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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a senior fellow at the Brookings Institution, former chief economist at Institute of International Finance and chief FX strategist at Goldman Sachs
Japan has long had an astronomical level of government debt. Yet government bond yields have been low for much of the past decade, which has given rise to the dangerous delusion that all this debt isn’t a problem. Japan’s recently announced fiscal stimulus, which new prime minister Sanae Takaichi hopes will differentiate her from her predecessor, is the latest manifestation of this issue.
Here’s the thing. Japan’s huge debt burden is real. Low interest rates are not. Government bond yields have been kept artificially low by the Bank of Japan, which has prevented yields from rising to market-determined levels through a combination of massive bond buying and its one-time yield curve control programme of capping rates at target levels.
All this was fine until the Covid-19 pandemic came along. The inflation surge in its wake saw central banks around the world hike policy rates and shift from quantitative easing programmes of asset buying to support economies and markets to quantitative tightening.
Those actions caused long-term government bond yields all around the world to rise sharply, except for Japan where the exceptionally high level of debt meant bond yields had to stay capped. What ensued was a spectacular depreciation of the yen against every major currency as interest rate differentials moved sharply against Japan.
In effect, Covid ended Japan’s yield capping experiment, because it vaulted the world into a high interest rate equilibrium. If you persist in capping yields in such an environment, you risk your currency going into a scary depreciation cycle.
All this highlights a key thing. Yield caps don’t make a country’s high debt problem go away. They just morph what would have been a crisis in the bond market into a currency crisis.
The scale of yen depreciation since Covid has deeply unsettled Japan. At one point in 2022, the Ministry of Finance was intervening to prop up the yen, even as the BoJ was still capping yields, which was doing the opposite. That’s a truly remarkable degree of policy incoherence and speaks to just how stumped Japan’s policy consensus had become.
This period of befuddlement has given way to acceptance that yields need to be allowed to rise. To give one example, the yield on 30-year government bonds is up from 0.7 per cent at the end of 2021 to 3.3 per cent now.
That’s a massive change and the BoJ deserve huge kudos for managing this transition smoothly. But it’s also true that the 30-year yield remains far below where it would be if markets were free to set it.
The easiest way to see this is to look at the gross government debt of key advanced economies and 30-year government bond yields. Japan’s yield is the same as Germany. This is despite the fact that German debt is far below that of Japan. Japan’s yields are still nowhere near market levels given the BoJ is still a large buyer of bonds on a gross basis.
Where does all this leave Japan? If Takaichi really wants to make her mark in government — especially in an era of elevated geopolitical uncertainty where spending needs may be large — it’s time to face up to the hard truth that Japan has maxed out on its available fiscal space.
The only way to sustainably stabilise the yen and ensure a level of interest rates that promotes solid growth is to raise taxes, cut spending or sell some of the government’s abundant assets, which includes privatising state-owned companies.
Japan’s net debt — after netting out all the government’s assets — stands at only 130 per cent, far below the gross number. Japan get’s no credit for this much lower number, because no one in markets believes assets will ever be sold on any meaningful scale due to the power of vested interests. Much can be done to right the ship. But that requires the new prime minister to make a true break with the past.
Even a small signal in this direction from Takaichi would go a long way. That’s because markets are currently uniquely attuned to the growing risk that governments around the world may ultimately try to inflate away unsustainably high debt levels.
This is what’s behind the “debasement trade” which in recent months has driven the crazy bubble in precious metals and diverted lots of flows into government bonds of low-debt countries like Switzerland. If ever there was a time to surprise markets positively and reap huge benefits, that time is now.
