Japan crisis: Will it rein in its massive public debt

Written by Bloomberg | Updated: Jan 31 2011, 03:25am hrs
William Pesek

This is Japans Sputnik moment. This phrase recalling how the Soviet Unions 1957 space launch shocked the US is back in vogue thanks to President Barack Obamas State of the Union address last week. He sees the rise of India and China as a catalyst for the US to boost its competitive game, and its hard to argue with that.

If any economy needs such a jolt, its Japan. News last year that Chinas gross domestic product surpassed Japans, knocking it into the No. 3 spot, wasnt quite it. Yet what about relegating wealthy Japan to the same level of creditworthiness as Chinas still relatively poor population

Standard & Poors did just that last week, and Prime Minister Naoto Kan cant be happy. This is a wakeup call like few others for a government that has been comatose since S&Ps last downgrade in 2002. Will it take the hint and rein in a public debt hurtling toward the 1 quadrillion yen ($12 trillion) mark I wish I could be more optimistic.

The odds dont favour Japan responding with fiscal austerity. The problem is political will, of which there is all too little.

The irony is that Kan is Mr. Debt ReductionJapans answer to Robert Rubin, even. Before becoming the third Japanese leader since Obama took office, Kan was finance minister. Hes never been reticent to talk about a Greece-like Japanese debt crisis and is even pushing for a tax increase to trim debt, just as Rubin did as a member of the Clinton administration in the 1990s. S&P is saying bold action is needed.

Sanity Check

This move is a welcome sanity check that there remain structural debt and deficit issues to deal with, says Callum Henderson, global head of foreign-exchange research at Standard Chartered Plc in Singapore.

The trouble is, Kan is politically wounded with approval ratings in the mid-20% range. Hes fighting to keep his job, never mind rally lawmakers to tackle the worlds largest debt. Kans battle to raise consumption taxes to prevent a crisis like Europes would be an uphill one if he were beloved.

Japan doesnt have the luxury of time. Its graying rapidly and the birthrate has been shrinking for years. Already, 23% of Japans 126 million people are over 65, while 12% are under 15, which is almost the mirror image of US demographics. As the working-age population dwindles, Japans tax base will plunge as its debt-servicing costs skyrocket.

Thats why I think S&Ps move to cut Japans credit to AA-from AA is a bit behind the curve. Japan is on a dangerous trajectory. It avoids crises because it has roughly $15 trillion of household savings and about 95% of public debt is held domestically. Theres little risk of the kind of capital flight to which Ireland and Portugal are vulnerable.

When Yields Rise

Yet Japans national balance sheet is getting more and more out of whack. Its only a matter of time before speculators begin attacking it, George Soros-style. S&Ps action, and the likelihood of more to come, should be a call to hedge funds to try their luck.

Ten-year debt yields, after all, are irrationally low at about 1.2%. Once yields begin edging higher, government borrowing costs will rise exponentially and banks, pension funds, insurance companies and householdseveryone, basicallywill experience massive investment losses.

For 20 years now, one of the biggest questions for market timers has been when, oh when, might Japan fully recover from its crash in 1989 It never seems to happen. Deflationary Japan doesnt plumb the depths of 1930s America, but neither does it manage to expand faster than 1% for very long.

Trapped Central Bank

Something bulls fail to consider when Japan is growing is why. Its because of zero interest rates, massive borrowing and efforts to weaken the yen, not economic dynamism. That formula is losing its potency. When Federal Reserve officials begin floating trial balloons about higher borrowing costs, the Bank of Japan will still be trapped. No serious economist sees the BOJ raising rates markedly in the next five or even ten years.

In fact, Bank of Japan Governor Masaaki Shirakawa will come under greater pressure to pump more liquidity into the banking system and buy huge chunks of government debt. It wont help. Japanese monetary policy has been pushing on a string for more than a decade now, achieving little to boost growth.

That wont stop politicians from calling on the central bank to do more, and thats just the point. Elected officials dont want to tell Japanese voters to tighten their belts, nor are the current crop of legislators wired to implement bold reforms.

I hope I am wrong, and that this Sputnik moment thrusts Tokyo into action. Its more likely that Japan will try to muddle along for a few more years. That would be a grave mistake. Japan can no longer use its past performance to distract investors attention from where its ultimately heading. Credit raters wont fall for that trick again. Neither will hedge funds.