Japanese debt: Bad, but not that bad!

How big is the Samurai debt?  Source: hg101.kontek.net/sumo/sumo.htm
How big is the Samurai debt? Source: hg101.kontek.net/sumo/sumo.htm

Government debt is mounting all across the developed world.  While Emerging Market countries such as China have low debt levels, and Brazil and India are beginning to grow out of their debts, the next crisis (or even the second half of this one) could be a fiscal shock — perhaps even a government bond default — in the industrialized world.  I’m talking about advanced countries with high credit ratings, which will experience sluggish growth and may fail to slash fiscal deficits over the medium term.  Greece may be a foretaste of what’s to come, unless reforms of public finances and efforts to increase growth potential are undertaken in earnest.

Japan’s fiscal woes predate the current crisis, going back to its lost decade of the 1990s.  No matter how you slice it, Japan’s government debt is unsustainably high.  Government debt is 200% of GDP, and GDP growth averages a sluggish 2% or worse in normal times.  Further, Japan seems to be under constant threat of price deflation, which is bad for debtors. 

Fitch Ratings prepared a nice report analyzing Japanese government debt (see press release below).  According to Fitch, Japan’s bond rating remains AA-, even though Japan’s headline government debt figure compares unfavorably with such highly-indebted advanced economies as Italy (AA-) and Belgium (AA+), whose debt/GDP figures are 115% and 98% respectively.  Yet Fitch does an exemplary job parsing the debt numbers to show that…it ain’t that bad.  The headline gross general government debt/GDP figure of 200% overstates Japan’s problem. 

First, Japan’s debt is held domestically.  Domestic savings have been higher in Japan than in most advanced countries. If you net out the amount of debt held by different levels of government, Japan’s debt drops to about 160% of GDP. A further 53% of government debt is held by  public institutions — the biggest one, Japan Post — yes that’s right, the Post Office.  Idiosyncratically, Japanese households deposit a good chunk of their savings at the government post office and these funds are invested in government debt.  A sizable portion of these funds go back to the private sector in the form of government loans to business.  Thus, Japan’s debt problem is a family affair.  It is between Japanese savers (households) and Japanese spenders (the government and business).  They have to work out who bears the burden of adjustment.

Likewise, Fitch points out that if you net out public sector assets, Japan is not such an outlier.  The OECD provides figures for what it calls governments’ net financial liabilities.  This figure subtracts from debt assets such as government deposits and loans to the private sector.  Japan compares more favorably here, with net government financial liabilities at 97% of GDP, the same as Italy and versus 81% in Belgium.  However, whether these loans to the private sector will be paid back in full is an uncertainty. 

Finally, the OECD figure does not include one major asset held by the Japanese public sector, over $1 trillion in foreign exchange reserves, derived from Japan’s persistent trade surpluses (automobile recalls notwithstanding).  This amounts to another 20% of GDP you can deduct from Japan’s debt burden.

In terms of the burden of the debt, the interest rate on Japan’s debt is low, making debt service less onerous than one would expect from the debt/GDP ratio.  Furthermore, with a relatively low tax burden — taxes in Japan were 32% of GDP versus the AA median of 41% — Japan has room to raise taxes to support debt payments in the future. 

The worry, however, is that any early tax hike would shut down GDP growth, which has been so sluggish for years.  Furthermore, Japan’s aging population suggests that the country’s high savings rate will decline.  Ergo, interest rates could rise in the future. 

Fitch suggests that the key to reducing the government debt burden in Japan is achieving higher GDP growth.  Under a scenario of 4% per year GDP growth, Japan’s debt/GDP would decline.  This will require structural reforms to improve growth potential and stave off price deflation.  Have a read…     

Fitch: Japan’s Sovereign Creditworthiness at Risk from Rising Government Debt   
22 Apr 2010 4:51 AM (EDT)

Fitch Ratings-Hong Kong/London/Singapore-22 April 2010: The Japanese government is one of the most indebted in the world. In the absence of sustained economic recovery and fiscal consolidation, government debt will continue to rise, placing downwards pressure on sovereign credit and ratings over the medium term, Fitch says today in a Special Report, “Just How Indebted Is The Japanese Government?”.

Japan’s headline gross government debt reached 201% of GDP by end-2009, the highest ratio for any sovereign rated by Fitch. Public debt sustainability is the central sovereign credit issue facing Japan, whose Long-term local currency Issuer Default Rating (IDR) of ‘AA-‘ is one notch below the Long-term foreign currency IDR of ‘AA’, uniquely among high-grade sovereigns. The lower local currency rating reflects the fact that all government debt is denominated in Yen and Japan’s net external creditor status. The ratings remain supported by low government debt yields, reflected in a budgetary debt service burden that is not especially high as a share of GDP, and by financing flexibility afforded by access to a large pool of domestic savings. The sovereign was a net external creditor to the tune of 15% of GDP at end-2009; but under Fitch’s forecast of rising government debt ratios, sovereign creditworthiness is set to deteriorate.

In the near term, the Japanese government’s funding prospects are further supported by ample banking-sector liquidity and by weak private-sector demand for credit. However, the slow but steady drop in the savings rate could eventually undercut the sovereign’s ability to fund itself domestically at low nominal yields, leaving it more exposed to interest-rate and refinancing risks. Fitch explored some scenarios for Japan’s public debt path using a simple debt dynamics model, and one possible development is that Japan’s government debt ratios could decline if positive nominal GDP growth were restored. However, upwards pressure on Japan’s ratings is unlikely without a sustained drop in government debt ratios consistent with a return to nominal GDP growth and meaningful fiscal consolidation.

The extent of Japan’s government indebtedness is often a source of confusion and conflicting statistics. On a broader measure, net general government financial liabilities reached 97% of GDP by end-2009; while still high, is not significantly more than other similarly rated sovereigns. However, the value and liquidity of the government’s financial assets is uncertain and on Fitch’s measure that only nets off currency and deposits; net government debt is estimated to be equivalent to 184% of GDP, still the highest of any rated sovereign. Fitch estimates the share of Japanese government debt owed to other public sector creditors at around 53% on the latest available numbers, including the postal savings and insurance systems, which partly mitigates concerns over the high level of the debt and reduces Japan’s exposure to ‘confidence shocks’. Nonetheless, on whichever measure is adopted, Japan’s government is amongst the most indebted and the key feature of previous rating downgrades – the adverse debt dynamics and steady rise in the debt ratio – remains the case, Japanese government debt will continue to rise bringing downwards pressure on Japan’s sovereign creditworthiness and ratings over the medium-term.

Applicable criteria ‘Sovereign Rating Methodology’, dated 16 October 2009, are available on http://www.fitchratings.com.

Contacts: Andrew Colquhoun, Hong Kong, Tel: +852 2263 9938; David Riley: +44 (0) 207 417 6338.

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