TOKYO — How much debt can an industrialized country carry before the nation’s economy and its currency bow, then break?
The question looms large in Japan.
Here, years of stimulus spending on expensive dams and roads have inflated the country’s gross public debt to twice the size of its $5 trillion economy — by far the highest debt-to-gross domestic product ratio in recent memory, and the biggest, in real terms, the world has ever seen.
Just paying the interest on its debt consumed a fifth of Japan’s budget for 2008. Yet, the finance minister, Hirohisa Fujii, suggested recently that the government would sell 50 trillion yen, about $550 billion, in new bonds — or more.
“There’s no mistaking the budget deficit stems from the past year’s global recession. Now is the time to be bold and issue more deficit bonds,” Fujii told reporters at the National Press Club in Tokyo. “Those who may call this pork-barrel spending — that’s a total lie.”
For jittery investors, Japan’s rising sea of debt is the stuff of nightmares: the possibility of an eventual sovereign debt crisis, where the country would be unable to pay some holders of its bonds, or a destabilizing collapse in the value of the yen.
Tokyo’s new government, which won a landslide victory on an ambitious (and expensive) social agenda, is set to issue a record amount of debt, borrowing more in government bonds than it will receive in tax receipts for the first time since the years after World War II.
“Public sector finances are spinning out of control — fast,” said Carl Weinberg, chief economist at High Frequency Economics in a recent note to clients. “We believe a fiscal crisis is imminent.” One of the lessons of Japan’s experience is that a government saddled with debt can quickly run out of room to maneuver.
“Japan will keep on selling more bonds this year and next, but that won’t work in three to five years,” said Akito Fukunaga, a Tokyo-based fixed-income strategist at Credit Suisse. “If you ask me what Japan can resort to after that, my answer would be ‘not very much.”‘
How Japan got into such a deep hole, and kept digging, is a tale of reckless spending.
The country poured hundreds of billions of dollars into civil engineering projects in the postwar era, marbling Japan with highways, dams and ports.
The spending initially fueled Japan’s rapid postwar growth and kept the Liberal Democratic Party in power for most of the last half-century. But after a spectacular asset and stock market boom collapsed in 1990, the country fell into a long economic malaise.
The Democratic Party, which swept to victory in August, promises to rein in public works spending. But the party’s generous welfare agenda — like cash support to families with children and free high schools — could ultimately enlarge budget deficits.
“It’s dangerous for the Democrats to push on with all of their policies when tax revenues are so low,” said Chotaro Morita, head of fixed-income strategy at Barclays Capital Japan. “From a global perspective, Japan’s debt ratio is way off the charts,” he said.
But Japan is rich in personal savings and assets, and owes less than 10 percent of its debt to foreigners. By comparison, about 46 percent of America’s debt is held overseas by countries such as China and Japan.
Moreover, half of Japan’s government bonds are held by the public sector, while government regulations encourage long-term investors like banks, pension funds and insurance companies to buy up the rest.
All of this makes a sudden sell-off of government bonds unlikely, officials argue.
“The government is just borrowing from one pocket and putting it in the other,” said Toyoo Gyohten, a former top finance ministry official and a special currency adviser to Fujii. “Although the numbers appear very fearsome, we have some leeway.”
Many analysts agree that during a recession, Japan should worry less about trying to cut debt. But they say Tokyo should at least concentrate on making sure that spending does not get out of hand.
“The government needs to stabilize the debt, first and foremost. Only then can it start setting other targets,” said Randall Jones, chief economist for Japan and Korea at the Organization for Economic Cooperation and Development.
A credible plan to pare down spending is important “to maintain public confidence in Japan’s fiscal sustainability,” said the OECD’s economic survey of Japan for 2009.
In the long run, even Japan’s sizable assets could fall and eventually turn negative. Japan’s rapidly aging population means retirees are starting to dip into their nest eggs — just as government spending increases to cover their rising medical bills and pension payments.
The fall in public and private savings could eventually reverse Japan’s current account surplus, possibly driving up interest rates as the public and private sectors compete for funds. Higher interest rates would increase the cost of servicing the debt, and raise Japan’s risk of default.
In a worst case, Japan’s currency could suffer as more investors switch away from Japan to other assets. And if Japan were to print more money and set off inflation to reduce its debt burden, the supply of yen would shoot up, lowering the currency’s value further.
In recent months, the yen’s surge on major markets as the dollar weakened has sent a false sense of security. The currency recently touched a seven-month high of about 89 yen to the dollar before easing slightly, as near-zero interest rates in the United States prompted investors to take their money elsewhere. Many strategists expect the yen to strengthen further, at least in the short term.
“In 10 or 20 years, Japan’s current-account surplus will fall into deficit, and that will lead to a weaker yen,” said Morita at Barclays Capital. “But if investors become pessimistic about Japan before that, the yen will weaken earlier than that.”
For all the recent talk of a shift away from the dollar as the reserve currency of choice, it is the yen that is becoming increasingly irrelevant, analysts say. The yen made up 3.08 percent of foreign currency reserves in mid-2009, down from 3.29 percent the same time last year and down from 6.4 percent in 1999. In mid-2009, the dollar still accounted for almost 63 percent of global foreign reserves.
“The yen is set to enter a long decline” in both stature and value as investors lose confidence in Japan, said Hideo Kumano, chief economist at the Dai-Ichi Life Research Institute in Tokyo.
Considering the state of Japan’s finances and economy, Kumano said, the yen’s recent strength against the dollar “isn’t an affirmation of Japan — it’s the yen’s last hurrah.”
How much debt can an industrialized country carry before the nation’s economy and its currency bow, then break?