Japan is debt-laden, but its sustainability remains high
Overseas investors are often concerned that Japan’s debt is too large. Indeed, Japan’s total sovereign debt-to-GDP ratio, which includes government and municipal bonds, is the highest in the world (as of 2014; Japan: 226%, Greece: 181%, US: 112%), which has called into question the country’s fiscal health. However, it is important to look at the country’s assets, as well. The Ministry of Finance (MOF), which is responsible for reconstructing the country’s finances, calculated that the Japanese government possessed JPY 680 trillion in assets at the end of fiscal year 2014, covering over half of its JPY 1,172 trillion in debts, and this highly likely understates its true assets. The assets it includes are funds consigned to the Government Pension Investment Fund (JPY 104 trillion), fixed assets such as national roads and seawalls provided for private use, Foreign Exchange Fund-related securities, fiscal loan funds, as well as capital contributed to independent administrative agencies, national university corporations, and international agencies. MOF explains that assets such as national roads are not realizable because they don’t directly generate revenue; however, in actuality, they do generate revenue in light of the fact that companies make use of them and pay income taxes on their profits. Of course, a majority of such assets, which have been accumulated through government expenditures, are not in place to produce profits because otherwise they would crowd out the private sector. For other examples, while protecting the peace, investments in national defense installations and capital contribution to international agencies are vital to healthy economic activity (and consequently generate taxes), the net present value of such cannot be calculated. As such, the fiscal health of Japan cannot be accurately measured by its balance sheet.
Indeed, Japan appears to be debt-ridden when seen from the total debt perspective, but it is inaccurate to analyze countries financially in the same manner as companies, as there is less need for governments to be fully profitable. It must be said, however, that the Japanese government’s operating deficit its high, with the draft budget for fiscal year 2016 allotting 35.6% of annual revenues from debt issuance. Also concerning is that social security costs will rise further, although it should be noted that the peak will pass and abate fairly soon. According to the MOF, the baby boomer generation will hit the 75-year-old or higher range around 2020 and 18.1% of the population is expected to be of age 75 or older by 2025. If the current social security system is maintained until 2025, then social security allowances (including nursing, medical, and pensions) are estimated to reach JPY 149 trillion, or a 36% increase from that of 2012.
In its fiscal consolidation, the government has set a goal to bring the primary balance (fiscal balance excluding interest payments on liabilities) of the central and regional governments back into the black in 2020. However, the administration’s priority in policy initiatives is economic recovery and specific measures to achieve this fiscal goal (consumption tax rate, expenditure reduction, etc.) have not been presented clearly enough. That said, there is potential for stronger implementation of pricing mechanisms for medical and nursing services (fees and drug prices) and the reduction of excessive medical treatment via an electronic medical chart system. Lastly, an automatic containment system has gone into effect for part of the social security burden.
Perception changes when including the private sector
The government invests in items necessary for production such as roads, but doesn’t directly collect tolls or fees on most of them. That said, the fiscal balance will improve if industries develop further and tax revenues increase. Thus, corporate sector activity is undoubtedly the key to achieving fiscal consolidation. As for the social security burden, the government is responsible for a portion of it, but there are also portions covered by social insurance premium contributions and various fees to individual users.
Another important point is that it would be incorrect to assume that the economy will remain in deflation for the next several decades. The nominal GDP growth rate already exceeds long-term interest rates, which should support future inflation. Furthermore, we are starting to see wage growth exceeding the inflation rate.
As a side point, looking at the circulation of financial flows, there is an unusally large negative correlation between the deficit of the general government and the capital surpluses of private corporations. Under the deflationary economy, the surplus of corporate capital grew as the economy deteriorated. Tax revenue would drop and the government would be prone to adopt stimulative fiscal policies, but the essence of the economy would not improve as added-value would not be created. Even so, the government’s deficit has been shrinking since 2013.
The key is to improve productivity and efficiency
The key to fiscal recovery is to improve productivity and efficiency. The new growth strategy of Abenomics aims to improve the “earning power” and capital efficiency of companies, which should help to unclog the cash of regular companies from their coffers. And let us not forget that among OECD countries, Japan has a very high level of total factor productivity, led by developments in fields such as robotics. We also see the boom in tourism as a long-term structural change, rather than a temporary effect of the weak yen, which should continue to boost productivity in many service industries.
It is also important to improve the productivity of the huge stock of household financial assets, which reached JPY 1,741 trillion at the end of 2015. Incentivizing the public to allocate their capital towards risk –bearing investments will also help Japan grow and improve tax revenues. Finally, in terms of future government revenues, the public has consented to a another consumption tax hike, as the related laws have passed, and in our view, will accept controls on medical expenses as deemed necessary in the future.
Risks and Conclusion
The worst conceivable scenario is hyperinflation. While such is not likely at this point in time, if the government practices insufficient tax collection, a large tax reduction, or inappropriate fiscal expansion that brings into question the government’s ability to make debt repayments, or if financial instability causes financial institutions to sell off large amounts of government bonds at the same time, which would result in higher liquidity premiums, the risk premium of government bonds could skyrocket (prices would plunge) as was seen in the European Debt Crisis.
In sum, Japan’s sovereign debts are high, but its assets are also high and likely highly understated by the official data. Meanwhile, there remains a logical path for the corporate and household sectors to increase economic activity, leading to higher tax revenues, while also accepting new contributions towards the sustainability of the government’s fiscal matters. Certainly, the fixed income and foreign exchange markets have long-believed in the creditworthiness of the country and will very likely continue to do so.