Japan's debt mountain By Gillian Tett Published: October 26 2000 18:16GMT | Last Updated: October 26 2000 18:38GMT

A decade ago Japan's vast wealth inspired awe. During the 1980s the country collected the largest ever pool of private savings, estimated at an eye- popping Y1,200,000bn ($11,000bn).

Today Japan is setting records again - this time for public debt. By the end of the year, it is forecast that the government will owe about Y650,000bn, or 130 per cent of gross domestic product. Such a figure would be the highest level in the industrialised world, and twice the ratio of a decade ago, before Japan fell into economic stagnation.

One might imagine that the financial markets would be getting worried. To fund the government's spiralling debt, the ministry of finance this week raised its monthly 10-year bond issue from Y1,400bn to Y1,600bn. But the bond markets barely blinked. At Thursday's close, 10-year bonds were yielding a mere 1.85 per cent, the lowest rate among Group of Seven industrial countries. This suggests that demand is able to keep pace with the growing supply of debt, and that investors still consider Japanese bonds to be low-risk.

For an economy battered by bad news in recent years, this result comes as a deep relief. It is also welcome to other G7 countries, given that Japan's outstanding debt now equals more than 10 per cent of global GDP; jitters over Japanese bonds could destabilise global markets.

But how long can this calm continue? While other countries, such as Italy, have recently touched similar debt ratios, 130 per cent usually marks the peak of their problem. In Japan's case, given the current deflationary climate, low growth and rapidly ageing population, the worst may be yet to come.

According to the Organisation for Economic Co-operation and Development, the debt ratio could reach 150 per cent by 2004 (see chart). Economists such as David Asher of the American Enterprise Institute, a US think-tank, believe 220 per cent is more likely. And even if a "mere" 150 per cent figure is assumed, history shows few countries emerge from such indebtedness without experiencing default, devaluation or high inflation - or some other economic crisis.

"By all conventional indicators, Japan has breached the boundaries of sustainable fiscal policy," warns Mr Asher. "All other countries that have experienced similar balance sheet deterioration have eventually experienced a funding crisis."

What makes Japan's position so unusual - and the markets so hard to interpret - is that the country also has the largest pool of private savings in the world. This means that it has become one of the first countries to be able to fund nearly all its debt from within its own borders. A mere 5 per cent of government bonds are held by foreign investors, far lower than in other G7 countries. So as long as Japan's savers keep buying bonds, a debt burden of 130 per cent, or even 200 per cent, will not create a crisis. But if that changes, the consequences could be devastating.

"The issue is whether the Japanese people will have faith in their own government," admits one senior G7 official. "This is basically about confidence."

So far, as this week's bond auction shows, this confidence remains strong. In the current deflationary climate, investors have few other places to put their money. Equities are considered risky following the 1980s' stock market crash; and few investors will go overseas, given the recent gyrations of the yen against the dollar and euro. Consequently, over the last year as Japanese banks have cut corporate loans by Y34,000bn, they have placed Y32,000b n of these funds in government bonds.

But if the economy starts to improve, funds may flow into equities again and banks begin to lend cash once more. Or if investors fear that the yen is heading downward, or if inflation starts to pick up, they might move their money overseas. Then again, if a political crisis were to erupt, domestic investors might start to ask whether the government will ever be able to pay back all the money it has borrowed.

Optimists, such as Takatoshi Ito, a senior adviser to the ministry of finance, insist that it can. He argues that there are three reasons why Japan's situation is less alarming than historical comparisons might imply. First, net debt, at 45 per cent, is still low compared with the rest of the G7, because the government holds an unusually high level of assets. These include JGBs purchased by public institutions.

Second, Japan has room to cut the debt. Its tax-to-GDP ratio is very low and public spending high, compared with the OECD average. "Cuts in inefficient spending projects would not cau se a decline in overall productivity [of the economy]," argues Mr Ito, speaking in a personal capacity.

Third, as Japan's economy starts to recover, the country will be able to "grow" its way out the debt, as the US did in the last decade. "The growth potential of the Japanese economy is still large," Mr Ito argues. "Past and future structural reform will bear fruit."

These arguments convince some economists, such as Standard & Poor's, the US credit rating agency, which insists there is "no reason to be alarmist about the debt". But others are less convinced: Moody's, for example, has downgraded Japan twice.

Most economists suspect that the government has overstated its assets significantly, and understated liabilities; net debt may in fact be higher than official figures state.

Waiting for government-led fiscal consolidation also looks risky. The debt is rising so fast that the cuts needed to reverse the situation would have to be draconian: the OECD calcula tes that cuts of Y50,000bn, or almost 10 per cent of GDP, would be needed by 2010 just to stabilise the debt at about 150 per cent of GDP.

Many economists think the best way to achieve this reduction would be to tackle inefficient public spending. But half of Japan's Y85,000bn budget is spent on health and social security. And although government tax revenues are low, there is political reluctance to raise taxes - not least because when consumption tax was increased from 3 per cent to 5 per cent in 1997, the economy went into recession. "If we tried to raise consumption tax by 2 percentage points now, many politicians fear they would lose their seats," warns Yoshinori Ono, a politician in the ruling Liberal Democratic party.

Mr Ito's confidence about Japan's economic recovery can also be questioned. Most economists expect growth of about 2 per cent this year but prices are also falling by up to 2 per cent and the cost of debt servicing is rising. This implies that Japan will need a much faster rate of expansion or higher inflation to "grow out" of its debt. As Thomas Keller, of Moody's, says: "Two per cent growth is not enough."

For the moment, domestic investors are ignoring such risks. But the higher the debt burden rises, the bigger the economic pain any future rise in yields will cause. The worrying aspec t of Japan's savings pool is that it means the government does not face the sort of external pressure to act that the International Monetary Fund exerted on south-east Asia in the 1990s, or on the UK in the 1970s; or that the European Union exerted on Italy in the last decade . The pressure on Japan has to come from within. And thus far Yoshiro Mori, the prime minister, has shown scant commitment to reform.

This may change. Koichi Kato, a senior LDP politician who is a potential replacement for Mr Mori, told the Financial Times this week that he was determined to see radical reform. "If we don't change our policies, then a debt crisis will become a reality one day," he warned. But without external pressure or a market crisis, reform-minded politicians face a tough task getting into power. So while this week's calm in the bond markets may seem a blessing, if it allows the government to remain complacent, future historians may conclude that Japan's wealth was one of its greatest curses.

http://markets.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT3EGPPQSEC&live=true&tagid=ZZZR4COD20C&subheading=asia%20pacific%20equities

-- Carl Jenkins (Somewherepress@aol.com), October 27, 2000