How long can Japanese bond prices defy gravity?

That’s the question posed in an interesting new paper by UCSD Professor Takeo Hoshi and University of Tokyo Professor Takatoshi Ito.

Although there has been much discussion recently of debt levels of some European governments, Japan is in a class by itself. Hoshi and Ito (2012) note the consensus among academic researchers that Japan’s current fiscal path is unsustainable:

Doi (2009), Doi, Hoshi, and Okimoto (2011), Doi and Ihori (2009), Sakuragawa and Hosono (2011), Ito (2011), Ito, Watanabe, and Yabu (2011), and Ostry et al. (2010) all find that without a drastic change in fiscal policy, the Japanese government debt to GDP ratio cannot be stabilized.

Net government debt as a percent of GDP for selected countries. Source:
Hoshi and Ito (2012).

Nevertheless, lenders to the Japanese government seem to have no concerns, as yields on the government’s debt remain extremely low.

Outstanding Japanese government bonds (trillions of yen, left scale) and interest rate on the debt (in annual percentage rate, right scale). Source:
Hoshi and Ito (2012).

Hoshi and Ito (2012) argue that the key feature that has kept this process going has been that 95% of the Japanese government debt is domestically owned. Japanese residents put their savings into banks and insurance companies who along with pension funds lend to the government at very low rates. But as more Japanese retire from the workforce, that is likely to change dramatically. When Hoshi and Ito extrapolated current saving rates associated with different age groups into the future as the population ages, here is what they predict will happen to the Japanese saving rate in the years ahead.

Predicted Japanese household saving as a percentage of GDP.
Hoshi and Ito (2012).

Hoshi and Ito then put those saving rates together with the assumption that tax revenues and social security contributions remain at their current values of 30% of GDP while expenditures follow existing projections. Given a rate of growth of GDP and an assumed path for future interest rates, projecting future Japanese debt as a percentage of GDP is then a straightforward exercise. The chart below is based on what the authors describe as the
“unrealistically optimistic assumption that Japan’s GDP will grow at 2% annually for the next 40
The purple path labeled “Debt1” assumes that the interest rate equals the growth rate. Under these assumptions, Japanese government debt would rise to 300% of GDP by 2024 and 400% by 2034.

Government debt and private sector financial assets for 2010-2040 under assumption of 2% GDP Growth.
Hoshi and Ito (2012).

Hoshi and Ito then ask, who is going to buy that debt? Projecting saving rates forward they calculate what total domestically held financial
assets would be under those same assumptions. This is the blue-grey line labeled “MaxDebt1” in the graph above. Total financial assets held by domestic residents are never projected to get much above 300% of GDP. In other words, under these assumptions, Japan would soon reach a point where even if government debt were the only financial asset held by domestic residents, the government would still need to borrow overseas to continue to finance its deficits. Presumably foreigners would be much less willing to continue lending at historically low rates.

Hoshi and Ito performed alternative simulations under the assumption that as the debt-to-GDP ratio increased, the yield on government bonds would begin to rise. Under this scenario, the Japanese themselves would be able to absorb a higher level of debt, because the accrued interest to the Japanese holders of the government bonds gives them additions to paper wealth (a version of the “we owe it to ourselves” argument). This is reflected in the red “Maxdebt2” line in the graph above. However, higher interest rates also make the debt itself accumulate faster (the turquoise “Debt2” line above). Given the fundamental driver that the deficit exceeds household savings, the result is that Japan exhausts domestic savings even sooner, although debt rises to a higher percentage of GDP before doing so. The “Debt3” and “Maxdebt3” lines assume an even faster rate of increase in interest rates.

If the Japanese government is soon forced to offer higher yields to foreign lenders, the result could be very troubling. Again from the paper:

the crisis would have a large adverse impact on financial institutions, because the majority of long-term government bonds are held by Japanese banks and insurance companies. When the interest rate rises, they suffer valuation losses. For example, Japanese banks collectively hold about 142 trillion yen of central and local government bonds as of the end of March 2010. This is about 32% of total bank loans. The interest rate risk is large, too. According to Bank of Japan (2010), 100 basis points increase in JGB yields is estimated to cause about 4.7 trillion yen of losses for Japanese banks collectively (BOJ 2010, Chart 3-2-3, p.39). This is about 11.7% of the Tier I capital at the end of March 2010 and about twice as much as the income before tax for the accounting year ending on March 31, 2010. The interest rate risk as of March 2008 was estimated to be around 3.5 trillion yen. This may not reduce regulatory capital immediately because the banks are not required to mark all the securities to the market, but many will none the less tighten their credit provision.

