By Desmond Lachman
Barely six months after its launch, something seems have gone awry with Abenomics, Japan’s bold new economic policy experiment to kick start the ailing Japanese economy. For, despite its early successes, rather than bringing down long-term government borrowing rates as intended, Abenomics seems to be increasing those borrowing rates. And this increase in government borrowing costs is now raising serious questions as to whether Japan might not be well on the road to a full blown public debt crisis.
For much of the past two decades, since its property and credit market bubble spectacularly burst in 1989, the Japanese economy has languished in a deflationary trap. Falling consumer prices have inhibited households from spending today on items that they might acquire more cheaply tomorrow. This in turn has prevented the Japanese economy from fully recovering, which has had the effect of causing consumer prices to keep falling.
The Abenomics approach
The essence of the bold economic program announced in December 2012 by Shinzo Abe, Japan’s newly elected prime minister, was to finally break the country’s vicious deflationary cycle by the boldest of monetary policy action. Henceforth, the Bank of Japan was to credibly commit itself to the attainment of a two percent inflation target, which was to be achieved within the next 18 months.
To give credibility to its inflation commitment, the Bank of Japan announced that through the end of 2014 it would purchase as much US$70 billion a month in Japanese government bonds and selected private sector assets. Considering that the Japanese economy is around a third of the size of that of the United States, the Bank of Japan’s policy action is very much bolder than the corresponding US$85 billion a month bond buying binge by the Federal Reserve under its QE3 program announced last September.
The initial results of Abenomics have been encouraging and have provided the basis for the Bank of Japan to now forecast a meaningful Japanese recovery in 2013. In response to the prospect of massive money printing by the Bank of Japan, on a scale that has no historical precedent, since December 2012 Japanese stock prices have risen by over 50 percent while the Japanese currency has depreciated by more than 20 percent. This has caused both a marked improvement in consumer confidence and has given rise to a significant increase in long-run inflation expectations. Whereas at the start of the year, the difference between 5-year inflation adjusted and non-inflation adjusted bonds suggested that the market expected no Japanese inflation, by May 2013 the market was expecting that Japanese prices would rise by around 1-3/4 percent a year over the next five years.
The initial results of the Abenomic program would be cause for true celebration if they did not also have the unintended consequence of drawing the market’s attention to the appalling state of Japan’s public finances. However, seemingly this is now occurring as markets have begun to question the logic of holding Japan’s very low yielding government bonds knowing full well that the Japanese government is intent on cheapening the country’s currency and on reigniting domestic inflation through an unprecedented policy of massive money printing. The incipient loss of market confidence has been reflected in a more than doubling in the 10-year interest rate on Japanese government bonds from a low of 0.4 percent in April to its present rate of over 0.9 percent.
The prospect of a further loss of investor appetite for Japanese government bonds would not be so serious were Japan’s public finances in reasonable shape. In truth, however, it is difficult to conceive of a worse state of public finances for the country. Japan’s government still has to finance a budget deficit of around 10 percent of GDP at at time that its gross public debt amounts to close to 240 percent of GDP, or almost 2 1/2 times the corresponding public debt ratio for the United States.
Compounding the dire state of Japan’s public finances is the fact that Japan’s population is now aging at by far the most rapid rate among the industrialized countries. As a result of this aging, Japan’s domestic saving rate is already now declining at a rapid rate, which will make it increasingly challenging for the government to continue financing itself at very low interest rates.
The Bank of Japan could very well soon find itself faced with a terrible dilemma. If it does nothing about rising government long-term interest rates, Japan’s government finances would appear to markets to be all the more unsustainable and Japanese banks would suffer increasing losses on their large portfolio of Japanese government bonds. If, on the other hand, the Bank of Japan were to step up its policy of bond purchases to keep the government’s long-term borrowing costs low, it would very likely accelerate the pace of Japanese yen depreciation and increase inflationary expectations. Such a course would make investors even less willing to hold those bonds which would require yet another round of Bank of Japan buying.
Needless to say, being the world’s third largest economy means that developments in Japan have very important implications for both the global and the US economic outlook. This is yet another reason that one has to hope that Japanese government bond holders do not lose confidence in Japan’s very compromised public finances anytime soon.
American Enterprise Institute (AEI) resident fellow Desmond Lachman previously served as director in the International Monetary Fund's Policy Development and Review Department. He was also a managing director and chief emerging market economic strategist at Salomon Smith Barney.