Over the past year and a half, the world's major central banks have enacted ultra-loose monetary policies to counter the post-pandemic, Ukraine-related spike in inflation. Japan's central bank, however, has instead chosen to maintain a negative interest rate policy, making it an anomaly.
The reason behind this is that Japanese authorities are more worried about a return to deflation rather than what they view as a temporary rise in consumer prices. Nevertheless, over the past year, the Bank of Japan (BoJ) has begun to adjust its policy framework to give it more flexibility to respond to inflation should it turn out to be persistent. Some economists and political analysts are worried that monetary tightening and higher interest rates may make Japan's massive debt unsustainable and even constrain the BoJ's willingness and ability to raise interest rates. However, the risks are manageable, and high government debt is very unlikely to make the BoJ hesitant to fight inflation with rate hikes, should this become necessary.
A Shift Toward More Flexible Monetary Policy
Since the bursting of the real estate and financial bubble more than 30 years ago, Japan has experienced very low inflation. This forced the BoJ to adopt increasingly unorthodox monetary policies — including quantitative easing, qualitative easing, yield curve control and negative interest rates — in an attempt to support economic growth and prevent the economy from sliding into deflation. Once an economy falls into deflation, domestic spending may stall on the expectation that lower prices and asset price deflation will raise the real value of liabilities, which weighs on investment and financial stability.
But by offering some reprieve from deflation and a debt-deflation spiral, Japan's post-COVID spike in inflation over the past year has forced its central bank to gradually adjust its broader monetary policy framework that was originally devised to prevent deflation. Inflation in the country spiked to more than 4% in January, which is very high by Japanese standards. By August, however, Japanese headline and core inflation had fallen to 3.2% and 3.1%, respectively. The BoJ has a mandate to maintain inflation at 2%, which, on its face, would suggest that the bank should abandon its unorthodox, ultra-loose monetary policy to bring down inflation. However, the Japanese government forecasts inflation to decline to 2.6% in fiscal year 2023 (which began in April) before further dropping to 1.9% in 2024 against the backdrop of current policies.
Current inflation dynamics raise the question of whether Japan's central bank needs to tighten its monetary policy at all. The BoJ certainly wants to avoid repeating the mistake it made in 2006, when the bank raised interest rates too early and pushed the Japanese economy back into an economic slowdown and deflation. Indeed, in recent months, Governor Kazuo Ueda has said the BoJ wants to see inflation reach 2% on a sustainable level, which suggests the bank is worried about the economy sliding back into deflation once the post-COVID and Ukraine-related energy price shocks abate. Today, tightening monetary policy would then precipitate a slide back into deflation territory.
At the same time, however, the BoJ wants to avoid triggering a financial shock and market instability in case high inflation persists and forces the bank to tighten monetary policy. As part of the rigid, constraining policy framework it adopted to combat the deflationary pressures of the 2010s, the central bank committed to capping long-term yields, effectively forcing it to buy as many government bonds as necessary to keep interest rates under the cap. If the BoJ were forced into removing this cap overnight to regain control of monetary policy to fight inflation, many investors would be caught off-guard, possibly creating a panic that would likely see markets suffer a massive sell-off and high volatility.
To avoid such a scenario, the bank has begun to make its policy framework more flexible over the past year, in an effort to prepare investors in case inflation fails to decline and forces the BoJ to adjust its policy. This has included tweaking its so-called yield curve control policy introduced in 2016, and widening the band around the zero-percent ten-year yield target from 0.25% to 0.5%. In July, the BoJ also announced it would start treating the upper and lower bound of the new interest rate corridor as references rather than rigid limits while establishing 1% as a cap, effectively allowing for a tightening of monetary policy as yields increased.
The Impact (or Lack Thereof) of Japan's High Debt Levels
Aside from risks related to rolling back 20 years of the BoJ's unorthodox monetary policies, some analysts have expressed concern about the potential impact of higher interest rates on Japan's government debt sustainability. Japan, however, does not suffer from what economists call ''fiscal dominance,'' whereby monetary policy is constrained by a high government debt for fear that higher interest rates may trigger a debt crisis. These concerns are thus overblown in economic terms, as the level of government debt will not keep the BoJ from tightening monetary policy should it need to do so in order to bring inflation under control.