As concerns about Greek sovereign debt and continuance with the euro intensified over the last two years, the troubling question became, “who’s next?”, a contagion of fear that continues to rattle Europe at the moment. If the scales tip for Japan as well, it is hard to imagine that the willingness of the world community to continue to buy U.S. Treasury debt would continue to be unaffected.

27 thoughts on “How long can Japanese bond prices defy gravity?

  1. Ricardo

    The whole world is in a debt crisis. Governments throughout the world embraced extreme Keynesian stimulus theory and are now facing the consequences. The only solution is to reject the demand side stimulation model to a production supply model.
    This is inevitable because the Keynesian model is not sustainable. The only question is do we make a conscious choice to let markets work sooner or do we force markets to discipline later. It is a matter of when and how disasterous not a matter of which theory will win out. We all know this in our real lives, now we have to force our governments to become responsible.

  2. colonelmoore

    Japan has been stimulating its economy with government programs and deficit spending for a very long time. However these have had little effect.
    One of Japan’s biggest problems is that its corporations join forces with government to make big bets on future industries. So for instance they have been pushing batteries for electric vehicles that turn out not to even be popular in Japan. So now the battery manufacturers are turning their attention to energy storage. But energy storage turns out not to be popular with utilities because it is still far cheaper to generate electricity as needed. They are hoping that the US market will save them but low-cost natural gas has eliminated that prospect.
    A recent Time op-ed titled, “Yes, More Solyndras” stated: “The federal clean-energy loan program that the infamous solar-panel maker was a part of was designed to finance risky ventures, and Solyndra was a reasonable risk: an innovative manufacturer with huge private backing and an opportunity to transform the industry. But the industry transformed itself first. Silicon prices plunged, Solyndra‚Äôs advantages vanished, and the firm went bust. It happens.
    This is supposed to justify government industrial policy, but in fact points directly to its failure and helps explain Japan’s problem. Japanese industries move into areas that government studies show are the wave of the future and government policies provide advantages to. It happens in most cases that the situation evolves rapidly in ways we could not have foreseen. This transormation does not necessarily happen in a straight line as in the solar panel example. But the bottom line is that government is not very good at picking winners and losers. Companies are not very good either which is why Microsoft dominates the scene but then Apple takes the lead. But when companies join a herd led and subsidized by government, the odds of them all going off a cliff increase dramatically.
    Certainly Japan’s problems are multifaceted. But this cautionary example is staring us right in the face. Just as Japan is heading into its worst fiscal crisis in our lifetimes its companies have invested heavily in money-losing ventures that will further reduce corporate taxes and employment.

  3. Lord

    The Japanese have a lot of foreign income to repatriate and foreign assets to sell. How much of the debt does the BOJ own and buy now? If you accept the central bank acts last, fiscal policy is irrelevant, and higher debt is just the choice of a low inflation rate, one they may choose to change in the future.

  4. Jeffrey J. Brown

    The following chart shows the ratio of Global Net Exports of oil (GNE*) to Chindia’s Net Imports (CNI) versus total Global Public Debt (which I believe does not count items like underfunded Social Security obligations).
    At the 2005 to 2011 rate of decline in the GNE/CNI ratio, it would be at 1.0 in 2030 (versus 5.3 in 2011), meaning that the Chindia region alone would theoretically be consuming 100% of GNE in 2030.
    At the 2005 to 2011 rate of increase in Global Public Debt, we would be at about $188 trillion n 2030, versus $43 trillion in 2011.
    In any case, as the developing countries, led by China, continue to consume an increasing share of a declining volume of Global Net Exports of oil, and as I suspect we see a similar pattern regarding food exports, arguably the countries in the worst position will be developed countries that are highly dependent on both food and energy imports, e.g., Japan.

  5. colonelmoore

    The Japanese seem worried about their fiscal position.
    The efforts to raise taxes are meant to combat the countries rising national debt. But the vote wasn’t without political controversy, as Prime Minister Yoshihiko Noda faced challenges from rivals who say the tax hikes will harm the economy. The bill still has to pass through the upper house, but major challenges there aren’t expected. As a result of the bill, sales tax will rise from 5 percent to 8 percent in 2014, then to 10 percent in 2015.

