Today’s ratings downgrade by S&P for Japanese public debt has brought further attention to Japan’s huge and growing debt burden.Â Yet with each round of concern, there’s always a viable response that says “So what, yields are still low.”Â And it’s true; if you were looking for sustainability concerns to be expressed in the level of yields, it’s hard to find — and those low yields coupled with the yen policy provided the key ingredients of the boom-era carry trade.Â An interesting working paper from the IMF looks in-depth at the reasons for the chronically low yields on Japanese public debt and comes to 2 conclusions.Â
First (as is fairly well understood),Â Japanese households haveÂ a strong habitat preference for public debt either directly or indirectly via savings institutions but second, this benign scenario for debt managers probably has about 5 years left as the demography turns around –Â the decline in savings rates already evident will continue as an ageing population draws down assets and the huge gross funding needs of the governmentÂ (they seem to do aÂ high amount of short-term funding) runs up against a shrinking pool of private wealth willing to be allocated in bonds —
Historically, Japanâ€™s public debt has been financed in a fairly smooth manner. The large pool of household savings and the stable domestic institutional investor base have contributed to keeping yields steady despite the rapid rise in public debt. However, Japan is undergoing rapid population aging, which will likely limit the marketâ€™s absorptive capacity of public debt. In addition, shifts in institutional investorsâ€™ behavior could serve to reduce inflows to the market. To maintain market stability, sound public debt management and fiscal consolidation will be critical.
Among the implications of this isÂ the need to be careful in using Japan as an example of how public debt can be allowed to get to very high levels before markets start to panic.Â Japan is a special case with a highly liquid currency and very tolerant domestic savers.Â Other countries would have a harder time with the same trick.Â And anyway, for Japan,Â the demographic clock is ticking.Â But is it ticking loudly enough for the politicians, who seem to be endlessly preoccupied with tactical considerations, to hear?