Japan’s debts are shrinking. Its troubles may be only starting

Japan, a heavily indebted country, is not known for its fiscal hawks. Yet for a few weeks in May austere types were ascendant. As long-dated bond yields surged worldwide, the Japanese market wobbled and their warnings seemed prescient. After a dodgy auction revealed weak investor demand, 40-year yields reached 3.7%, a record, having started the year at 2.6%. Was a buyer’s strike afoot? Ishiba Shigeru, the prime minister, certainly seemed worried: “Our country’s fiscal situation is undoubtedly extremely poor, worse than Greece,” he told parliament on May 19th.

The Ministry of Finance was forced to act: it sent out a survey suggesting it was willing to sell fewer long-dated bonds and more short-term ones in an effort to match supply with demand. The move has worked, for the time being, with the 40-year yield back near 3%. Japan’s fiscal position also appears healthier following a rare burst of inflation, which has boosted tax receipts. Preliminary data suggest the country recorded a surplus for the first time in 17 years in the final quarter of 2024. The debt-to-GDP ratio, at 130% or so, has shrunk every year since 2021.

So all good? Not quite. Although inflation has brought Japan’s debts under control, it also lies behind the country’s bond-market troubles. Moreover, even modestly higher yields will, in time, mean uncomfortable interest payments. According to the IMF, interest costs, which already account for 10% of central-government spending, are on track to double by 2030.

And future rises may not be modest. Despite the finance ministry’s move, an imbalance of supply and demand in long-dated bonds is here to stay. The Bank of Japan, once a reliable buyer, has embarked on an effort to shrink its balance-sheet, even if policymakers said, at a meeting on June 17th, that they would slow the pace of change. Life insurers, also formerly keen buyers, have become net sellers, having completed a buying binge encouraged by new rules. For now, the market is propped up by foreign demand, which may prove flightier than the domestic sort.

At the same time, Japan is preparing for a sizeable rise in government spending, adding to the debt pile. It plans to lift defence spending from 1.4% of GDP to 2% by 2028. But even that may not satisfy a Trump administration which is hyper-vigilant about freeriding. Elbridge Colby, an American official, has called for Japan to spend “at least” 3% of GDP on defence.

Then there is the pressure to provide goodies to voters, who are not used to inflation. Rising prices are especially noticeable for rice, Japan’s most important foodstuff. An election to the upper house of parliament is due to be held in July. Seven opposition parties have proposed cuts to Japan’s 10% consumption tax. These range from the modest (temporary reductions on the 8% tax on food) to the extreme (abolishing the tax altogether).

Mr Ishiba’s position is weak. He has batted away these proposals with reference to Japan’s fiscal position, which he has cause to exaggerate (as per the Greece comparison), and has sworn off debt-financed tax cuts of any kind. Still, the prime minister has given ground. On June 13th he proposed a one-off handout of ¥20,000 ($139) to every adult and twice that to children and poorer citizens. It is not the first time his Liberal Democratic Party has opted for such a scheme: one carried out in the run-up to the general election of 2009 was widely reviled as baramaki (”money-scattering”) and paid for with debt. This time, though, the LDP insists the giveaway will be paid for by an expected bump in tax receipts owing to higher inflation.

How much longer can Japan muddle on? It has some protection. Inflation will continue to boost tax receipts for a while yet. Rising prices also mean that the government can run modest deficits without lifting its debt-to-GDP ratio. A rough calculation suggests that, at current overnight interest rates and with annual economic growth of just 0.5%, Japan could run a fiscal deficit before interest costs of more than 2.5% of GDP without seeing the ratio rise. Yet this comes with a big proviso: if real rates increase to zero, three-quarters of the leeway would disappear.

On top of this, inflation will not last for ever—at least if the Bank of Japan has its way. Prices are rising at an annual rate of 3.6%, which is well above the bank’s target of 2%, and is crushing household purchasing power. Real wages are 4% lower than in 2019. This, in turn, will lower nominal growth and tax receipts, possibly even leading to higher real rates. Meanwhile, rising interest rates are inflicting losses on the Bank of Japan’s bond portfolio; before long the ¥2trn in profits that the bank remits to the government each year will dry up. Falling revenues and rising interest costs threaten a crunch.

All of this means it would have been a good time for Mr Ishiba to have made progress on his party’s promise to balance Japan’s budget, excluding interest payments, by 2026. Instead, he is promising handouts for all. Little wonder that bond investors remain on edge. ■