Japan's combination of high government debt and ultra-low, even negative interest rates has long puzzled casual observers. High, potentially unsustainable government debt is supposed to translate into higher interest rates to compensate for the higher default risk. Japan's experience is not as unique anymore, as other advanced economies have seen sharp increases in debt levels coincide with ultra-low interest rates in recent years.
But Japan is currently the only country in the world that still has a negative policy rate. And at 260% of GDP, the country also has one of the highest government debt ratios in the world (though when measured in net terms, Japan's government debt is around 160% of GDP, which is high but far less daunting than at 260%).
More important than the level of debt is its effective cost of that debt, which is determined not by the nominal interest rate (which monetary policy can influence) but by the real interest rate. In real terms, Japanese interest rates were not all that low over the past two decades, as the country's economy teetered on the verge of deflation, while interest rates were more or less zero. This is also why deflation — which increases the real debt burden and real interest rates — was such a concern to Japanese policymakers. So even if the government paid zero interest rates on its debt, real interest rates were not necessarily negative, which contributes to adverse debt dynamics.
But while the real interest rate affects debt dynamics, it is not the sole determinant. Real economic growth and the primary fiscal balance (government revenue minus government expenditure, before interest) co-determine debt sustainability by deciphering whether the debt-to-GDP ratio increases, remains stable or declines in the long term. In other words, higher real interest rates do not necessarily undermine debt sustainability as long as real economic growth picks up, too. There is little reason to expect that real interest rates should significantly exceed the real growth rate of the Japanese economy. If economic growth falls, so should interest rates, and vice versa. This is why an increase in nominal interest rates in the context of higher inflation or higher economic growth will not fundamentally alter Japan's government debt dynamics.
There is one caveat, however. If the BoJ were to proceed with significant quantitative tightening in an effort to increase long-term interest rates and, in turn, keep a lid on inflation, the consequent sale of government bonds held by the bank would increase the amount of interest-bearing debt held by the public. At present, the BoJ holds around 50% of all Japanese government bonds and bills, worth a little more than 100% of GDP. In a hypothetical scenario where the BoJ reduces its balance sheet to the levels seen a decade ago, this would increase the amount of interest-bearing bonded debt to around 170-180% of GDP, up from 100% of GDP today. This could double the public sector's debt service, all other things equal. However, such a massive balance sheet reduction would only happen if inflation remains stubbornly high and forces the BoJ to take more severe action in order to alleviate the debt burden.
This is a long-winded way of saying that the broader outlook for Japan's debt sustainability hinges not only on nominal interest rates, but also on the combination of real interest rates, real economic growth and the government's fiscal policy. Last but not least, the average maturity of Japanese government bonds is about six years, meaning it would take time for higher real interest payments to affect long-term debt dynamics, which would give the government some breathing room to adjust its fiscal policy. For the moment, however, the BoJ is unlikely to feel constrained in its monetary policy actions by Japan's high government debt levels.
Additional Financial Buffers
Moreover, while Japan may have the highest government debt ratio in the world, it is also the world's largest international creditor in dollar terms, as well as a substantial net international creditor measured as a share of GDP. Unlike the United States, Japan does not rely on foreigners to finance its government deficit to a significant degree, with only about 15% of Japanese government bonds owned by foreigners.
In fact, an increase in interest rates would help incentivize Japanese investors to repatriate their foreign assets, while incentivizing foreigners to acquire Japanese government debt. Assuming that foreign investors are more fickle, Japanese investors have every reason to buy Japanese debt once interest rates increase. Effectively, overseas Japanese assets can be seen as providing an additional financial buffer. Moreover, and perhaps more importantly, Japanese government debt is denominated in Japanese yen. This further sharply curtails roll-over risk, as the central bank can always step in to absorb newly issued debt.
Japan continues to run sizable current account surpluses, fluctuating between 2% and 4% of GDP. These surpluses mean that Japan accumulates foreign assets, and (all other things equal) its net creditor position strengthens and makes more foreign assets available for potential repatriation and the purchase of government debt. It is virtually impossible for a country with such a large net foreign creditor position and large foreign surpluses to default. Japan's strong international financial position also makes it unlikely that the government would not be able to attract sufficient demand for its debt from Japanese residents.
