It's only a matter of time before the Japanese public debt market blows up, causing a financial calamity.
The Japanese public debt market is still a time bomb. Public debt now exceeds 135 percent of Japan's gross domestic product. If state pension liabilities are included, the ratio rises to over 240 percent. There is worse to come.
The central government budget for FY2000, prior to any supplementary budgets, calls for 84 trillion yen in spending, against 48 trillion yen in revenues. This leaves a gap of 36 trillion yen to be financed with new debt. Of the 84 trillion yen in planned spending, debt servicing accounts for 22 trillion yen, legally required transfers to local governments for 15 trillion yen, and central government civil service salaries for 11 trillion yen. These mandatory expenditures amount to 48 trillion yen, which means that all other spending must be financed with debt. If we add the local government deficit and the deficits of government-backed organizations to the central government deficit, the general government deficit approaches 10 percent of GDP in FY2000. Sadly, there is no sign of improvement going forward.
To date, this deficit has been financed surprisingly smoothly, and the currency and bond markets have remained stable. Adding to the false sense of security, Japan's economy has posted recent rises not only in industrial production and exports, but also in capital expenditures and corporate profits. To the casual observer, the Japanese economy, having grown by 0.5 percent in FY1999 in real terms, appears to be on the mend.
In Japan's present deflationary circumstances, however, these "real" figures have little meaning. What is more significant is that the Japanese economy actually declined by 0.7 percent in FY1999 in nominal terms. Including Q2 2000, the Japanese economy has declined year-on-year in nominal terms on a quarterly basis for eight of the past ten quarters. Financial stability has not come as a result of the Japanese economy being strong or sound. On the contrary, Japan remains mired in a deflationary recession. Ironically, the Japanese Government Bond (JGB) market has remained stable only because the Japanese financial sector is still so weak.
Japanese savers, risk averse as ever, are still keeping the bulk of their money in the bank deposits and life insurance products which make up Japan's traditional "indirect financing" system. At the same time, Japan's current account surplus continues to mount. Japanese financial institutions, if able to fulfill their original function, would be recycling this surplus by investing overseas. However, the normal cycle has been interrupted by the delayed recovery of Japanese financial institutions' balance sheets following the collapse of the bubble economy.
Banks and insurance companies have been weakened by an effective lack of shareholders' equity, and are unable to take on risk, particularly exchange rate risk. Indeed, Japanese financial institutions are perhaps in worse shape now than ever, and are hence more risk averse than ever. Rather than recycling Japan's current account surplus into international financial markets, the banks and insurance companies have ploughed funds into "risk-free" JGBs. This has kept the yen overvalued and interest rates at rock bottom in spite of the huge accumulated government debt and rising deficit.
Perhaps the worst consequence of this warped flow of funds structure has been the postponement of restructuring. Ultra-low interest rates have allowed the weakest and least efficient Japanese firms to continue to survive. At the same time, the ongoing low-interest-rate environment has allowed the government to maintain its wasteful pork barrel-spending, thereby propping up the lamest of Japan's lame-duck industries.