases at a rate of €100 billion per month (80% short-term bonds, 20% long-term bonds), which could help refinance public debt over the next two years.
This monetary policy would have three effects. First, credit should pick up, even if the surplus reserves of Japanese financial institutions are such that doubts remain about the effectiveness of the BoJ’s action. Second, inflation should settle at 2% for the long term. Finally, the third effect would be a depreciation of the yen against other currencies. This exchange rate policy could boost Japanese exports, particularly to Southeast Asia, and be a source of growth (the trade balance contributed -0.8 percentage points to GDP in 2012, compared with an annual growth rate of 1.8% in the same year). On the other hand, the deterioration of trade relations with China and the risk of politicization of exchange rates with other currencies could offset the beneficial effects of the yen’s depreciation.
Beyond the effects on economic growth, the 2% inflation target should be achieved. In terms of the public debt-to-GDP ratio (see formula in footnote), 2% inflation, combined with economic growth of 1.2% in 2013 (IMF forecast for October 2012) and an apparent interest rate of 0.8%, would result in a coefficient of -1.4 (1 + 0.8 – 2 – 1.2) on the existing public debt stock (more than €8.4 trillion in 2012 at an euro-dollar exchange rate of 1.3). This calculation corresponds to a reduction in the real value of the public debt stock of more than €100 billion.
Conclusion
This analysis gives us a better understanding of how Japan can finance a high debt-to-GDP ratio. However, we must not overlook the imbalance in public finances, linked to a decline in tax revenues (due to a reduction in direct taxation over the past decade), which has had a much greater impact on the budget balance than public spending. Thus, beyond monetary policy and the new government’s stimulus plan, changes in taxation will remain a crucial issue in the coming years.
Notes:
Debt-to-GDP ratio formula:
2012 public debt / GDP = (debt stock / GDP) (1 + nominal interest rate – inflation – GDP growth) + (2012 budget deficit / GDP) = (debt stock / GDP) (1 + real interest rate – GDP growth) + (2012 budget deficit / GDP)
References:
Evelyne Dourille-Feer, « Les dessous de la dette publique japonaise » (The ins and outs of Japanese public debt), CEPII, October 29, 2012.
IMF: « World Economic Outlook, » October 2012.
