by Charles Yuji Horioka, Takaaki Nomoto and Akiko Terada-Hagiwara
Originally posted in Voxeu.org 21 January 2014
Japan’s sovereign debt-to-GDP ratio is higher than any country in Europe and more than twice the OECD average. This column explains why Japan’s massive government debt did not wreak havoc in the past. Robust domestic saving and a temporary inflow of foreign capital caused by the Global Crisis have prevented a crisis thus far. As both of these factors become less applicable the government faces pressure to reduce debt-to-GDP ratio can be brought under control quickly.
The potential sovereign debt crisis in Japan looks even grimmer than those in the Eurozone economies if one looks only at the gross general government debt-to-GDP ratio. According to the OECD, this ratio ranged from 90 to 166% in some developed economies in 2012 (“only” 166% in Greece, 140% in Italy, 139% in Portugal, 123% in Ireland, and 91% in Spain — collectively referred to as the PIIGS economies) but was a full 219% in Japan in the same year. Thus, Japan’s gross general government debt-to-GDP ratio is more than twice the OECD-wide average (109 percent) and by far the highest in the developed world. Moreover, the OECD projects that Japan’s gross general government debt-to-GDP ratio will increase even further to 231% in 2014.
What makes Japan different?
Why has Japan been able to avoid the fiscal crises of the magnitude faced by the PIIGS economies even though her gross general government debt-to-GDP ratio is much higher? What is different about Japan? The most commonly given answer is that domestic saving is much higher (relative to domestic investment) and home bias is much stronger in Japan, as a result of which a much higher proportion of her massive government debt could be absorbed domestically without having to rely on foreign investors.
However, Reinhart and Rogoff (2008) have argued that domestic sovereign debt is just as important as external sovereign debt and that it is the total amount of sovereign debt that is of paramount importance. Why then has Japan’s massive government debt not wreaked havoc – at least not yet? This column tries to answer to this question.
Trends over time in the share of foreign holdings of Japanese government securities
Horioka, Nomoto, and Terada-Hagiwara (2013) analyse trends over time in holdings of Japanese government securities by sector and find that Japanese government securities were held primarily by domestic savers until recently. The reason is that robust domestic saving, especially household saving (and, in more recent years, corporate saving), combined with strong home bias, made it possible for domestic savers to absorb most of the government debt. Direct holdings of government securities by households remained relatively low, but household savings in the form of bank and postal deposits, insurance policies, and pension funds were funneled into government securities through government financial institutions, private banks, and insurance companies. As a result, the share of foreign holdings of Japanese government securities was at most 11% until 2006. Starting in 2007, however, the share of foreign holdings of short-term Japanese government securities skyrocketed to as high as 30% although the share of foreign holdings of medium- and long-term Japanese government securities remained below 7%.
Why the share of foreign holdings of short-term Japanese government securities skyrocketed starting in 2007
In our recent papers we perform an analysis of why the share of foreign holdings of short-term Japanese government securities skyrocketed starting in 2007. We find that it can largely be explained by the fact that:
- Their yields increased relative to the yields on alternative government securities as yields elsewhere – in the US and Eurozone in particular – fell sharply in 2008-09 due to monetary easing in response to the Lehman crisis; and
- The gap between risk levels on Japanese government securities and those on alternative government securities widened dramatically from late 2008 until early 2010 not because risk levels in Japan declined but because risk levels elsewhere increased sharply due to the advent of the Eurozone crisis.
Both factors caused risk-adjusted hedged returns on government securities in the US and the Eurozone to converge to Japanese levels in 2008-09, and remain below Japanese levels thereafter as well in some cases. This induced foreign investors to (at least temporarily) shift their portfolios from government securities of other economies and regions to Japanese government securities and caused foreign holdings of short-term Japanese government securities to increase sharply.
The surge in foreign holdings of Japanese government securities will not continue indefinitely because risk in the rest of the world will eventually decline (in fact, risk levels on government securities in the US and the Eurozone had already declined sharply by early 2010). This is because investors’ appetite for risk will eventually return as the Eurozone crisis subsides, and because bond markets are developing in emerging Asia and creating increasing competition for Japanese bonds (especially since they offer higher yields and the possibility of currency appreciation as their economies grow further). However, there is a possibility that there will be a revival of yen carry trade utilizing the interest rate gap between the US and Japan, as observed around 2007, and this may have the effect of stabilizing foreign holdings of short-term Japanese government securities at a high level; although as of this writing, the share of foreign holdings of short-term Japanese government securities has fallen somewhat since peaking at 30% in September 2012, presumably for all of the aforementioned reasons, and was only 28% in September 2013.
The current situation is even more tenuous than appears at first blush. The increasing share of foreign holdings and the shortening of maturities on Japanese government securities – especially on foreign holdings – increase the difficulty of rollover and the risk of sudden reversals in trends, as we are now observing. Additionally, the household and private saving rates in Japan can be expected to decline even further due to the aging population, meaning that domestic banks and insurance companies will not continue to have sufficient bank and postal deposits, insurance policies, and pension funds from the household sector to invest in Japanese government securities.
The policy implication is that, although Japan was able to ‘buy time’ by inducing foreign investors to invest temporarily in Japanese government securities, the Japanese government faces increasing pressures to reduce its massive government debt-to-GDP ratio. One way of doing so is to increase tax revenues (for example, by raising the consumption tax, which is very low by international standards, as the Japanese government is in the process of doing) and/or by cutting government expenditures (for example, by reforming the public pension system and other social safety nets). The other way of doing so is by stimulating economic growth, which Prime Minister Shinzo Abe is trying to do using the three arrows of ‘Abenomics’ (massive fiscal stimulus, more aggressive monetary easing, and structural reforms to boost Japan’s competitiveness). Prime Minister Abe is trying to use both ways simultaneously, but it is a Herculean task to skilfully combine all of the policy levers at his disposal since the two ways are often conflicting (for example, raising the consumption tax will reduce the government debt but may at the same time put a damper on economic growth).
To answer the question in the title of this column, Japan’s massive government debt has not wreaked havoc in the past because of robust domestic saving, especially household saving (and, in more recent years, corporate saving) and a temporary inflow of foreign capital caused by the Global Financial Crisis, but it may wreak havoc in the future as both of these factors become less applicable unless the government debt-to-GDP ratio can be brought under control quickly.
- Horioka, Charles Yuji, Takaaki Nomoto, and Akiko Terada-Hagiwara (2014), “Explaining Foreign Holdings of Debt Securities in Japan and Emerging Asia: The Feldstein-Horioka Puzzle Revisited,” Working Paper, Office of Regional and Economic Integration, Asian Development Bank, Manila, The Philippines.
- Horioka, Charles Yuji, Takaaki Nomoto, and Akiko Terada-Hagiwara (2013), “Why Has Japan’s Massive Government Debt Not Wreaked Havoc (Yet)?” NBER Working Paper 19596, National Bureau of Economic Research, Inc., Cambridge, Massachusetts, USA.
- Reinhart, Carmen M, and Kenneth S Rogoff (2008), “This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises,” NBER Working Paper 13882, National Bureau of Economic Research, Cambridge, Massachusetts, USA.