RIETI Report March 2004

Japan's Fiscal Condition: Dealing with Debt <RIETI Featured Fellow> TAKAHASHI Yoichi

Greetings from RIETI

March 14th, more commonly known as "White Day" in Japan, also coincided this year with the day of the "Oohiwatari" festival, held annually under the shadow of Mount Takao. Perhaps one of the more unique religious festivals in Japan, it revolves around the building of a 30m² pyre which is first blessed by priests and then ignited. When all that is left are hot ashes, entreaties are made for the year - good health and protection from road accidents etc - upon which the priests cross the still-burning cinders. Following this, anyone attending the festival is then also invited to walk on the ashes, barefoot. From the ceremony of the prayers, featuring swords and bows and arrows, to the enormity of the incense-ridden fire, it is quite a spectacular festival and accordingly draws quite a crowd. The most endearing part of the festival is the fearless participation by those of all ages and one commonly witnesses octogenarians and eight-year-olds alike traversing the ashes, with priests helping the former hobble and stern mothers pushing the latter. Welcoming a safe year free from harm by walking on fire is a brave step indeed. This week RIETI Report had the pleasure of talking with Consulting Fellow Yoichi Takahashi and learning of some equally brave steps that are needed to resolve Japan's current fiscal state. (DC)


Mr. Takahashi is a graduate of both the Department of Mathematics in the School of Science and the Faculty of Economics at the University of Tokyo. He has served in the Ministry of Finance and in the Ministry of Land, Infrastructure and Transport for the National and Regional Planning Bureau as Director of the Special Coordination Division, and has also been a visiting fellow of Princeton University. He currently holds the position of Director of the Kanto Finance Bureau for the Ministry of Finance, whilst being a consulting fellow of RIETI. Recent works include: ALM (co-authored with Toshifumi Ikemori, Ginko Kenshusha, 1996) and Economic Analysis of Fiscal Investment and Lending (co-authored with Kazumasa Iwata, Nihon Keizai Shimbunsha, 1998), both published in Japanese.

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Japan's Fiscal Condition: Dealing with Debt

RIETI Report: How do you assess Japan's fiscal condition and heavy reliance on government bonds?

Takahashi: On a flow basis, roughly half of the government's general account budget is being financed by the issuance of bonds. Meanwhile, on a stock basis, the outstanding balance of government bonds - measured as a ratio against gross domestic product (GDP) - is at an extremely high level, unparalleled by those of other countries and a record in Japan's peacetime history. This situation is, by any standards, abnormal.

The question is how we can manage this situation so as to not let the country go bankrupt. A short answer to this is to satisfy the conditions of the Domar growth model, by maintaining a nominal economic growth rate that is at a level higher than nominal long-term interest rates. What is needed now is to raise the nominal economic growth rate.

Japan, being in the midst of deflation, is not fulfilling such conditions. Obviously, the current fiscal situation is not sustainable. But we do still have a slim chance as there is also a notion called real interest rates. When a slight inflation occurs, nominal interest rates will certainly go up. But real interest rates - which are nominal interest rates minus the nominal rate of inflation - are certain to fall from their current level, thereby pushing up the economic growth rate. This is probably the last string of hope to which we can cling.

If nothing is done, Japan is doomed to fall apart. We need to raise the inflation rate by at least three to four percentage points. And when this happens, nominal interest rates would increase by two to three percentage points, not three to four. We must move into such a situation as quickly as possible and stay there.

RIETI Report: Concerns have been voiced over a rise in long-term interest rates.

Takahashi: What we are witnessing now is the so-called Fisher effect, a process where an increase in expected inflation rate pushes up nominal interest rates. But we should focus on the degree to which the inflation rate and nominal interest rates go up respectively. Japan is currently in deflation, an abnormal situation where the nominal inflation rate is negative but nominal interest rates are positive. So, a slight increase in the inflation rate would not immediately lead to an equivalent rise in nominal interest rates. There is no need to panic over the recent rise in long-term interest rates as it simply reflects market expectations for future economic growth. In the midterm, these nominal interest rates would not go up as sharply as the inflation rate. A lot of money would be converted into bonds and this would cool down the bonds market.

RIETI Report: A series of pump-priming economic packages in the 1990s were financed by the massive issuance of government bonds. Over the next several years, the government needs to refinance them. Will this cause any problems?

Takahashi: No. It is just a matter of resetting the interest rates. It has no impact on the outstanding balance of government bonds. Meanwhile, the interest payment burden borne by the government will remain unchanged or decrease because the current level of interest rates - though slightly up from its recent low - is far below the level it was at 10 years ago when these soon-to-be-redeemed bonds were first issued. As to the question of whether all these refunding bonds can find buyers, those holding government bonds would most likely reinvest in more government bonds upon receiving proceeds from ones that are redeemed. Such a rollover would not cause any significant problem unless financial institutions, a major holder of Japanese government bonds (JGBs), make drastic changes to their investment portfolio.

RIETI Report: Japanese banks' JGB holdings are rising to a record high. What would happen to their balance sheet if long-term interest rates go up and JGB prices go down?