    Right now Japan is practicing financial repression. It had privatized the post offices with their postal savinga accounts but then reversed the process with the postal savings so that the government could order the company to buy more government bonds. The famous domestic funding of government debt is in large part through this one conduit.
    What this means is that domestic savers face the possibility of the postal savings bank becoming insolvent should the value of its bond portfolio fall. To prevent this from happening the Bank of Japan might monetize its debt. But once savers get wind of the fact that their savings are in large part noting more than government debt, a bank jog might start.

  6. Jeffrey J. Brown

    Regarding my prior comment:
    *GNE = Global Net Exports of oil, top 33 net exporters in 2005, BP + Minor EIA data, Total Petroleum Liquids

  7. sherparick

    Since the debt is in Yen, the Bank of Japan could just buy the debt up. Of course, this would eventually cause at least a mild inflation. However, since the bad debt to GDP ratio is mostly the result of Japan’s deflation and low to negative nominal GDP growth the last 22 years, perhaps that would not be such a bad thing. Japan’s pensioners and savers would not be happy though.

  8. mje

    the answer to your question is that Japan has something called the Japan Central Bank. the bank can purchase the JGB ad infinitum. Then, it can send the interest back to the Japanese govt. Also, what you do not mention is the Japanese labor force is declining which means its productivity will go up, which means the living standards will go up as the GDP goes up divided by fewer workers. Then, subsequency Japanese govts can tax the real increase in wages to pay for the benefits. Also, the Japan baby boom, will peak on 2030, so I do not see the were is the hysteria comes from.

  9. Max

    I haven’t read the paper, but what do they say about investment? After all, savings is only half the picture. If (desired) investment falls in tandem with (desired) savings, then there’s no reason for interest rates to increase.
    Think of it this way: a shrinking population can sustainably consume its capital. It has too many houses, too many roads, etc.

  10. colonelmoore

    Also, the Japan baby boom, will peak on 2030, so I do not see the were is the hysteria comes from.
    I am not sure what baby boom that is. Japan’s baby boom started five years before ours. Its population started decreasing in 2008 and it is on track to lose a million people a year.
    I like the idea that a country can spend twice as much as it takes in in tax revenue and have its central bank buy up all the debt it issues ad infinitum. I suggest that Japan cut taxes to zero and double government expenditures. Since the Bank of Japan can buy up all the debt ad infinitum, that should be no problem. Infinity times four is just infinity.

  11. colonelmoore

    arguably the countries in the worst position will be developed countries that are highly dependent on both food and energy imports, e.g., Japan.
    The Japanese are quite worried about the future supply of energy. They have sent study missions to Alaska, Canada, Australia and the continental US to see about future coal imports. They are doing studies in Canada on efficient and safe ways of extracting methane hydrate. (Offshore methane hydrate is Japan’s only domestic fossil fuel supply and it has a lot of it.)
    One bright light on the horizon for Japan is that China appears to have the world’s largest supplies of shale gas. Unlike us it is not shy about using the Celanese process to convert natural gas to ethanol. The Celanese process produces ethanol at a wholesale price that may now be less than $2 per gallon. Communist China doesn’t have the equivalent of our Iowa primary, so while we discuss the political issues of shale vs corn, Celanese is building a plant in China now. It is also inviting US oil and gas companies to study its shale formations.
    So Japan might get a break in the long run if China can tap and process its domestic fuel sources.

  12. Cezmi Dispinar

    The crucial question, whether the debt is sustainable, depends not only on the amount of the debt, but on (a) interest rates and (b) GDP growth.
    This means that the future growth prospects play a relevant role, but also the stability of the economy and what foreigner investors (lenders) make of this.

  13. c thomson

    Funny how everyone loses sight of micro economics in the fun of discussing macro issues. Japan Inc is constipated. The largest companies are run in effect by their personnel departments. Yet only large Japanese companies can be entrepreneurial, with rare exceptions.
    What this means is that given a choice between closing a promising venture in the US or having to fire ten Japanese in Osaka, the US venture will close. Note how Howard Stringer was made CEO of Sony only to find that a Japanese president in Tokyo could block his moves. Poor Stringer thought that CEO meant the same in Japan. Examples like this abound.
    The fiscal stuff is a symptom – not the disease. Bust Japan open economically and the debt issues will evaporate. NB: there might be a lot of hara kiri.

