Japan's Fiscal and Monetary Solutions are Exceptionally Harsh

April 1, 2015Japanby East Asia Forum

Fiscal sustainability will come at a heavy price for Japan.

Japan is facing a dual problem of an ageing population and increasing government debt. While pension payouts will balloon out in the next decade, a low tax base means that the government will struggle to finance this. In 2013, Japan’s gross debt-to-GDP ratio was 243 percent, the highest among OECD countries. If the government does not implement strict reform, Japan risks a financial crisis similar to the European crash in 2009.

Whether or not Japan’s debt is actually sustainable depends in large part on whether the market believes that it is sustainable.  If the investors buying Japan’s government bonds begin to believe that they may default, then they will demand a higher rate of interest on government bonds, and those higher interest rates will make the debt even less manageable. In other words, a debt crisis could be a self-fulfilling prophecy. Japan’s government bonds have been steadily absorbed by markets and long-term interest rates have remained low. For now, it seems that market participants have confidence in the government’s ability to conduct fiscal management.

How long can these expectations sustain?

Social security expenditures are increasing by more than 1 trillion yen (US$8.2 billion) a year and that rate expect to continue over the next decade. Even if Japan’s zero interest rates continue, interest payments on government bonds project to increase by approximately 8 trillion yen (US$66 billion) over the next decade.

If market participants expect that the future yield on bonds will be significantly negative, they will likely stop buying them, and the government will be unable issue any new bonds. The government would need to run a primary surplus (that is, a budget that is in surplus if you ignore interest repayments) in order to pay back the debt it has already acquired.

The yield on government bonds has remained stable, if extremely low, but the fiscal situation in Japan seems to be extremely poor, with governments running persistent budget deficits. The present low yield on debt therefore does not automatically mean that Japan can avoid a fiscal crisis in the future. Market expectations can change dramatically in the space of just one or two years.

To prevent Japan’s debt from exploding through spiralling interest rates, the amount of net debt needs to be less than the future stream of primary surpluses used to pay it off. Japan’s net debt estimate is approximately 140 percent of GDP.  A primary budget surplus is necessary therefore to prevent an explosion. However,  Japan’s primary balance is currently negative and would remain so even if the consumption tax was increased to 10 percent.

So, as social security expenditures increase, Japan needs further financial and social security reforms, and the government needs to tackle the politically sensitive hurdle of cutting expenditure.

If market expectations change as a result of a political or economic shock and the yield on Japan’s government bonds rises to 4–5 percent, then Japan’s interest expenses — approximately 9 trillion yen (US$74 billion) — would increase four- or five-fold. While interest payments are slow to adjust to changes in rates due to the average length of government bonds, the impact of such a rise on finances would be prohibitive. If the yield on bonds increases to approximately 5 percent, then the government would need to run primary surpluses of around 5.2 percent of GDP in order to prevent a debt crisis.

Japan’s long-term interest rates are currently stable, despite an accumulation of government debt. There is an undeniable risk that a change in market expectations could cause the government bond bubble to collapse.

With this in mind, Japan must carry out fiscal restructuring immediately. The government needs to provide its people with three choices: a high level of welfare with a high financial burden; a medium level of services at a medium financial burden; or a low level at a low financial burden. If there is insufficient discussion on the overall framework, the reform process will collapse. The government needs to prioritise.

If the government pursues a ‘high welfare, high burden’ model, Japan must first debate whether curtailing the increase in social security expenditures is possible.  Japan’s financial responsibilities must be clear. A solution may include increasing the consumption tax rate to around 30 percent. But if the Japanese government is reluctant to increase the consumption tax above 8 percent and instead chooses the ‘low welfare, low financial burden’ route, it must reduce its expenditure by approximately 42.5 trillion yen (US$340 billion). Obtaining this figure can only happen by reducing the ever-increasing social security expenditures.

What about the ‘medium welfare, medium burden’ route?

Even in this scenario, it is highly likely that the consumption tax rate would have to increase to more than 20 percent. Over the next 15 years, the Japanese government must increase the tax rate by 15 percent and reduce government expenditure by 12.5 trillion yen (US$99 billion) to reach the effective 20 percent tax rate.

Japan must advance its social security reforms. It should increase the pension age and increase pension taxation. The government needs to increase the share of healthcare and nursing costs that are borne by the individual rather than the state. And it should strive to curtail the natural increase in costs that will occur over the next 20 years.

The cost of benefits currently exceeds the financial capacity to pay for them, meaning that there is no balance in the system. Genuine political leadership necessitates a debate on the overall framework. Politicians must consider the financial burden on future generations, while still helping people of the current generation. Japan’s politicians need to focus less on whether its fiscal strategy is popular and more on whether it is right.

How to solve Japan’s fiscal sustainability issues is republished with permission from East Asia Forum

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