What Japan needs now is a fiscal management plan

Even as demographically mature Japan was coping with the aftermath of 2008 global economic crisis, it suffered from triple disasters - a powerful earthquake on March 11 followed by the tsunami and near total loss of one its nuclear energy complexes.

Japan’s economy is the third largest in the world with the nominal GDP in 2010 of yen 476 trillion ($5.6 trillion). It exhibits large, though declining, current account surpluses (averaging 3.7% of GDP annually between 2004 and 2009). Japan’s total external trade in 2009 was $1,406 billion. Its production capacities are vital for electronics industry globally.

The quake-stricken Northeastern Japan accounts for less than 10% of Japan’s economy. Even then, there has been justifiable anxiety in Japan and elsewhere about the economic and fiscal implications of the recent events.

The Bank of Japan (BoJ) in January 2011 projected Japan’s real GDP growth rate at 1.6% for fiscal 2011-12, and at 2% the following year.

Most recent indications are that the 2011-12 growth will be significantly lower than 1.6%, but still will be positive; but growth will rebound in 2012-13. This is consistent with past experiences of Japan.

The resumption of manufacturing as reported by Bloomberg, that Toyota will resume output at all its factories in Japan from April 18, 2011 is a hopeful sign. If this spreads to other key corporations, output recovery could be relatively swift.

The growth for the current and the next fiscal year will also depend on the additional reconstruction budget and how it is financed. Reconstruction provides an opportunity to enhance competitiveness of the north eastern Japan.

The official projections are that the additional budget expenditure during financial year 2011-12 for the first phase of relief and rebuilding (primarily for relief) will be yen 4,000 billion ($47 billion) or 0.8% of GDP, which is larger than some earlier estimates.

The second and the third rounds will cost substantially more (yen 6,000 billion of $71 billion or 1.2% of GDP) during 2011-12. These expenditures do not include the rebuilding expenditure in subsequent fiscal years, which could be as high as additional yen 15,000 billion ($176 billion or 3.1% of 2011 projected GDP).

The contingent liabilities on the state, from the damage to the nuclear energy complex, from government guaranteed loans and from other areas, represent additional sources of fiscal risk for the Japanese economy.

Recent events will lower Japan’s economic growth in the short term, and require additional fiscal spending for relief and reconstruction. How would this impact fiscal and debt management in Japan?

Historical experience points generally to higher fiscal deficits and stock of public debt (in relation to GDP) frequently leading over time to higher real interest rates. Debt management and sustainability issues become acute when real interest rate is persistently higher than real GDP growth.

Japan’s experience, however, has not been consistent with the standard historical experience since at least the early 1990s. A 2010 research paper by Kiichi Tokuoka of the IMF suggests that during the 1990s the 10-year Japanese Government Bond (JGB) yields declined from 7% to below 2%, while net public debt increased from 20% of GDP to 60% of GDP.

Since 2000, net public debt has further climbed to 90% of GDP, but the long-term yields have not increased above 2%. The global monetary ease and BoJ’s accommodative policies have contributed to yields remaining low.

In case of Japan, it is important to differentiate between gross public debt to which the question refers, and the net public debt. The public debt comprises debt of the central government, local governments and social security fund. The gross public debt in 2012 is projected to be little over 200% of GDP.

The net public debt is defined as gross debt minus all the assets of the central and local governments and of the social security funds. As these assets are substantial, net debt is significantly lower than the gross debt.

Several additional factors have contributed to relatively smooth financing of Japan’s fiscal deficits, and helped in debt management.

The JGBs are denominated in yen and only around 6% are held by foreign entities. Large and stable institutional investors (including the Japan Post Bank and the Government Pension Fund) own nearly half of the public debt. In addition, the BoJ holds nearly one-tenth of the debt. Such ownership structure has contributed to greater flexibility in debt management.

Relatively large, though fluctuating, savings flows from the corporate sector have partly compensated for declining household savings as avenues for purchasing the JGBs. Finally, the declining role of the Fiscal Investment and Loan Program (FILP) to finance government capital expenditure has created fiscal space for other government debt. This has significantly cushioned the impact of continuing high fiscal deficits on the debt levels in recent years.

It is because of the above reasons that some analysts contend that Japan’s main debt issue is one of managing liquidity and not that of solvency.

The external macroeconomic environment, however, has been altered by the 2008 global crisis. Many countries, in Euro zone and elsewhere face substantially higher spreads on their sovereign debt, and sovereign debt default is no longer unthinkable.

Internally in Japan, the abilities and willingness of the traditional institutions, including the Japan Post Bank and the Pension Fund, and of households and corporations may not remain as strong as earlier, in absorbing Japanese government debt.

Relatively benign environment for managing Japan’s fiscal deficits and public debt is not likely to be sustained in the future. Even before the recent natural disasters, Moody’s had assigned a rating of Aa2 (the third highest for sovereign debt) to Japan but lowered the rating outlook to negative from stable. 

As foreign share of the JGBs increases, Japan’s high level of insulation from global investors will decline, and its debt costs may increase. Projected higher global inflation and tighter monetary policies globally may accentuate this increase.

If Japan is to continue to pursue fiscal and debt management policies without experiencing a crisis, it will need to begin implementing credible fiscal consolidation plan in next couple of years.  Some estimates suggest that the fiscal consolidation will need to approach nearly 10% of GDP. This will involve roughly equal measure of tax increases, and expenditure reductions, particularly in pensions and health care.

Recent natural disasters in Japan will have global ramifications, including for India. There is even greater urgency to continue to constructively and skillfully engage with Japan to enhance economic and strategic space for both countries.

The writer is a professor of public policy at the National University of Singapore and can be reached at mukul.asher@gmail.com.