  14. dwb

    no, the question that you should be asking is when will we see Japanese inflation high enough to justify higher yields. foreign investors are not going to mysteriously demand higher yields in case of default, because a Japanese default would merely be a political not economic event (they can print their own currency). The question is, when does the debt monetezation (if ever) become inflationary?
    The alternate explanation of course is that high interest rates stem from a high real rate of return: If retirees are spending their savings in retirement, not saving, then that increases current-year GDP. interest rates then should rise to incent people to postpone consumption.
    hopefully, we all realize that the euro crisis is a growth and monetary policy crisis: prior to the Euro, interest rates reflected FX and inflation risk. Now they are pricing, in the event of a breakup, future inflation and fx risk. You might argue that Spain (for example) needs a “real” alignment of its nominal debt to gdp… but that’s exactly what inflation does.
    Japan needs to generate more inflation to bring down debt/gdp. At some point, the market might think its inevitable and yields might rise. After 20 years of being in a liquidity trap though, i doubt anything is inevitable.

  15. Jeffrey J. Brown

    Re: colonelmoore
    I am not aware of any commercial methane hydrate production facilities anywhere in the world.
    Regarding “Shale Gas to the Rescue,” it’s always useful to look at some case histories regarding shale gas, e.g. Texas, which has the most years of experience with applying recent high tech methods of increasing production from shale gas formations.
    The Texas Railroad Commission (RRC) shows a steady year over year increase in annual natural gas production from the Barnett Shale, through 2011.
    However, the same data source, the RRC, shows that total Texas natural gas well production started falling in 2009, after hitting a secondary peak in 2008 (absolute peak was in 1972).
    In other words, starting in 2008, rising production from the Barnett Shale, and from other shale formations, could no longer keep total Texas natural gas well production on an upward slope.
    This is not a terribly encouraging model for global shale gas and shale oil efforts, especially since the permeability relative to gas is higher than to oil.
    But on the crude oil side, I estimate that about 23% of all crude oil ever consumed globally was consumed in just the 10 year period ending in 2011, with flat to declining annual crude oil production since 2005. And we have seen a measurable decline in Global Net Exports of oil (GNE), with the developing countries consuming an increasing share of a declining volume of GNE. (We have seen a small increase in total liquids production, inclusive of low net energy biofuels.)
    What I find fascinating is that the prevailing conventional wisdom is not that our rate of extraction of finite fossil fuels is too low. On the contrary, the conventional wisdom is that our extraction rate is too low, and there is no inherent problem with a virtually infinite rate of increase in our consumption of a finite fossil fuel resource base, despite all of the evidence to the contrary.
    At the end of the day, people will believe what they want to believe, and in my opinion the increase in debt in areas like Japan is an example of the consequences of operating on the premise of an infinite earth, while the reality is that we have a finite fossil fuel resource base.
    In my opinion, we are seeing cognitive dissonance on a global scale as developed OECD countries go massively into debt trying to keep their “Wants” based economies going, while waiting for what most people seem to believe will be a flood of new oil supplies.

  16. Jeffrey J. Brown

    Small correction (bold):
    “What I find fascinating is that the prevailing conventional wisdom is not that our rate of extraction of finite fossil fuels is too high. On the contrary, the conventional wisdom is that our extraction rate is too low, and there is no inherent problem with a virtually infinite rate of increase in our consumption of a finite fossil fuel resource base, despite all of the evidence to the contrary.”

  17. BUrk

    Don’t worry- be happy! When the savings rate turns, and the elderly start to net spend, then the economy of Japan will no longer be in a deflationary trap. At this point, the government would naturally start reducing its deficits and debt accumulation. Yes, government spending will have to go down, and that will be quite do-able.
    The current spending trajectory is all predicated on the need for continued stimulus because for the time being, the Japanese are champion savers, with chronically deficient aggregate internal demand, and insufficient external demand (with China taking the lead in exports) to make up the difference.

  18. jimmy james

    The only way out is to inflate.
    If the Japanese wanted to be really clever they’d go Swiss… buy JGBs hand over fist, with newly created money, until USDJPY is somewhere around 100.

  19. BigEd

    The Japanese economy is experiencing deflation. With deflation their bond interest rates will remain “too low” for a long, long time.