Takahashi: Banks' asset portfolio is not solely composed of JGBs and on a flow basis they should be able to cope adequately with changes in interest rates by maintaining proper asset liability management (ALM). Another question would be what to do with possible valuation losses. One simple answer to this is to classify JGBs as held-to-maturity securities, thereby not making them subject to valuation. And even if they are classified as such, JGBs can be still used as collateral when the need arises for a bank to raise funds. So, this would not cause any liquidity problems. If banks decide to hold JGBs as marketable securities, which are subject to valuation, then they can also invest in other types of assets, such as stocks, whose market value is expected to rise when interest rates go up. Furthermore, they can also shift some of the money invested in JGBs to lending because demand for bank loans would increase when long-term interest rates begin to pick up. All these schemes work as forms of built-in stabilizers. When banks take natural steps in response to changes in economic conditions they are, in effect, implementing proper ALM.

RIETI Report: What is the future prospect for Japan's fiscal condition? How soon would we start to see the outstanding balance of government debts decrease?

Takahashi: Given the current primary balance, the outstanding balance of JGBs will not begin to fall anytime in the near future. In terms of debt-to-GDP ratio, there is no economic theory which dictates a threshold level below which we should keep the ratio. But based on history, one can assuredly say that no country has ever maintained debts at a level of 200% to 300% of GDP over a long period of time. Japan's debt-to-GDP ratio exceeded 200% immediately after the war but it only lasted for few years. Should such a situation occur and prolong, we just would not know how to manage it. Today, however, Japan's debt-to-GDP ratio is as high as 140% or 150%, leaving only 50% or 60%, or about ¥250 trillion to ¥300 trillion, before it reaches that critical level. If the current pace of bond issuance, a net increase of ¥40 trillion per year, is maintained, we have only six to seven years before we plunge into unknown territory.

There certainly exists the optimistic view that Japan would be able to sustain itself even with a debt-to-GDP ratio of 200% because of strong domestic bias among Japanese investors. Indeed, Japanese investors show an inexplicably strong tendency to invest in Japanese assets. But this is a matter of people's preference which may change at anytime. There is no guarantee that Japanese people will continue to buy Japanese assets forever.

RIETI Report: What needs to be done before the situation becomes uncontrollable?

Takahashi: We have no room to allow the net increase in bond issuance to grow any further. So we need to improve the primary fiscal balance as soon as possible.

RIETI Report: Is this possible under the current economic condition?

Takahashi: There are many things that could have been and can be done through monetary policy. The Bank of Japan (BOJ) can and should supply more money to push up the inflation and the nominal rate of economic growth, which can be done without hurting the government's fiscal condition. If the BOJ pumps in more money, real interest rates would be somewhat lowered whereby economic growth rates - both in nominal and real terms - would go up. This is the simplest way to improve the government's fiscal balance because tax revenue moves up and down in line with nominal economic growth rate. But there remains the risk that the BOJ will fail to do what it is supposed to do. In this case monetary and fiscal cooperation will be needed. I recommend a fiscal policy financed by money creation with inflation targeting.

Although the BOJ is doing a better job than it used to be, it is not doing enough. For eight to nine years, Japan has been in deflation and this is a problem that can be solved by the sufficient easing of monetary policy. The BOJ has been irresponsible in managing long-term interest rates. Long-term interest rates - though they are difficult to control because they are also subject to market expectations - are primarily determined by money supply or monetary policy, and therefore, a central bank is the only one that has the capacity to control them. The BOJ, however, is not fully utilizing this capacity.

Despite its pledge to increase the outright purchase of long-term government bonds to ¥1.2 trillion per month, the actual scale of outright purchase by the BOJ has been ¥700 billion on average. Instead, it is purchasing financial bills - in an operation to affect short-term interest rates - thereby sending out the message that the BOJ is not serious about suppressing a rise in long-term interest rates. So, the recent rise in long-term interest rates can be partly explained by market expectations of economic recovery, which is good, but it also reflects market anticipation that the BOJ would tolerate a rise in long-term interest rates.

RIETI Report: What can be done on the fiscal side?

Takahashi: Apart from the aforementioned fiscal and monetary cooperation, there are only two things one can do on the fiscal side. One either stops using money or increases revenue, in other words, cut expenditures or increase taxes. I personally believe that we can make cuts in the payment of pension benefits because today's elderly people - those in their 60s and 70s - are receiving far more than what they paid. As to tax revenue, I think employment of a tax identification number system is universal, but there is no such system in Japan. The simplest way to capture people's income more accurately is by numbering taxpayers. Raising consumption tax rate is also an option, if it is accepted. Based on my estimates, the introduction of a taxpayer identification number system would bring in additional tax revenue roughly equivalent to a 5% increase in the consumption tax rate. So, I would say that the people can either allow the taxpayer numbering system or accept a consumption tax rate of 10%. But this is for politicians to decide, based on what the public wants. And if people keep on saying "no" to everything, then that will also be their choice.


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This month's featured article

Japan's Fiscal Condition: Dealing with Debt <RIETI Featured Fellow> TAKAHASHI Yoichi

TAKAHASHI YoichiConsulting Fellow, RIETI

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RIETI Report is published monthly.