Japan, trade balance and national debt

No reasonable person would think that the huge amounts of debt accumulated by the Japanese government to expand the welfare state will ever be repaid. Interest alone currently eats up about a quarter of public revenues, and a small rise in interest rates would increase that share to 100%.

Many economists argue that the size of a country's government debt is as important as who holds it. If the debt is held mainly by residents, there is little risk of rising interest rates on it, even if it rises as a percentage of GDP. In Japan, government debt has long exceeded 200% of GDP, and the fact that creditors are mainly Japanese investors leads many analysts to believe that interest rates on these obligations could remain at record lows for a long time.

However, there is an important relationship that determines the amount of debt held by foreign investors. When production and trade in a country lead to trade surpluses, residents have a surplus of foreign currency received for exported goods and services. The logical consequence is that this surplus should be directed to domestic assets, with government debt being one of the most preferred candidates. This is precisely why China and Japan are the largest external creditors of the US economy, they are the countries with which the US runs large trade deficits. The surplus dollars that remain in the hands of local companies in the two Asian countries are immediately invested in US government securities due to the high liquidity of these instruments and the (albeit small) yield they provide.

Returning to our example of Japan, the country’s government debt is held mainly by residents because the country is characterized by its strong exports, which have helped generate trade surpluses for many years. However, this is starting to change. In November, Japan recorded a trade deficit of 953 billion yen, its fifth in a row (see Chart 1). Over the past 12 months (December 2011 – November 2012), the country managed to register only two trade surpluses on a monthly basis, totaling 95 billion yen, and for the entire period the total trade deficit amounted to 6.4 trillion yen. The logical question arises: what is happening to Japan’s government debt?

Graphics 1

According to the Bank of Japan, at the end of September 2012, the share of Japanese government debt held by foreign investors reached a record 9.1%, which corresponds to 86 trillion yen. In addition, the total amount of foreign debt in Japan at the end of September 2012 reached 246 trillion yen, registering the first decline in the last 2 years (see Chart 2). This trend (of increasing foreign debt) creates a bunch of other questions, answers to which no one can give with certainty. However, one thing is certain; if Japan continues to register trade deficits in the future, this will automatically increase the share of foreign investment in Japanese debt instruments. This, in turn, puts at serious risk the increase in returns on these instruments - an event whose occurrence keeps all rulers in the Land of the Rising Sun under pressure.

Graphics 2

No reasonable person would think that the vast amounts of debt accumulated by the Japanese government to expand the welfare state will ever be repaid. Interest alone currently eats up about a quarter of public revenues, and a modest increase in interest rates would increase that share to 100%. The expansionary policies of the new “conservative” Prime Minister Shinzo Abe will not solve the problem; they will deepen it and postpone it indefinitely. The million-dollar question is when the growing number of foreign investors in Japanese debt will decide that they are holding an empty promise.

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