News in Charts: Can Japan handle higher rates?

At 263% of GDP, Japan has by far the largest sovereign debt burden in the world. Half of the government bonds in that debt mountain belong to the Bank of Japan. What would happen if the market regained control of Japanese yields? Fathom expects borrowing costs would rise, and potentially by enough to exceed growth, meaning that primary surpluses would be needed to stabilise the debt level. That’s something we have not seen for many a moon in Japan.

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Japanese monetary policy and fiscal policy have been highly accommodative for two decades, in an attempt to break free of the low-growth, low-inflation environment that followed the financial crisis of the early 1990s. The Bank of Japan’s (BoJ’s) grip on government bond yields became much tighter with the advent of Abenomics in 2012. The central bank first ramped up targeted bond purchases and then, in September 2016, employed a policy called yield-curve control (YCC), which sees it conduct sufficient bond purchases to keep the ten-year yield around 0% and below 0.25%.^[1]

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With the central bank manipulating the yield curve, the release valve for the economy has been the yen, which has fallen almost 20% against the dollar and 10% against a broad basket of currencies this year. The BoJ has even stepped in here, announcing interventions to support the yen in September and October; and the yen has rallied recently on signs of inflation having peaked in the US.

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There was little sign of a structural break higher in inflation arriving, until now perhaps. October’s inflation release showed both headline and core inflation at their highest levels since the early 1990s, excluding the aftermath of the sales-tax hike in 2014. As in Europe, energy has been a key factor in the uptick in headline inflation. Perhaps more significantly for the BoJ, wage growth is moving closer to the 3% level seen by the central bank as necessary for sustainable achievement of its inflation target. Weakness in the currency has also added to inflationary pressures, raising inflation expectations, which may ultimately be the trigger for the Bank of Japan to tighten policy. It is worth remembering that core inflation remains far lower than in other G7 economies though, at 2.5%.

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BoJ Governor Kuroda insists that headline inflation will “decelerate gradually” to the 2% per cent target without policy tightening; but almost all economists polled by Reuters in November expected the central bank’s next move to be a tightening of policy. Fathom is concerned that the ultra-loose fiscal and monetary policy of the past decade has created vulnerabilities that could then come to the fore. For at least a decade, investors have known that there is a ready buyer for copious amounts of Japanese government bonds (JGBs), and that since 2016, that buyer has a public minimum price. That is not how markets work, and the aftermath of any change could leave Japan exposed to fiscal risks.

We estimate that over the period 2000–2015 a 1 percentage point rise in Japan’s debt-to-GDP ratio was associated with a 1 basis point rise in ten-year JGB yields, while a 1 percentage point increase in the BoJ’s holdings had the opposite effect. Were the BoJ to stop yield-curve control and keep its nominal level of JGBs constant, our best guess is that ten-year yields would rise by 40–50 basis points. Were it to stop yield-curve control and reduce JGB holdings by a third over the next 5 years, we believe the impact would be double that — and likely more, given higher expected policy rates.

What would rising yields mean for Japan’s debt sustainablity? The gap between a country’s cost of borrowing and its growth rate is critical to determining whether debt is on a sustainable path. With real growth above real borrowing costs, a government can run a primary deficit indefinitely. Low Japanese growth has exceeded even lower borrowing costs for most of the past decade, partly due to the BoJ’s actions.

Forward-looking, market-based measures of Japanese ten-year real rates are already only slightly negative (-0.6%), and that is with the BoJ surpressing upward moves in nominal rates. With Japanese trend growth running at between 0.5 and 1%, a rise in in real yields of more than 1 percentage point could thus create adverse debt dynamics. To put that possibility in context, UK and German ten-year real yields have risen by 2.5 and 1.4 percentage points so far this year. This scenario would put Japanese debt on an explosive path, without fiscal consolidation. Given that Japan has not run a primary surplus since the early 1990s, that should give pause for thought. Events in the UK this year should act as a wake-up call to others: being an advanced-economy currency issuer does not prohibit the possibility of a fiscal crisis if market sentiment sours.

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The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

[1].      The BoJ’s still targets a yield of 0%, but since March 2021 has allowed the ten-year yield to move in a range of +/- 25 bps from this level. The range had earlier been set at +/-10 bps.

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