Greece, China, Puerto Rico. Is Japan the next hotspot on the financial wall of worry? Probably not. But the world’s third-largest economy faces substantial challenges, and the reform program of Prime Minister Shinzo Abe, referred to as Abenomics, needs to accelerate.
Without a more forceful push to tackle public-sector debt, Japan’s strategy of stimulating stronger economic growth could stumble and deflation could once again bedevil what should be a key component of global economic growth. And the global economy needs a stronger Japan, considering that the recovery since the Great Recession has been fragile and uneven.
On July 23, the International Monetary Fund (IMF) warned that Japan’s debt is “unsustainable.” Unless the government takes more forceful measures, the IMF estimates that Japan’s public-sector debt as a percentage of GDP, which has stabilized around 250 percent of GDP, will resume its upward trajectory and be around 290 percent of GDP by 2030. Japan’s public-sector debt is already the highest by far of any advanced economy.
The IMF was very clear about its concerns:
Doubts about long-term fiscal sustainability could lead to a jump in the sovereign risk premium, forcing further fiscal adjustment with adverse feedback to the financial system and the real economy. Japan’s extremely high financing needs point to vulnerabilities to changes in market perceptions.
Part of the problem is that the Japanese government’s economic-growth projections are probably too optimistic. Moreover, the exchange rate, adjusted for trade and inflation, is moderately weaker than is consistent with the country’s economic fundamentals.
To be fair, Prime Minister Abe is working hard to change Japan, and his approach is decidedly pro-growth. Structural reforms are being pushed through the Diet, economic growth is up from 2014, corporate profitability is good, the Nikkei stock market is up in double digits, and there is even some traction in wages. The government has passed and is implementing a number of new laws on corporate governance, which have pushed a significant introduction of outside directors on boards (up 46.5 percent from 2014 over 2015), a more significant introduction of stock options, and a greater number of IPOs (Initial Public Offerings). Additionally, the government is seeking to improve the governance and management of the Government Pension Investment Fund, the largest pension fund in the world.
With an eye to stimulating more growth, the government in 2015 reduced the effective corporate tax rate from 35.64 percent to 33.06 percent. The Abe administration plans to reduce the rate down to the twenties in several years. Other measures include agricultural-sector reform, electricity market reform, and the creation of National Strategic Special Zones, which seek to take advantage of multiple exemptions from economic regulations.
On the fiscal front, the government reliance on debt (Japanese Government Bonds or JGBs) has fallen and tax revenues are up. In FY 2014, Japan’s tax revenues hit a twenty-one-year high of yen 54 trillion, which exceeded government expectations. Furthermore, Prime Minister Abe is seeking to cap spending growth over the next fiscal years at yen 1.6 trillion ($12.9 billion), excluding interest payments and grants to local governments.
While the IMF gives Japan credit on these fronts, it is not convinced that enough is being done on the debt front. Kalpana Kochhar, the IMF’s chief for Japan, stated that while debt risks “have been contained, we cannot assume this will continue.” Much of this points to concerns over the ability of the Japanese economy to grow at levels that help push along revenue collection and allow the government to continue to contain spending. It also believes that the central bank, the Bank of Japan, should be more accommodative to keep growth momentum and nudge up inflation.
The IMF is not alone in its concerns with Japan’s debt. In April, Fitch Ratings downgraded Japan’s sovereign rating from AA- to A+ (the same level as Israel and Malta). The main points of concern raised by the rating agency were the rising level of gross public-sector debt, the government’s commitment to maintaining the pressure on debt reduction in its budgets, and government reliance on economic growth (which could be a little too rosy). Fitch also had worries over the sustainability of corporate profit growth as it could be too extensively linked to the yen’s devaluation.
What has given Japan a break in concern from global investors is that the bulk of the country’s $8.8 trillion in debt (according to Bloomberg) is held by Japanese institutions, including banks and pension funds. This “sticky” money is not likely to be easily stampeded into selling off its JGBs. To be certain, there is a push to find higher-yielding assets on the part of Japanese asset managers.
This takes on a greater sense of urgency in the future as Japan’s demographics are negative and the population is set to decline considerably in the years to come. Ten-year JGBs with a 0.396-percent yield do not provide much income for a growing retirement community in Japan. As a greater number of higher-yielding items (which may not be high risk) are put on the menu, some of the stickiness of Japanese money could opt not to finance government debt.
The debt issue will not go away for Japan. Although the government has considerable assets to tap and the Abe administration has stabilized debt levels, medium- and long-term concerns are justified. At the same time, the authorities are caught in a position in which they do not feel that they can abandon a growth strategy and take a more aggressive austerity approach. Japanese policy makers are keenly aware of the impact of tough austerity measures in Europe. At the same time, they understand that fiscal control, matched with targeted growth measures, similar to what occurred in the United States and the United Kingdom, can have success. The major difference is that debt levels in the United States and the United Kingdom were far lower.
The Japanese economy is in a race between the need to increase economic growth, which seems to be gradually taking hold, and the pressing urgency to control debt. The Abe administration has stabilized debt, but there remains significant questions as to the sustainability of the commitment to that policy line. The IMF and Fitch are right to articulate their concerns and Japanese politicians and policy makers need to hear those views. Japan will not be part of the wall of worry in the short term, but the longer the bad debt situation continues, the more likely it is that we could face a “Puerto Rico” in the Pacific.
Scott MacDonald is the Head of Research for MC Asset Management Holdings, LLC, a wholly owned subsidiary of the Mitsubishi Corporation. He is the co-Author of the Forthcoming State Capitalism's Uncertain Future. The views are Expressed His own and not May Reflect Those of MC Asset Management Holdings, LLC, the Mitsubishi Corporation or Their Affiliates.
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