Special report: Why Japan will avert a fiscal meltdown

By Alan Wheatley, Global Economics Correspondent

TOKYO (Reuters) - In these dark hours, Japan would do well to heed former White House Chief of Staff Rahm Emanuel's memorable maxim that you never want a serious crisis to go to waste.

As the nation struggles to avert a nuclear catastrophe on the heels of a deadly earthquake and tsunami, it takes a huge leap of faith to foresee any positives emerging from the triple disaster for a stagnant, rapidly aging and heavily indebted economy.

Yet a number of experts say the disaster might -- just might -- shake Japan out of its collective economic and political torpor of the past two decades and provide a new sense of purpose for a nation that has seemingly lost its way.

They also say that widespread fear of a Japanese fiscal death spiral is mostly overblown.

Masaru Hamasaki, a senior strategist at Toyota Asset Management in Tokyo, said the severity of the challenge facing Japan should not be underestimated.

The numbers killed in last Friday's quake centered on Sendai in northeastern Japan will far exceed the 6,400 toll from the 1995 temblor in Kobe.

Many more people have been affected directly and indirectly, for instance by power cuts and the risk of radioactive fallout from the crippled Fukushima Daiichi nuclear power plant. The usually bustling streets of Tokyo were eerily empty this week.

And the economy is even less vigorous than in 1995, smack in the middle of Japan's so-called Lost Decade.

"But out of this crisis affecting a large part of the population, a sense of 'public morality' is already building up," Hamasaki said. "If the country's leaders can harness this spirit in the long term, then I'm sure Japan will move in a positive direction."

This civic duty, an impulse of shared responsibility, is likely to count for more than any spreadsheet in trying to assess the impact on Japan's bond markets of financing the still unknowable bill of rebuilding after the quake, the strongest on record here.

Some pundits fear that adding substantially to a gross debt burden that is already more than twice Japan's national output will be the straw that breaks the bond market's back.

"The debt will rise significantly. Until now, the country could finance its obligations at relatively low rates. If additional debts come on top now, there will be questions about solvency," Peter Bofinger, a member of Germany's "wisemen" council of economic advisers, said in an interview with the German daily Sueddeutsche Zeitung published on Monday.

Economics Minister Kaoru Yosano has acknowledged that, unless it changes its ways, Japan faces a fiscal dead end.

But the Sendai quake is very unlikely to trigger that day of reckoning.


On paper, Japan's liabilities will hit 204 percent of GDP this calendar year, larger than 137 percent for Greece and 113 percent for Ireland, according to the Organization for Economic Co-operation and Development (OECD).

But Japan is not about to follow Greece and Ireland into the emergency debt ward. Both countries have needed a bailout arranged by the eurozone and the International Monetary Fund.

For a start, the government owes nearly half of the debt to other arms of the government such as the Japan Post Bank and the Government Pension Investment Fund. The Bank of Japan also owns a tidy chunk of Japanese Government Bonds (JGBs).

Net debt, taking account also of Japan's official foreign reserves, will reach 120 percent of GDP this year, according to the OECD.

That will be the highest among major economies, but the burden is not significantly greater than that shouldered by Belgium and Italy in the 1990s, both of which avoided a sovereign debt crisis.

True, net debt has risen sharply from 80 percent of GDP in 2007, and the government is running a budget deficit of close to 10 percent of GDP even before counting the cost of the quake.

But whereas about 70 percent of Greece's public debt is held by foreigners, domestic investors hold 95.4 percent of Japan's bonds. This gives Tokyo's policymakers a huge advantage.

"They have much more room to manoeuvre than Greece or Ireland would have in similar circumstances," said Marcus Noland of the Peterson Institute of International Economics in Washington.

"One has to assume Japanese residents are a much less footloose debt-owning class than, say, London hedge funds."

Quite apart from the fact that low-yielding JGBs have proved a good investment in recent deflationary years, Noland expects banks, insurers and pension funds will readily accede if the government asks them to buy extra quake reconstruction bonds.

In a country with a high degree of social cohesion, the loyalty of individual investors in Japan's hour of need can also be taken for granted.

"If the government says 'we're going to tighten our belts; cut expenditure in other areas and shift spending to rebuild Sendai; and we're going to issue more bonds at the margin to make that happen', I simply do not believe the Japanese public is going to dump Japanese bonds," Noland said.

