Japan has been piling up debt for years. Over two decades, the government of the world's second-largest economy has borrowed staggering sums of money to fund domestic stimulus spending. Much of the spending has produced public goods of questionable value, the Japanese equivalents of "bridges to nowhere."
This profligate borrowing has left the island nation with ratio of debt to gross domestic product (GDP) nearing 200%, almost double that of troubled Greece (113%).
Japan's government debt has more than tripled since 1992, and that doesn't include local government borrowing, the equivalent of state and county municipal bonds in the U.S.
How has Japan been able to sustain a debt load that would have crushed other economies long ago?
Saving -- and Retiring
The answer lies in a dynamic few nations share: a populace which saved an extraordinarily large percentage of its income, and then invested those savings in its own government's debt. More than 90% of Japan's government bonds are owned by its people.
In effect, Japan's soaring debt was self-funded. As long as the Japanese people saved trillions of yen and handed them to their government for 1% interest, then the government had a cheap and seemingly limitless supply of low-cost money to tap.
But demographics are finally putting the squeeze on this arrangement. As Japan's population ages, the nation's savings rate is plummeting. A recent report from the McKinsey Global Institute summed the situation up succinctly: Japan: The World's Savers Retire.
The consequences are visible in this chart, which shows that Japan's savings rate is slowly dropping to zero.
Why is the savings rate falling so dramatically? As workers retire, they stop saving as their income declines in retirement. They need cash to live and cover the costs of aging -- additional health care, home care, etc. -- so they sell their investments (often Japanese government bonds) to raise cash. This puts double pressure on bonds: buying dries up and selling accelerates.
Japan Faces a New Reality
The net result of this demographic trend toward lower savings means Japan's government must soon start competing on the world market for capital. In other words, it must start selling its bonds to international investors since its own savings will no longer be substantial enough to fund its enormous debt.
For two decades, Japan's fiscal policy has operated on the assumption that the government can always borrow money at very low interest rates. But as domestic demand for government bonds declines, the government will have to raise interest rates to attract buyers.
Currently, Japanese ten-year Treasuries currently yield 1.3%, compared to U.S. bonds yielding 3.5% or German bonds offering 3%. Facing international competition for capital, Japan will have little choice but to double or even triple the interest rate paid on its bonds. This jump in servicing costs will place impossible pressures on the nation's budget, as roughly 40% of all tax revenues have long gone to paying interest on Japan's ballooning debt.
The consequences of Japan's declining savings rate and the necessity of paying higher interest rates will not stay bottled up in Japan. As the second-largest holder of U.S. government debt behind China, Japan may decide to start selling some of its hundreds of billions of dollars in U.S. Treasuries. That would put pressure on the U.S. Treasury, which already must sell $1.5 trillion in new bonds every year, in addition to rolling over hundreds of billions in bonds which mature.
As Japan's need to sell bonds on the global market increases, the world may see an increasingly desperate competition for global capital arise, as all nations seeking to fund their sovereign debt must raise the yield (the interest rate) they pay on their bonds. That would dramatically raise the interest costs each government pays annually, further pressuring their other spending priorities.
If Japan's cheap debt balloon finally does pop, the consequences will reverberate throughout the global economy.
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