A load to bear

Reuters

Weighed down

IT IS one of the hottest shows in town. People queue up, replace their shoes with slippers, and enter a gymnasium where TV cameras are filming. What they have come to see looks like “Dragons' Den”, a popular TV show. But bureaucrats, not entrepreneurs, are the ones begging for cash to fund their pet projects. And politicians give the thumbs up or down.

This is budget-balancing, Japanese-style. The new administration of Yukio Hatoyama has come to office with big spending plans, which it intends to pay for by scrapping wasteful expenditures of the sort that, it says, helped keep its opponents in power for half a century. Judging by the TV audiences, the public is impressed. The trouble is that Japan has a fiscal hole likely to approach 10% of GDP next year, or about ¥50 trillion ($500 billion). Such gestures are like using a toothpick to fill it in.

That means the government may need to issue more bonds next year to bridge the gap, unless there is a strong pickup in growth or the government abandons some of its spending pledges. The prospect of more borrowing has spooked the government-debt market recently. The jitters reflect the sheer size of Japan's public-sector debt, which next year is expected to be twice as big, on a gross basis, as the country's GDP. On a net basis (offsetting the government's financial assets), it is smaller but still among the highest in the OECD.

As bond yields edged higher recently, several Wall Street banks issued warnings about potentially crippling debt-service costs. Their case was strengthened by evidence of mounting deflationary pressures and expectations that Japan, with its shrinking population, will be unable to grow fast enough to pay down its debt.

JPMorgan, for instance, has calculated that even if ten-year yields on Japanese government bonds rose by just one percentage point over the next decade (and the fiscal deficit increased each year as a result of social-security and other payments), the government's debt-service costs would triple because of a steadily rising stock of debt. It also said that an ageing-related decline in household savings might lead to a current-account deficit by 2014. That could make Japan more dependent on foreigners for its borrowing needs.

Even the bears acknowledge that there is scant likelihood of Japan blowing up in the short term. There are several reasons to remain calm, notably the remarkable loyalty of Japanese debtholders over the past 15 years. By some estimates more than 93% of Japanese debt is held domestically, which means that the government need never default because it could simply print money to pay the debt off.

This home bias also helps explain why, though the stock of debt is huge, debt-servicing costs as a percentage of GDP have been relatively low compared with Japan's OECD peers (see chart). Even at the peak of their recent run-up, ten-year Japanese-government bonds only yielded a miserly 1.43%, but in a deflationary environment they were still attractive to Japanese investors in real terms. What's more, the government is the world's largest creditor, with plenty of foreign assets to sell. And Japanese citizens are sitting on another {Yen}1,410 trillion of financial assets. These comfortably exceed the government's debt. As a last resort they could be heavily taxed if the government ran into trouble.

Japan would, indeed, become more exposed to foreign creditors if the current account were to slide into deficit, but that is unlikely unless the world economy takes a turn for the worse and oil prices soar—two things which are unlikely to happen simultaneously. More likely, a worsening current-account balance would weaken the yen, which hit a 14-year high against the dollar on November 26th.

The problem is that even those who remain relaxed about Japan's debt are deeply pessimistic about other aspects of the economy. Deutsche Bank talks of an “iron hexagon” comprising a fiscal deficit, current-account surplus, yen appreciation, falling prices, low nominal interest rates and economic stagnation. “The most realistic path for the Japanese economy is not a crash but a sustained decay or hibernation,” writes Mikihiro Matsuoka, its chief economist in Japan.

Hibernation is nothing new. Nominal GDP has increased at an annual rate of 0.1% since 1991. In the third quarter GDP grew at a quarterly rate of 1.2% in real terms, the fastest growth in the G7, but in nominal terms, as a result of the pernicious effects of deflation, it fell by 0.1%. Deflation creates other headwinds. It means real interest rates are abnormally high for a country just emerging from a crunching recession. As long as it persists, the debt-to-GDP ratio will get steadily worse.

That suggests the authorities should take drastic steps to reflate the economy, jolting it out of its stupor and weakening the currency. Yet bizarrely, the Bank of Japan seems to think its credibility is more at risk from reignited inflation than from the stigma of mild deflation. Provided there is no downward spiral in prices, it believes the economy will eventually heal itself.

The Hatoyama administration has barely begun to consider how to prolong the recovery, let alone pay down debt in the long run. It only inserted an “economic growth strategy” into its election manifesto as an afterthought. Analysts believe it is too worried about winning upper-house elections next summer to do anything but pussyfoot on economic policy. Japan needs stimulus in the short term and credible plans for fiscal retrenchment in the long term. At the moment it has neither.