Is Japan now facing its own Liz Truss moment?
Former British PM Liz Truss’s disastrous mini-budget, which crashed the pound and ended her tenure after just 44 days, has quickly become a cautionary tale for policymakers around the world as they debate how to spur economic growth and address rising inflation. But some national leaders, such as Japan’s, have not heeded the warning.
The main feature of the economic plan concocted by Ms Truss and former chancellor of the exchequer Kwasi Kwarteng was a £45 billion (1.9 trillion baht) unfunded tax cut for the rich. This kind of fiscal stimulus made little sense amid the worst inflationary surge since 1980. Accordingly, the pound plummeted and long-term interest rates soared until the Bank of England had no choice but to intervene to protect pension funds. Ms Truss was ultimately replaced by current Prime Minister Rishi Sunak, who plans to introduce tax increases to fill the fiscal hole created by Trussonomics.
Against this backdrop, Japanese Prime Minister Fumio Kishida’s cabinet this month approved a ¥29.1 trillion (7.3 trillion baht) spending package. Most of these measures, which aim to ease the pain of soaring inflation, will be financed by issuing new government bonds, bringing total issuance this fiscal year to ¥62.4 trillion — equivalent to 11.4% of GDP and 37% of the annual budget. While this is an improvement over the 2020 budget, 73.5% of which relied on new borrowing, the increased spending will drive up Japan’s already-elevated debt levels. The country’s outstanding government debt is now expected to exceed ¥1.4 quadrillion, or 250% of GDP.
By any measure, Japan’s current fiscal path — running larger deficits and amassing more and more debt — is unsustainable. At some point, markets may no longer accept Japanese bonds as a safe asset, resulting in a sell-off similar to the one that recently crashed British government bonds. But so far, Mr Kishida’s extra spending has not triggered the violent market reaction that Ms Truss’s mini-budget encountered, even though the UK’s debt-to-GDP ratio is less than half that of Japan’s.
One frequent explanation of Japan’s ability to amass debt without triggering higher borrowing costs is that most of its government bonds are held by domestic investors and financial institutions that have never questioned the state’s solvency and are unlikely to do so in the future. Another explanation is that investors expect the Bank of Japan (BOJ) to support the local bond market whenever a sell-off occurs, as it did when speculators targeted Japanese debt in the past.
Another, more questionable interpretation is that Japan’s net debt is actually smaller than it seems because much of it is owned by the government itself. But the biggest buyer of Japanese government bonds is the Government Pension Investment Fund, and liquidating it to pay creditors would destabilise the entire pension system.
Then there are those who claim that Japan could just raise taxes in the event of a fiscal crisis. By raising the value-added tax (VAT) to 25%, the argument goes, Japan could generate ¥33 trillion in additional tax revenues, since at the current 10% rate, VAT revenue is around ¥22 trillion. Assuming that these proposed tax hikes would not shrink Japan’s GDP, the extra income would still cover only half of the current fiscal hole. Moreover, Japan will likely need to raise the VAT anyway to pay for social security, pensions, and health care for its rapidly ageing population.
The BOJ introduced a “yield curve control” regime in 2016, capping the ten-year bond rate at 0.25%. If the yield approaches that level, the BOJ will purchase long-term bonds, ostensibly to stimulate growth and address deflation. But the BOJ has faced renewed pressure from those who argue that the policy might be ineffective or even harmful at a time when the yen is depreciating rapidly and government-bond yields around the world are rising. The yen’s exchange rate against the dollar has depreciated to ¥150 from around ¥115 since the start of the year, contributing to sharp increases in import prices that have been hurting consumers and small and medium-sized companies. But, so far, the BOJ has refused to raise interest rates or exit the yield-curve-control policy.
Since the BOJ launched its massive quantitative and qualitative easing (QQE) campaign in April 2013, its share of outstanding Japanese government bonds has increased to nearly half. Traditional central bankers, many of whom were trained long before the QQE era, have criticised the BOJ for enabling the government to run unsustainable budget deficits and inducing moral hazard.
But the BOJ seems intent on maintaining near-zero interest rates, at least for now, citing the economy’s slower-than-expected recovery from the Covid-19 pandemic. Japanese inflation, at 3.7%, is also much lower than in the US and Europe, where prices have increased by 8-10% year on year. And while current inflation is above the BOJ’s 2% target, the authorities expect it to ease next year.
But policymakers must use inflation as an opportunity to shake off the deflationary mindset that dogged Japan’s economy for more than two decades before the shift to monetary tightening. To be sure, exiting the BOJ’s long-standing ultra-loose monetary policy is not without risk. Interest payments will likely rise, and, as I recently argued, rapid rate hikes could lead to technical insolvency and so-called negative seigniorage, which would require the government to provide subsidies to the central bank.
Still, the sooner Japan exits its yield-curve-control policy, the better. No doubt, monetary tightening will cause some economic pain. But remaining on the current policy path of keeping interest rates at near-zero and issuing more and more new debt will only increase the costs of eventual fiscal consolidation. Given Japan’s adverse demographic trends, the burden on future generations will be all the heavier.