Japanese fiscal management dragged into the spotlight

February 26, 2010

foleyJane Foley is research director at Forex.com. The opinions expressed are her own.-

Perhaps the oddest side-effect of the  Greece debt crisis has been its ability to drag Japan’s budget into the spotlight.

There are so many differences between Greece and Japan that the question asked by at least one media report “is Greece the next Japan” sounds like a clumsy analogy.

For one thing Japan is not involved in a monetary union and has a flexible (and very liquid) currency.  That said, given that all governments will have to compete harder this year to place larger amounts of debt and since there are estimates that Japan’s gross public debt/GDP ratio could expand to beyond 200 percent this year and given S&P decision to lower the outlook on Japan’s sovereign credit rating to ‘negative’, it is easy to see why Japan’s budget is drawing attention.

Japan needs to commit itself to budget reform particularly given its ageing population.  A country’s demographics tend to shift at a slow pace meaning that politicians have been aware for decades that budget pressures will increase with the retirement of the baby-boomers.

This is a common theme in almost all industrialised countries though the problem is particularly acute in Japan.  Aware of the issues, there have been attempts by Japanese governments to tackle structural reform.

However, a prolonged period of slow growth in the 1990s (Japan’s lost decade) and again as a consequence of the most recent recession have thwarted progress.  Instead of cutting spending various Japanese governments have been forced to use stimulus spending in an attempt to shore up domestic demand and stave off deflation.

Not only does an older population increase the draw on health, welfare and pension schemes but it also changes the dynamics of the savings rate; pensioners tend to draw down savings.  This is of particular note in Japan where domestic savers make up the bulk of demand for Japanese government bonds (JGB).  Strong demand from a large pool of savers has helped pushed down the yields on Japanese bonds.

Understandably there are concerns that as the baby boomers retire, the savings ratio in Japan will lessen and yields on JGB will rise relative to yields on German bunds or US t-notes and treasuries.  Japan’s savings rate has been in rapid decline since the 1980s.

This is partly a function of the increased provisions stemming from government spending.  However, the gap over the US savings rate is now all but eroded suggesting a change in the demand dynamic for JGBs may be afoot.

All this is bad news, but unlike Greece, Japan is still a long way from crisis.  Some commentators have pointed out that Japan’s net public debt must be considered.  This is valid as once the government’s financial assets are considered, Japan’s debt is closer to 100% of GDP.  Since changes in the net debt basically equal the budget deficit (or surplus), this ratio is solid indicator of a government’s fiscal performance.

Not only that, but unlike Greece, Japan has the advantage of a flexible exchange rate – though the yen tends not to be driven by Japanese fundamentals.  The fact that so much of Japan’s debt is held domestically has afforded the yen with stability in times of global uncertainty.

This has made the yen a safe-haven which has hindered its ability to soften in reflection of Japan’s weak economic fundamentals.   While this is a concern to the Japanese authorities, it is reasonable to assume that the return of growth in 2010 to most countries will allow the yen to continue softening which will support domestic growth and lessen the pressures on the budget.

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