Japan's Debt Challenge

Three major global credit rating agencies currently place Japan on a negative watch. How would a downgrade in Japan’s credit rating affect the nation’s ability to borrow?

A downgrade in Japan’s credit rating would likely have little or no effect on the country’s ability to borrow. The bulk of Japanese government debt is held domestically by public entities, including the Bank of Japan (BOJ) and government trust funds; financial institutions (banks, insurance companies, and securities firms); and households. None are as sensitive to credit ratings as are foreign financial institutions.

Breaking down incentives by type of investor reinforces the point. Starting with public entities, trust funds are limited in their choices regarding investments even where choices are formally separate from the Ministry of Finance’s Fiscal Investment and Loan Program. While it is true that there are limits to the amount of new money coming into trust funds (e.g., postal savings), it is hard to imagine that trust funds will decrease their holdings of Japanese government bonds (JGB).

For the BOJ, meanwhile, the purchase of JGBs is a core element of monetary policy in this era of quantitative easing; to stop purchasing large amounts of JGBs would run counter to the institution’s declared monetary policy aims. Some analysts have suggested that the BOJ could at some point stop increasing its holdings of JGBs based either on the need to maintain the integrity of its balance sheet or due to the limitations of the “Banknote Rule,” which limited BOJ holdings of JGBs to the amount of currency in circulation. These are weak limits, however, insofar as balance sheet quality is self-defined and the Banknote Rule is not legally binding (and in practice was abandoned in fall 2010). Further, the political implications of the BOJ stopping its JGB purchases would be enormous—whatever might be gained in credibility would be swamped by the adverse reactions of political leaders.

Other domestic investors also have little incentive to stop purchasing or to move out of JGBs. Banks, for example, have no good options in an environment of low corporate credit demand and growing deposits. As long as domestic investors are not leaving the JGB market, the price of debt will remain stable and foreigners will have no incentive to reduce their holdings unless they expect a significant depreciation of the yen.

Japan’s government debt currently exceeds 200% of the country’s GDP. What measures can the government take to reduce the current level of public debt while continuing to finance post-quake reconstruction efforts?

It is not possible to simultaneously reduce the current level of public debt without creating a serious recession, if at all. Japan’s central government is currently running fiscal deficits in the neighborhood of 8% of its GDP. It is just not feasible to cut deficits by that much in a short timeframe—even the disastrous Hashimoto fiscal consolidation efforts of 1997 did not go that far. Even if the Japanese government did somehow manage to stop the growth of debt (the numerator of the debt-GDP ratio) quickly, the shrinking of the GDP (the denominator) would mean that the ratio would not level off.

The only way to think about debt reduction is as a longer term process. Japanese policymakers need to figure out a way to reduce the primary deficit (i.e., not including debt repayment) over a period of five years or so without inducing new recessions. After that, an extended period of surpluses will slowly eat away at the debt. Economic growth is also important, since the relationship between the size of the economy and the size of the debt is crucial to the ability to repay. Unfortunately for Japan, most analysts predict that the aging of society and the concomitant shrinking of the labor force will restrict the country to a trend growth rate of around 1%–1.5%. This means that Japan is not likely to be in a position to simply grow its way out of debt—one way or another, debt reduction will be essential.

To return to the short term, the Japanese government should move quickly to address the damage caused by the triple disaster. Such action will get more Tohoku residents back to work and will have a short- to medium-term stimulative effect on the Japanese economy as a whole. The fiscal stimulus will be limited, as most of the supplemental budgets are being funded through reducing spending elsewhere, but providing productive employment, not to mention housing and services, for Tohoku residents will have a significant positive effect regardless.

The Democratic Party of Japan (DPJ) has decided to raise the consumption tax to 15% by 2016. How do you see Japan addressing the challenge of increasing the consumption tax, and what measures should be taken to reduce public resistance to the tax increase?

