Japanese debt

The Japanese bond market has been spooked by the new Prime Minister, wishing to put through further fiscal stimulus measures. Posing as some new Maragaret Thatcher, she did not read about the Iron Lady's insistence on living within your means, controlling debt by the sale of state assets and applying discipline over spending. Japan's state debt is a massive 1,324 trillion yen (£6,400  bn), more than double the UK’s. For years this has been affordable as for much of that time Japan has been able to borrow at rates below 1%. Now alarmed by both the enormous stock of debt and by future high borrowing requirements, the markets have put the cost of 10 year borrowing for the state up to almost 2%. As the old debt matures the government has to replace it with new borrowing at much higher interest cost, with further strains on the Japanese budget and taxpayers.

Current debt interest costs are around 10 trillion yen a year (£48 bn), a manageable cost. Were the whole 1,324 trillion yen to be refinanced at 2% in due course, that would be an interest cost of 26 trillion yen (£125 bn). If this takes place at the same time as the government seeks to borrow a larger share of its current budget each year, the compound effects become more serious. The Japanese bond market will experience big demands and further strains. The pressure is on the Prime Minister to reduce her additional demands to spend more and cancel proposed tax cuts. 

The absolute level of debt interest is still modest compared with the UK. With much higher interest rates - in excess of 4% - the debt service costs in the UK have already exceeded £105 bn and are on course to reach £131 bn by the end of the decade according to the official forecasts. Over the next five years on current government plans, the UK needs to raise £628 bn for additional spending and £675 bn to replace retiring debt. Both these fund raisings will add to the interest burden. That is why UK 10-year rates are at 4.4%.

Japan authorities can say that debt interest levels are still low by comparison, and will take time to get above the UK level in cash terms. Markets however are also motivated by sentiment and can suddenly decide a government's past and future indebtedness is a problem. Japan today is the advanced country in the firing line of the bond vigilantes. They can rightly point to excessive reliance on debt for many years of reflationary packages, and to the future threat from the need to replace old debt with much dearer new debt. 

Japan for years craved some inflation. Now it has some, the country is discovering why western countries have been struggling to control their price levels. Higher inflation brings higher interest rates, and   with higher interest rates come the bond vigilantes, raising uncomfortable issues over how affordable all the growing debt will prove to be. Bond traders can move interest rates against their victim country if they want a change of policy. That is self-validating, making future debt dearer and making the budget sums look worse, just when a government wishes to present an improving picture. 

For a long time, Japanese debt has been offering too low an income return to make it worthwhile as an investment. The yen has also usually been weak, though there have been rallies when investors could make money by holding the Japanese currency. The bond markets may have their way and get the PM to curb some of her fiscal stimulus.

About the author 

The Rt. Hon Sir John Redwood has been a long-standing member of the EPIC Investment Partners Advisory Board. 

John is a well known commentator on governments and economies, with long experience of investment markets. Trained as an analyst at Robert Flemings, he moved to N.M. Rothschilds where he became a Manager and Director of pension and charitable funds and Head of Equity Research. He was seconded to become Head of the Downing Street Policy unit before chairing a large, quoted UK industrial business. He served as an MP and a government Minister.  

In 2007 he set up Pan Asset with a colleague, an investment management business that pioneered active/passive funds and models in the UK. Following the sale of the business to Charles Stanley, a quoted investment manager in the City, he became their Global Chief Strategist advising on non-UK markets and economies. He also ran a demonstration fund for the FT, writing articles about it and illustrating the use that can be made of ETFs in portfolios. 

He is now an adviser to EPIC, providing insights into the big investment issues of the day from the debt and spending problems of the major governments to the green and digital revolutions which have so much impact on equity markets. He is a Distinguished Fellow of All Souls College, Oxford, where he helps with their Endowment investments and gives occasional lectures on modern economics and politics.