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Will Earthquake in Japan Trigger Country's Debt Problems?

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Japan has many serious problems, but the lack of ways and means to finance public deficits and debts related to disaster reconstruction is not one of them.

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Observers have been warning for many years that Japan's public debt levels -- that now surpass 200% of GDP – are "unsustainable." In this context, many economists and financial analysts are wondering whether the enormous prospective cost of Japan's recovery and reconstruction from recent disasters could detonate a sovereign debt crisis in the Nipponese nation. At the very least, many analysts are concerned that Japan's enormous levels of public debt will act as a major impediment to its ability to economically recover from the disaster.

How Large Is Japan's Public Debt?


The issues surrounding Japan's public debt are not well understood.

First, much of Japan's gross debt is intra governmental. This means that the governmental debt of one agency of Japan's government is held by another governmental agency as an asset. Thus, due to the fact that intra governmental debts and assets net out to zero, the gross value of intra governmental debt needs to be subtracted from Japan's public debt when calculating relevant debt to GDP ratios.

Second, the government of Japan holds massive amounts of domestic financial assets in the form of loans, bonds, and equities. These are earning assets that offset not only the stock of gross liabilities itself, but the costs of carrying those liabilities.

Third, Japan's central bank holds over 1 trillion USD worth of foreign currency assets which amounts to roughly 20% of GDP. Again, there are earning assets that generate revenue for the Japanese government, thereby offsetting the cost of carrying gross debt.

Fourth, Japan's government holds substantial non-financial earning assets such as toll roads (that were often acquired with deficit spending). These assets not only offset the value of gross debt, but actually pay for the gross debt that was used to acquire them.

Finally, Japan's government holds substantial non-earning assets such as land and buildings that need to be accounted for when considering Japan's financial position.

If we net out intra governmental holdings and the financial assets held by the central government, Japan's net financial liabilities amount to slightly more than 100% of GDP. The net financial liabilities held by the Japanese government, including the foreign currency assets of the central bank, add up to around 80% of GDP. Accounting for non-financial earning assets would bring the net liability figure down into the 70% range. And if the value of non-earning public assets held by the Japanese government were fully accounted for, the total value of Japan's net liabilities becomes almost negligible.

Is Japan Really Debt-Constrained?

Japan's public debt as a percent of GDP is usually cited as being over 200% in the media. This is the basis for the claim that that Japanese public debt is "unsustainable."

However, as we have just seen, the true level of Japanese public indebtedness is radically different from that which is commonly cited. Even if we only focus only the net financial liabilities held by the Japanese government, including the foreign currency assets of the central bank, this adds up to around 80% of GDP. This figure compares favorably to the average debt levels of the countries that make up the EU and is only moderately higher than the comparable figure for the US.

To put this into further comparative perspective, consider that according to the OECD, Japan's government paid net interest of around 1.1% of GDP in 2010. The comparable figure for the US is over 50% higher, while the debt interest burden as a percent of GDP in Europe is more than double the Japanese figure.

Notwithstanding the favorable international comparisons, one may still ask: Is Japan's debt level actually sustainable in absolute terms? Yes. There should be no question about it.

Given that its public net interest burden as a percent of GDP is currently around 1.1% and that Japan should be able to comfortably sustain a nominal GDP growth rate of 3%-4% with low real interest rates over time, Japan's government could not only sustain its current level of debt for a long period, it could comfortably increase it. And it could increase it very substantially.

The Japanese government's ability to engage in major disaster-related deficit spending that would substantially increase its stock of public debt from current levels is greatly enhanced by the way in which Japanese public debt is financed. 94% of Japanese public debt is held by Japanese nationals. This means that for virtually every yen of Japanese public debt, there is a corresponding yen worth of savings assets held by thrifty Japanese investors. This essentially means that the Japanese economy has no debt problem whatsoever, on aggregate. Furthermore, the way in which the Japanese tend to hold their savings is structured in such a way that there is little or no danger that local investors will sell their holdings of Japanese public debt to a degree that would cause significant rises in interest rates in Japan.

Perhaps the most important fact to understand about the ability of the Japanese government to finance disaster related deficits and debt is that the Japanese yen is a fiat currency issued by the Japanese central bank. As such, there is scant possibility that the Japanese government will ever have trouble financing and/or servicing virtually any amount of deficits and debt. If the need were to arise, new public debt issuances could always be financed directly or indirectly through Japanese central bank asset purchases. Furthermore, the Japanese central bank, through its control of interest rates as well as its ability to conduct open market operations can manipulate the money supply and inflation rate in such a way that insures that Japan's government debt can always be comfortably serviced.

It should not be forgotten that inflation increases the nominal value of tax revenues that the Japanese government can tender as payment for the debt, while the principal value of the existing stock of debt and its interest payments remain constant. Thus, it is important to keep in mind that the Japanese central bank will always have the power, if needed, to help the Japanese government service its debt through the mechanism of inflation.

Finally, any lingering doubts about the ability of Japan to sustain and even substantially expand its current stock of public debt can be assuaged by consulting one further statistic: Yield on 10 year Japanese government bonds: 1.22%. This extraordinarily low level of interest rates, in the context the very deep and liquid market for JGBs, shows clearly that the Japanese government enjoys considerable scope to engage in high levels of disaster related deficit spending.

Conclusion

The Japanese nation has many serious problems. The lack of ways and means to finance public deficits and debts related to disaster reconstruction is not one of them.

That is not to say that the Japanese are not and will not experience problems related to the earthquake-related disasters. What I have demonstrated in this essay is that, contrary to widespread popular beliefs, Japan is not in any imminent danger of experiencing a sovereign debt crisis. Furthermore, it should be clear that the current level of public indebtedness in Japan does not pose any substantial impediment to the nation's ability to finance reconstruction efforts.


Lasting through April 15, 100% of the donations made to The Ruby Peck Foundation for Children's Education will be channeled to the children of Japan as they attempt to find their footing following this natural disaster; and to kick off this drive, we'll pledge $5000 to get it started. Please do what you can, as it will add up, and thanks.
No positions in stocks mentioned.
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