Promising to raise consumption taxes has consistently been one of the best ways to lose votes in Japan. I think it will be very difficult to make such a program attractive to the public. Probably the only way to make consumption tax hikes palatable to voters would be if the DPJ could secure LDP (Liberal Democratic Party) support for the tax hike—at least that way, voters would be mad at both parties. I am skeptical that the LDP would play along, however. Perhaps the best argument to be made in favor of such a scenario is that LDP leaders know that they will need to do the same thing when they return to power and so will calculate that it is worth supporting the DPJ’s efforts so that they do not have to take the blame themselves. But I am not holding my breath.

In the long run, the logic of shifting reliance away from income and corporate taxation toward consumption tax remains as strong as it has been since Ministry of Finance bureaucrats started advocating such a tax in the late 1970s. A consumption tax reduces volatility in tax collection (particularly in contrast to taxes on corporate profits) and is easy to administer. Most importantly, in Japan’s aging society, it is the best way to ensure that the entire tax burden does not fall onto the nation’s dwindling workforce.

That said, the short run carries its own economic risks. As many observers have argued, taxing consumption when it is already weak raises the likelihood of further declines. That certainly was the lesson of 1997. Those effects can be mitigated to some extent—first by balancing consumption tax hikes with tax reductions elsewhere (i.e., making the change revenue-neutral, at least in the short term), and second by phasing in the increase slowly. I like the idea of a 1% increase per year over the next ten years, which creates incentives for consumers not to postpone purchases while also not overwhelming them with price increases. The DPJ plan strikes me as too fast, too soon, but at least it follows that basic logic.

Domestic households are one of the Japanese government’s chief sources of funds to finance its debt. With Japan’s population decline, how will the government continue to fulfill its debt obligations as total household assets decrease?

It will undoubtedly become more difficult over time for the Japanese government to finance its debt obligations. That is one reason why the Ministry of Finance has been trying to market JGBs to foreign investors for more than a decade. But this is not a near-term problem, given that Japanese households and financial institutions have relatively few good alternatives to government debt for the moment. In the longer term, the key will be improving growth and reducing debt.

Why do you think that Japanese politicians have been unwilling to create and agree on a comprehensive long-term solution for reducing the level of government debt?

My starting point is that Japanese voters have the same appetite for benefits and the same distaste for taxes that we see elsewhere in the world. In a slow growth environment, the effects of those preferences are much worse.

The situation is made worse in Japan by certain aspects of the political system. Fundamentally, the Japanese political system has a very large number of “veto points.” These can be found within the Diet, the political parties, and the bureaucracy. In the period of high-speed growth, the rapid growth of both the economy and tax revenues meant that those regions or sectors that were relative losers could be easily compensated through transfers, public works spending, and subsidized lending through policy banks (including financial institutions oriented toward farmers, housing, small- and medium-sized enterprises, and depressed regions). In the face of twenty years of slow economic growth, it has become much harder to compensate losers, and those who are not compensated are much more aware of the impact on them. Thus, veto points have reappeared as a serious obstacle to fiscal policy reforms. Compensation politics was the grease for the policymaking wheels in Japan and we are seeing the results of the loss of lubrication.

At this point, the incentives for cooperation both within and between the DPJ and LDP are limited. Parties and factions opposed to the prime minister have no incentive to cooperate in imposing policies that will cause pain to key constituencies, as they jockey to dislodge the current leadership. While I don’t personally see the allure of thwarting leaders in order to take over an increasingly dysfunctional government, Japan’s politicians appear willing—if not eager—to do so. The fact that even the triple disaster of March 11 was not enough to induce effective cooperation on reconstruction makes me more pessimistic about Japanese government than I have ever been.

William W. Grimes’s book Currency and Contest in East Asia: The Great Power Politics of Financial Regionalism (2009) was awarded the 2010 Masayoshi Ohira Memorial Award.

This interview was conducted by Chris Acheson, a graduate student at the London School of Economics, and produced by the Japan-U.S. Discussion Forum, NBR’s public email forum on Japanese affairs.