Dealing with National Debts-A Pricky Issue

Question:

How much debt can an industrialized country carry before it ravages its economy and the nation’s currency?

Right now, that question looms large in the United States, as a surging budget deficit pushes government debt to almost 50 per cent of gross domestic product. In Europe and developing Asian nations like India,it has also become a major concern. But it looms even larger in Japan.

Let us look at the Japanese scenario.

Gross public debt mushroomed during years of stimulus spending on expensive dams and roads. In 2009,it passed 187 per cent of Japan’s economy.

This debt could soon reach twice the size of the US$5 trillion (RM17 trillion) economy — by far the highest debt-to-GDP ratio in recent memory — and the biggest, in real terms, the world has seen. Just imagine,Japan’s outstanding debt is as big as the economies of Britain, France and Germany combined.

Now, in this testy time, a new government in power, has promised yet another ambitious social agenda; to issue more debt this year than Japan has ever issued in a single year. Yesterday, Finance Minister Hirohisa Fujii said the government would sell a record ¥50 trillion (RM1.9 trillion) or more in new bonds this fiscal year to meet a budget shortfall he attributed to the fallout from the global financial crisis.

Japan has pumped about 3 per cent of its economy into stimulus measures aimed at easing the country’s economic slump, the worst among the most developed countries.

“There’s no mistaking the budget deficit stems from the past year’s global recession. Now is the time to be bold and issue more deficit bonds,” Fujii told reporters at the National Press Club in Tokyo. He indicated that tax income for the year could fall below ¥40 trillion, more than ¥6 trillion less than previously expected, as companies continued to suffer from the global recession. For the first time since the chaos of World War II, Japan will issue more in new government bonds than it will receive in tax receipts.

Still, “those who may call this pork-barrel spending — that’s a total lie,” Fujii said.

For jittery investors, Japan’s growing debt raises the nightmarish prospect of a sovereign debt crisis, a currency meltdown or both. Fujii’s remarks raised concerns of a supply glut in bond markets, sending yields on 10-year Japanese government bonds to their highest level in six weeks.

“Public-sector finances are spinning out of control — fast,” said Carl B. Weinberg, chief economist at High Frequency Economics, in a recent note to clients. “We believe a fiscal crisis is imminent.”

Japan’s troubles also demonstrate how a government saddled with debt can quickly run out of room to maneuver. Plunging tax revenue, anaemic growth prospects and the costs of caring for a rapidly aging population have tied the government’s hands in terms of any workable solutions.

“Japan will keep on selling more bonds this year and next, but that won’t work in three to five years,” said Akito Fukunaga, a fixed-income strategist in Tokyo for Credit Suisse. “If you ask me what Japan can resort to after that, my answer would be, ‘Not very much.’”

How Japan got into such deep debt is a tale of reckless spending. The country poured hundreds of billions of dollars into civil engineering projects in the postwar era, riddling Japan with highways, dams and state-of-the-art ports.

The spending initially fuelled Japan’s rapid postwar growth and kept the Liberal Democratic Party in power for most of the past half-century. But after a spectacular asset and stock market boom collapsed in 1990, the country fell into a long economic malaise.

The Democratic Party, which swept to a landslide electoral victory in August, has promised to rein in the public works spending, cutting as much as a fifth of an extra budget passed by the previous government to divert to social welfare.

But the party’s generous welfare agenda — like cash support for families with children and free high schools — could ultimately widen budget deficits at a time when tax revenue continues to plunge in the aftermath of the global financial crisis, analysts say. “It’s dangerous for the Democrats to push on with all of their policies when tax revenues are so low,” said Chotaro Morita, head of fixed-income strategy at Barclays Capital Japan. “From a global perspective, Japan’s debt ratio is way off the charts.”

Still, officials insist that Japan is better off than the United States by some measures.

For one thing, Japan is rich in personal savings and assets and owes less than 10 per cent of its debt to foreigners. By comparison, about 46 per cent of America’s debt is held overseas by countries like China and Japan.

Moreover, half of Japanese government bonds are held by the public sector, while government regulations encourage long-term investors like banks, pension funds and insurance companies to buy up the rest.

All of this makes a sudden sell-off of government bonds unlikely, officials argue.

“The government is just borrowing from one pocket and putting it in the other,” said Toyoo Gyohten, a former top Finance Ministry official and a special currency adviser to Fujii.

“Although the numbers appear very fearsome, we have some leeway,” Gyohten said during an interview.

But others say the sheer size of Japan’s debt makes even paying off the interest increasingly difficult. Japan’s debt service obligations took up a fifth of the entire budget for 2008, compared with the roughly one-tenth of its budget that the United States spent on servicing its debt.

Each year, Japan doles out more in interest payments alone than the GDP’s of midsize countries like Malaysia or Israel.

Many analysts agree that Japan should forget trying to cut down that debt for now and concentrate on at least making sure that spending does not go overboard again.

“The government needs to stabilize the debt, first and foremost. Only then can it start setting other targets,” said Randall S. Jones, chief economist for Japan and South Korea at the Organization for Economic Cooperation and Development.

A credible plan to pare down spending is important “to maintain public confidence in Japan’s fiscal sustainability,” said the OECD’s economic survey of Japan for 2009.

In the long run, even Japan’s sizable assets could fall and eventually turn negative. Japan’s rapidly aging population means retirees are starting to dip into their nest eggs — just as government spending spikes to cover their rising medical bills and pension payments.

The fall in savings could eventually reverse Japan’s current account surplus, possibly driving up interest rates as the public and private sectors compete for funds. Higher interest rates would increase the cost of servicing the debt and hence increase Japan’s default risk.

In the worst case, Japan’s currency could suffer as more investors switched away from Japan to other assets.

And if Japan were to print more money and set off inflation to reduce its debt burden, the supply of yen would shoot up, lowering the currency’s value.

One puzzle, however, is the yen’s resurgence in recent months as the dollar has weakened against major currencies.

The yen recently surged to a seven-month high, with US$1 buying about ¥89 before easing slightly, as near-zero interest rates in the United States prompted investors to take their money elsewhere.

Many strategists say they expect the yen to strengthen further, at least in the short term.

Still, “in 10 or 20 years, Japan’s current account surplus will fall into deficit, and that will lead to a weaker yen,” said Morita at Barclays Capital. “But if investors become pessimistic about Japan before that, the yen will weaken earlier than that.”

A slide in the national currency would not be as detrimental to Japan as it would be to the United States, because most of Tokyo’s debt is held in yen. If the dollar were to depreciate sharply, American debt burdens would surge.