Another way to look at this is that a current account surplus means that Japan continues to save more than it invests, and that it consumes less than it produces. Japan's government debt burden thus does not reflect national financial profligacy since the country as a whole — i.e. the combined government and private sector — is financially on a sound footing. Rather, Japan's government debt burden is a reflection of inter-sectoral financial imbalances and a high level of government dissaving, which are more than offset by an even higher level of private sector savings.
In other words, Japan generates enough savings domestically to finance government deficits, which principally means that the government could simply increase taxes rather than issue debt to the private sector. This makes it unlikely that domestic investors will balk at financing the government because they understand that, economically, the Japanese government can always raise taxes to ensure solvency (assuming Tokyo retains the political willingness to do so).
Assessing the Counterargument
If, contrary to the argument laid out above, Japan had a debt problem, it would face significant constraints. First, it would have to accept higher inflation, which would prove unpopular and further undermine its ruling party and prime minister's hold on power. If higher interest rates were to risk putting Japanese government finances on an unsustainable path, Japan would also find it more difficult to mobilize the financial resources to support defense spending. Lastly, if Japanese debt truly became unsustainable after the BoJ shifts away from unorthodox monetary policies, Japan might eventually suffer an economically and financially destabilizing debt crisis, which would weaken its international standing and credibility. Given the present dynamics in East Asia, this could also prove destabilizing geopolitically.
Some analysts have cited these risks in expressing their concerns about what higher interest rates might do to Japan's economic and financial stability and, by extension, its geopolitical standing. But as this column argues, such concerns are unwarranted. Even if the BoJ lifts interest rates, Japan will not necessarily be more constrained in terms of fiscal policy and resources, and it certainly will not face debt sustainability issues. If anything, higher interest rates might lead to a decline in asset values, which might cause some stress, particularly in the financial sector, similar to what the United States experienced earlier this year. However, the Japanese government will overall face manageable financial difficulties.
A Tricky Balancing Act
As it shifts toward a more flexible monetary policy framework, the BoJ will need to be cautious in terms of tightening too much, too early. With inflation declining in the United States and Europe, the recent uptick in prices around the world does not appear to be structural or permanent. Of course, the U.S. Federal Reserve and the European Central Bank have increased rates very forcefully, but a case can be made that much of the decline in headline inflation has been due to the sharp decline in energy prices and the normalization of supply chains following the COVID-19 pandemic. The next few months will provide further evidence in this regard.
More than uncertain about whether high inflation is here to sta, the BoJ has adopted a wait-and-see approach, indicating it needs further data on inflation to decide whether to change its monetary policy more forcefully. But the Japanese central bank faces a difficult balancing act to that end. If the BoJ injects more flexibility into its main policy framework too quickly, it may trigger policy tightening and expectations about further policy tightening that risk pushing the economy back into deflation. But if the bank goes too slow and inflation remains persistently high, it may be forced to suddenly and rapidly adjust its policy framework, monetary policy and interest rates, creating an upheaval that would risk rippling through domestic and even international capital markets. Indeed, the BoJ's December 2022 decision to widen the range around the zero target for ten-year bond yield has already pushed up yields and translated into higher interest rates — highlighting the tightrope authorities are walking in terms of granting themselves greater flexibility and engaging in possibly unwanted monetary tightening.
This is why the BoJ will go as slowly as it can and as quickly as it must in its effort to exit two decades of unorthodox and largely unprecedented monetary policies. The BoJ will continue to move toward a more flexible monetary policy framework by abandoning both yield curve control and its commitment to a negative short-term policy rate, which would give it the flexibility to move away from quantitative easing, should this ever become necessary. The point is to reform the policy framework so that the BoJ is in a position to deal with both inflation and deflation while limiting the risk of a precipitous policy shift upsetting financial markets, as well as the risk of increasing deflationary pressures by making the framework less rigid.
The BoJ is unlikely to feel constrained by Japan's large government debt burden or concerns about debt sustainability, due to the factors mentioned above. But the bank does face an economic-technical challenge that will require Governor Ueda and his colleagues to muster all their experience, skills and — most importantly — sound judgment to navigate.
