Japan, the state that was heavily indebted, now has to pay interest

BarcelonaFor many years, Japan was an economic anomaly. For decades, the government of the Asian country has been the most indebted in the world, but despite this, it continued to issue debt without problems and place it in the markets, paying a ridiculously low interest rate, sometimes even negative. Now, however, the situation has changed and the Japanese state sees the cost of financing its debt rising ever higher. If this is already a problem under normal conditions, when a country has accumulated debt for so long, if it suddenly becomes more expensive, the headaches for economic authorities multiply.

In total, the Japanese state debt currently exceeds 204% of the country's gross domestic product (GDP, the indicator that measures the size of an economy), according to data from the International Monetary Fund (IMF). This means that to pay everything it owes, the state would need all the wealth that the Japanese economy produces in two years, and it would not be enough.

This data is very impressive on paper and shows a level of debt that might seem unsustainable at first glance. However, despite being the highest in the world, there are several elements that mean high debt is not a death sentence for a government.

Inflation and domestic investors

One factor to consider is that, in developed economies, a good part of the investors who buy treasury bonds are citizens of the country. That is, the weight of the domestic market is important, since bonds function both as a savings tool for individuals – in an industrialized country, government debt is considered a safe asset, with a very low risk of bankruptcy – and as assets for institutional investors, for example investment funds, pension funds or banks. This is also the case in Japan: 88% of the debt securities issued by the Japanese state are held by Japanese investors, according to estimates by the Bank of Japan. Japanese society, therefore, owes money to itself.

The second factor is inflation. In the 70s and 80s, Japan was the great emerging economic power in Asia and the world, similar to the role China plays now, but on a smaller scale. However, it became clear that part of the growth was the result of a cheap credit bubble. When the bubble burst in the early 90s, the economy stalled for almost thirty years and prices plummeted: In fact, deflation – the relatively infrequent phenomenon where the cost of living gets cheaper, another of the Asian country's economic anomalies – was the norm until the arrival of covid. The fact that inflation was low or negative did not force the government to adjust its interest rates every time it issued new debt, because the bonds did not lose value.

During the almost three lost decades, Japan was able to place its debt at a very low price on the markets, largely thanks to the fact that the Bank of Japan, the country's central bank, kept interest rates very low: when a country's central bank wants to reactivate the economy and make prices rise, it keeps the price of money low to facilitate credit.

For example, during several periods in 2016, as well as 2019 and 2020, the interest rates on a ten-year Japanese debt security were negative (see the graph). That is, despite being heavily indebted, the Japanese state received payment for issuing new debt, or, from the opposite perspective, investors paid the Japanese government to lend it money.

Change with the pandemic

This situation began to turn around with the reactivation of the global economy in 2021, when the pandemic was left behind and inflation affected the entire global economy, aggravated a year later by the Russian invasion of Ukraine and the resulting energy crisis. In 2022, Japan definitively left deflation behind and saw prices grow in some months at a rate of 3% annually, lower than in most advanced economies (in Catalonia it exceeded 10%), but at the same time unthinkable a short time before.

In this context, the Japanese central bank was forced to reverse its policy and increase rates to curb the escalating cost of living. This directly affected the yields on Japanese bonds. The interest rate on ten-year bonds began to climb and stood at 0.5% at the beginning of 2023, at 1% in the autumn of the same year and continued to rise to nearly 2.9% this week. From being a state with free debt, it is now approaching countries to which markets have traditionally treated them worse at forced marches. For example, the ten-year Spanish Treasury bond now pays 3.5% interest.

After years of knowing that Japan had low interest rates and low inflation, the fear in the markets now is that the central bank will be forceful enough with its policies to curb price rises, which further increases debt interest: investors fear that their assets will lose value if prices continue to rise. The rise in Japanese bond yields is "a reflection of market concerns that the Bank of Japan will not be able to raise rates faster," Katsutoshi Inadome, a strategist at the Japanese investment fund Sumitomo Mitsui Trust Asset Management, told Reuters.

However, this concern is not the only one analysts have about Japanese debt. Despite being the most indebted country, the new government of Prime Minister Sanae Takaichi, who took office last October, has promised to spend more than two trillion euros on investments over the next 14 years, which would further increase the country's already historic debt. Despite having clarified that ways would be found to finance this public spending without resorting to debt markets, investors do not fully find Takaichi's explanations coherent and continue to demand higher interest rates to buy government bonds.