Ready, Abe?

**In December 2012, the people of Japan elected Shinzo Abe as Prime Minister after a landslide victory for Japan’s Liberal Democratic Party (LDP**). Following his resignation as Prime Minister in 2007 after less than a year in power, Japan’s newly-elected leader is hoping that his second stint in office will be a more successful one. Abe has promised to reflate the world’s third largest economy through aggressive monetary easing and increased government expenditure on public works and defense. For a nation plagued by two decades of low GDP growth since its property bubble burst in 1990, these policies have resounding appeal.

Nonetheless, Japan lies in a precarious position. It currently has the largest debt-to-GDP ratio in the world, attributable to 21 years of back-to-back budget deficits, and is projected to reach 226.8 per cent of GDP by 2013, according to latest OECD figures. Yet despite Japan’s fiscal imbalances, the markets remain unfazed over seemingly ‘unsustainable’ levels of public debt. From a high of 8.2 per cent in 1990, the yield on the benchmark 10-year Japanese Government Bond (JGB) fell to an all time low of 0.5 per cent in June 2003, which has since plateaued to around 0.8 per cent.

In essence, Japan has been able to finance its debt at historically low rates, undoubtedly contributing to the accumulation of such an excessive debt burden.

In this light, the government’s reflationary rhetoric is seen by some analysts as rather disconcerting. Yields on JGBs have remained low precisely because deflationary pressures have anchored rates. Although inflation erodes the real value of government debt, the flip side is that nominal interest rates tend to rise along with expected inflation. Inflation erodes the value of future payments, and thus investors seek higher returns to compensate for this ‘inflation risk’. Though the evidence supporting this is far less compelling over the short-run, a sharp rise in government borrowing costs could potentially trigger a sovereign debt crisis.

The threat to Japanese financial stability is also real. Over the past 20 years, Japanese banks have dramatically increased their exposure to JGB’s, which now constitute 18.9 per cent of total bank assets, leaving them hostage to a sharp rise in yields that could render them insolvent.

From a broader perspective, Japan’s current account surplus is shrinking, the result of a reversal in a historically strong trade balance which has slipped into deficit in recent years. Performance of exports has deteriorated, and there has been a steady decline in market share since the early 1990s due to a fundamental loss of competitiveness vis-a-vis trading partners such as China and the Eurozone. Although still in surplus because of a substantial positive net income balance from interest receipts, the current account is following a clear downward trend, and is projected to flip to deficit by 2015. In such a scenario, in order to finance its debt, Japan would have to borrow on international capital markets who would likely demand a higher return than domestic savers.

Others believe this apparent ‘crisis’ has been overstated and owing to the majority of Japanese debt being held domestically, Japan will not be held ransom by its creditors (i.e. its own citizens). Furthermore, it could be a while before Japan slips into current account deficit.

Though the threat may not be imminent, the current path trodden by Japan _is_ unsustainable in the long-run. Voters are hoping that the LDP has learnt its lessons from the past. Otherwise, Japan faces the prospect of another decade of low-growth, and with that the possibility of the markets losing faith in the Sovereign.