  20. 2slugbaits

    JDH I small quibble. Your summary of the paper did not include the authors’ point that raising taxes (albeit to very high rates comparable to Denmark) could fix the problem. Readers who do not have NBER subscriptions might come away with the idea that Japan was in an impossible position. That wasn’t my reading of the paper. My sense was that Japan was in a very difficult situation, but there were ways out of the mess. Not necessarily attractive ways out, but increasing taxes was a possible solution.
    One thing that the authors didn’t really develop was the possibility of Japanese savers turning outward for higher returns. If Japan won’t import more workers, then they could export capital investment. In that case the appropriate metric would be something like debt-to-GNP rather than debt-to-GDP. If Japanese savers earned a higher rate of return by looking offshore, then those higher returns might ease some of the fiscal pressure because retirees would be able to substitute higher return foreign assets in exchange for reduced social security benefits. In other words, a Japanese version of private accounts.
    Finally, I don’t think the authors really addressed what is likely to happen to returns on private assets if social security benefits are reduced. I don’t know what would happen, but I’m pretty sure returns on private assets would change one way or another.
    The paper puts most of Japan’s problems on unfortunate demographics rather than the various explanations conjured up by some posters. It’s a shame there isn’t an open link.

  21. Brian

    Japan’s system has fundamental differences with most in the West. The primary of these is labor.
    Japan’s unions are the most protected by law on earth. This forces their corporations not to cut jobs unless the union accepts it and to try every possible alternative first. Since managements must deal, period, there is very little real strike activity, just symbolic. The protection of Japan’s labor unions also makes it useless to do sympathy strikes, thus enforcing the company union and binding union workers to the company’s fortunes.
    The lack of appreciation for law and social capital that underlies all economic activity is the achilles heel of analysis like this one.

  22. ekonomist

    Japan’s GDP will grow at 2% annually for the next 40 years”. it would be possible but we’re living at same world with Japan. so we must all develope together..

  23. Michael L

    What most observers seems to miss is that Japan can easily monetize its debt and adjusted for that the debt to GDP ratio is not so high. They already pay most of the interest expenses on the government debt to themselves due to the massive QE that they’ve done so far. No inflation in sight whatsoverever despite rather low unemployment rates and potentially government crowding out effects (that theoretically could push wage price effects) due to all the fiscal stimulus that they’ve done.
    The Eurozone could easily also solve its debt crisis through QE without much inflation, if any, at all, if only the austerians would allow it.

  24. gman

    If Japan goes bust given the shortage of “safe assets” globally the US 10yr could go to 0.50% and the bund goes to -0.10%

  25. Troy

    Raising taxes to pay off the debt is deflationary.
    Falling population is deflationary.
    Monetizing the debt is inflationary.
    Not too terribly difficult to combine these into a policy that doesn’t make the situation worse for Japan.
    Japan has a net $3T capital position in the world. They won the 20th century, essentially. Don’t cry for them, they are the richest people on the planet, bar none.
    Their baby boom was tiny compared to ours, so their support burden will not be half as large. AND their efficiency in health care is 3X ours for that matter.
    I suspect Japan will do OK this century. It’s the ideologues (some of them posting above) that don’t understand how this could be.

  26. A Sinclair

    Japan is running out of buyers for JGB’s. Japan Post Holdings, the largest financial institution in the world at $3.5 trillion is the largest holder of JGB’s and is trying to diversify from 60% of assets in JGB’s. GPIF, the Japanese retirement fund at $1.4 Trillion is liquidating over $100 billion per year of JGB’s to pay out benefits and the number is growing. That means that the two largest buyers are net sellers and of a large quantity. The national savings rate is projected to go negative as interest earnings do not provide retirement income and people are withdrawing deposits to fund retirement income and life insurance companies are paying out death benefits. As the article states JGB’s are a large part of bank assets and banks are not growing because savings are declining. Japan must also fund it’s deficit as close to 60% of spending for this fiscal year is borrowed and Japan is contemplating another supplemental budget for “stimulus”. The BOJ can buy JGB’s but that destroys the currency. There is no exit for this approach as that would force interest rates higher. A move to 3% on the average cost of the debt would absorb all of government revenue according to an article I just read. Japan must either start growing which is hard when you have a lot of debt or cut government spending 50%. It is not going to be fun. Short the yen and short their bonds.

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