The time when Japan financed itself cheaply despite an abysmal debt could soon be over. Concerned by the costly tax reduction measures promised by the new Prime Minister, while inflation has returned to the country, investors are becoming more intransigent and demanding ever higher returns. Voters are called to the polls this Sunday, after the dissolution of the lower house of Parliament in mid-January.
Will Sanae Takaichi obtain a comfortable majority to carry out her program? The new Japanese Prime Minister is calling voters to the polls this Sunday after deciding to dissolve the lower house of Parliament in mid-January.
If pollsters predict the victory of the Liberal Democratic Party of the very popular nationalist leader, the game will still be far from won for the one whose action is closely scrutinized by investors. It must be said that the vote comes after several shocks in the Japanese debt market which is already the highest in the world at nearly 230% of GDP. Successive alerts which revive fears about the financial solidity of the country.
Borrowing costs at their highest
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In November, the announcement of a massive recovery plan of 117 billion euros by Sanae Takaichi and the prospect of a new record budget (665 billion euros) had already pushed up Japanese bond yields, investors demanding better remuneration in the face of this costly program to support household purchasing power deployed despite exorbitant debt.
The surge in sovereign rates continued at the beginning of December with the prospect of an increase in the key rate from the Bank of Japan (BOJ). Anticipating this tightening of monetary policy and therefore more attractive interest payments to come, investors turned away from Japanese bonds.
The Bank of Japan finally raised its key rate to 0.75% in mid-December, its highest level in 30 years. With this monetary tightening which began in 2024 to respond to the return of inflation – which is notably maintained by the weakness of the yen which makes imports more expensive – Japan seems to have entered a new era. For several years in fact, the world’s fourth largest economy had been accustomed to deflation and the very accommodating monetary policy of its central bank.
But it was on January 20 that investor nervousness reached its peak. In a market haunted by the prospect of new tax cuts and stimulus measures promised by Prime Minister Sanae Takaichi three weeks before the snap elections, bond yields have soared to record levels. Yields on 30-year bonds jumped to an unprecedented level of 3.66%, and those on 40-year bonds reached the 4% mark for the very first time. Rates on 10-year bonds also climbed, reaching a new high since 1997, at more than 2.34%.
“Yields could rise further”
By promising new expensive gifts such as the elimination of food VAT for two years, is Sanae Takaichi not playing with fire? Even if the Prime Minister assured that she wanted to implement these tax cuts “without having to resort to additional bond issues, the reduction in the food tax will potentially represent a shortfall of around 5,000 billion yen per year (27 billion euros)”, declared to AFP, Michael Wan, of the MUFG bank.
Investor mistrust is all the greater as the opposition parties are also calling for a reduction in the tax on food products. In other words, “the bond market is losing hope regarding budgetary discipline, and yields could rise further,” judged Ryutaro Kimura, senior strategist at AXA Investment Managers cited by Bloomberg.
If the tension on the Japanese bond market has eased a little since January 20, some fear further turbulence or even a possible financial crisis: “There are certainly good reasons to think that the Japanese government bond market (JGB), worth $7.3 trillion, could collapse if Prime Minister Sanae Takaichi’s party resumes its fiscal recovery program,” observes Yardeni Research.
The investment strategy consulting firm also points out that Tokyo cannot count on its sluggish growth to get out of debt. Especially since Japan is facing a serious demographic crisis with more than 30% of its population aged 65 and over, which is slowing down the growth of its GDP more than elsewhere. In short, this “hardly encouraging” context does not justify “the unfunded tax cuts recommended by Takaichi”, judges Yardeni.
A risk of propagation to Western economies?
The Japanese media are not more reassuring. The business daily Nihon Keizai Shimbun accuses Sanae Takaichi of promising “measures consisting of spending public funds without any control” and goes so far as to warn of the risk of “financial bankruptcy” of the country.
Others even believe that the Japanese situation could turn against other major world economies. The mechanism would be as follows: while Japan is the world’s largest creditor, investors could be tempted to repatriate their capital to benefit from more attractive bond yields, to the detriment of the foreign bonds which they would get rid of. States, particularly Western ones, would then see their borrowing costs skyrocket in turn.
US Treasury Secretary Scott Bessent himself assured that the rise in the yield on 10-year US Treasury bonds was already partly linked to “internal factors specific to Japan”. “I have been in contact with my Japanese counterpart, and I am sure he will start saying things that will calm the market,” he said in an interview with Fox News from Davos on January 21.
90% of Japanese debt held by… the Japanese
Be careful not to fall into catastrophism either. Many people dismiss the risk of a short-term financial crisis given Japan’s undeniable strengths. Despite its inglorious observation of the current situation, Yaderni Research recalls that Japanese debt is 90% held by the Japanese themselves. And almost half by the central bank. This limits the risks in the event of investor panic.
As for the BOJ, its key rate has certainly reached its highest level since 1995, but “only 0.75% remains” and the probability that it will proceed in the short term “to further rate increases is almost as low as the borrowing costs themselves”, further notes the consulting company, further specifying that historically, “the Ministry of Finance and the Bank of Japan manage to coordinate their actions in order to keep very long-term bond yields below the bar. 4%.
At the end of January, the institution had the “kindness and courtesy not to raise its short rate”, just a few days after the announcement of the early elections, underlines on BFM Business Jean-Yves Colin, specialist in North Asia at the Asia Centre. He “does not believe” in the risk of a financial crisis, even if “we are never safe from a market incident”. The BOJ governor in any case warned that the institution “stands ready to take rapid measures to deal with exceptional (bond) movements”.
“No immediate risk”
In the meantime, the level of long-term rates which is close to 4% “is not dramatic either”, still believes Jean-Yves Colin. Especially since the expert who has followed Japan for almost 50 years recalls having “only known expansionist budgets”. So much so that “the question of debt sustainability is a problem that we have been asking ourselves since the 1960s”. In short, not much new under the sun according to those who therefore expect to see Japanese sovereign rates continue to rise gradually but without getting carried away.
For its part, the Barclays bank indicates that “an overwhelming victory for the Liberal Democratic Party is already widely anticipated, thus limiting” the risk of further turbulence on the markets in the event of Sanae Takaishi’s victory.
“There is no immediate risk of a public finance crisis in Japan,” adds economist Sylvain Bersinger in a note. But in the “longer term, the situation could become critical” or even “untenable”, in particular “due to very weak growth prospects (demographic aging, tensions with China)” and the “gradual loss of confidence of domestic investors in the solidity of public finances” which “would cause rates to jump even further”.
