Are Japan's Public Finances Really in Danger? An Overseas Investor Explains the Unexpected Conditions That Make a Country Vulnerable to Default

On a YouTube channel I regularly watch, an investor based overseas was explaining the fiscal positions of different countries and their risk of sovereign default.

It was quite interesting.

In Japan, we often hear that the national debt keeps growing and that the country will eventually face a fiscal collapse if this continues.

According to this investor, however, Japan is not necessarily a country that is especially prone to default.

Of course, Japan’s debt is exceptionally large by global standards. But investors do not look only at the total amount of debt.

Who supplied the money, and in what currency was it borrowed?

These differences have a major effect on a country’s risk of default.

Why Japan Is Unlikely to Default Suddenly

Japanese government bonds have two major characteristics.

First, most of them are held by domestic financial institutions, the Bank of Japan, and other Japanese entities.

Second, the Japanese government borrows primarily in its own currency, the yen.

This is extremely important.

A country that borrows in a foreign currency, for example, must obtain that currency to repay its debt. If its own currency collapses, the debt burden can suddenly become much heavier.

The Japanese government’s debt, by contrast, is denominated primarily in yen.

The Bank of Japan also has tools for supplying yen liquidity. This makes it relatively unlikely that the government will suddenly run out of funds and become unable to repay its bonds.

Of course, this does not mean that the Bank of Japan can simply buy an unlimited amount of government debt. Doing so would create other problems, such as inflation and a weaker yen.

Even so, the ability to issue the currency needed to repay debt makes a major difference in public finance.

Europe Has a Vulnerability That Japan Does Not

Europe provides an interesting contrast.

The circumstances of countries that use the euro are particularly different from Japan’s.

Italy and Greece, for example, use the euro as a shared currency. But their national governments cannot issue euros at their own discretion.

Monetary policy is handled by the European Central Bank, or ECB.

In other words, when their public finances come under pressure, they have less freedom than Japan to coordinate a response with their own central bank.

During the Greek debt crisis, Greece was required to undertake severe fiscal reforms in exchange for financial support from the European Union, the International Monetary Fund, and other institutions.

Pension cuts, tax increases, and reductions in public-sector staffing had a major impact on people’s lives.

This does not mean that nothing similar could ever happen in Japan.

However, a country with its own currency and central bank has different options for responding to a crisis than a country using a shared currency.

The situation is also different for European countries such as the United Kingdom, which retains its own currency. What matters is not whether a country is in Europe or Asia, but the difference in its monetary system.

Does That Mean Japan Never Has to Repay Its Debt?

This naturally raises a question.

Does Japan not have to repay its debt?

Government debt is indeed different from a household mortgage.

Whenever government bonds mature, the government can maintain the outstanding balance by refinancing them. There is no rule requiring a country to pay off all its debt completely.

That does not mean, however, that it can increase its debt without limit.

If confidence in government bonds weakens, interest rates will rise and the government’s interest payments will increase. If confidence in the currency declines, the yen will weaken, and higher import prices will put pressure on people’s lives.

In Japan’s case, rather than suddenly announcing one day that the country has gone bankrupt, the burden may gradually reach the public through inflation, a weaker yen, higher taxes, and increased social security contributions.

A country does not have to default for its people to suffer financially.

We must not confuse the two.

Avoiding Default and Being Prosperous Are Two Different Things

What I found interesting about the video was that it allowed me to view the fiscal issue from a different angle than the usual debate within Japan.

In Japan, discussions tend to emphasize the size of government debt above everything else.

Overseas investors, however, assess risk by combining factors such as the monetary system, the ownership structure of government bonds, central bank policy, and economic growth.

From that perspective, Japan is a country that, despite carrying an enormous amount of debt, has tools for avoiding a sudden default.

But that does not mean Japan’s public finances are healthy.

In fact, I think this is precisely what makes Japan’s problem so troublesome.

In a fiscal crisis like Greece’s, outside institutions demand severe reforms. The social pain is great, but the problem becomes obvious to everyone.

Japan, by contrast, can continue managing its finances while refinancing its debt.

That also creates ample room to postpone dealing with the problem.

Instead of arriving as a sudden default, the fiscal burden is passed on to the public over a long period through rising prices, taxes, and changes to the social security system.

Japan may be a country that is unlikely to suffer a fiscal default. But that does not mean its people will escape paying the bill.

What may be more frightening is that life gradually becomes harder without any clear event called a default ever taking place.

The country may avoid bankruptcy while its citizens’ wallets go bankrupt first.

That is not much comfort.