Jeremy Lawson, an economist with the Institute of International Finance, a lobby group for global banks in Washington, agreed. The trajectory of Japan's debt is unsustainable, but, in the short term, "domestic residents may display even greater willingness to lend to the government as an act of national solidarity," Lawson said in a report.


That's today, though. What about the future?

If Japan's households are avid buyers of bonds, it is because they are sitting on a mountain of savings -- some 1,400 trillion yen ($17,320 billion), compared with approximately 870 trillion yen in outstanding long-term government bonds.

Little noticed by the rest of the world, Japan's household savings rate has in fact already plunged to about 3 percent of disposable income from a peak of 18 percent in the early 1980s.

Despite the government's big budget deficit, Japan still enjoys surplus national savings, reflected in a current account surplus, thanks to high corporate savings and a large income stream from its overseas investments. Japan is the world's largest creditor nation, with net external assets of 225.5 trillion yen, according to official figures.

The question preoccupying economists is how long it will take for the savings rate to erode and drive the current account into deficit. At that point, Japan will have to import capital to balance its books. That's when unexpected shocks like the Sendai quake could trigger a financial as well as a humanitarian crisis by undermining the confidence of foreign investors.

"Without policy adjustment, the space for household assets to absorb public debt will continue to shrink over the medium term," said Kiichi Tokuoka, an economist with the International Monetary Fund.

In a January 2010 working paper, he said Japan's gross public debt could exceed households' gross financial assets by 2015 or 2020, depending on the accounting treatment.

"Although these results do not imply any specific turning point for public debt financing, they suggest that if current trends continue, domestic financing could become more difficult toward the mid-2010s, placing a premium on other sources of funding, including from overseas," he wrote.


George Magnus, senior economic adviser to UBS in London, guessed that three years was too short a time for Japan to reach the turning point. But 10 years was too long because the aging of the workforce was inexorable.

"At some point in the medium term, I do think there's a sporting possibility that Japan will start to run trade deficits and have to start selling debt abroad," said Magnus, the author of a study on the economics of aging. "And that probably is when the crunch will come, because people will want to see Japan taking material measures to manage its public debt over the longer term."

Crucially, no respected economist is arguing that Japan should think twice about spending right away whatever is needed to put the economy back on its feet.

One of the lessons from the recession brought on by the collapse of investment bank Lehman Brothers in 2008 is that the increase in the public debt ratio in Japan and other countries was not due to fiscal spending to stimulate the economy. Rather, it was more due to the abrupt slowdown in economic growth.

The government should do the same today, said Sebastian Mallaby, an economist with the Council on Foreign Relations in New York.

"It should be willing to act aggressively to increase the budget deficit in order to have the money to rebuild the damaged areas promptly," he wrote on CFR's website. "Now is not the time for being cautious or conservative. Now is the time for a bold response, and I've got every reason to think that they will do that," he added.


When the time comes to rein in the budget deficit, Japan already knows from years of experience what Greece and Ireland and other countries are just discovering: there is no secret recipe. It's "simply" a question of agreeing on a politically acceptable mix of tax increases and spending cuts.

The IMF and other agencies have zoomed in on Japan's low rate of consumption tax, five percent, as the most promising candidate to raise the revenue needed to help stabilize the government's debt-to-GDP ratio. In its 2010 review of Japan, the Fund projected that by 2015 gross debt would reach 250 percent, and net debt 154 percent, unless there was a shift in policy.

The government could raise some 2.5 trillion yen for each 1 percentage point rise in the consumption tax.

But a hamstrung political process has hobbled policymaking. Prime Minister Naoto Kan is the fifth man to hold the job since 2006, and his popularity ratings have been sinking like a stone, further reducing his chances of getting budget bills through a split parliament. Indeed, just hours before Friday's earthquake, Kan, accused of illegally receiving campaign funds, was rebuffing calls from an emboldened opposition for his resignation.

The tantalizing question now is whether the Sendai tragedy will change not only Japan's economic and fiscal outlook but also its politics.

"Kan needs to show his leadership to craft a big supplementary budget. This is the time to show his leadership by gathering ideas from the ruling and opposition parties very quickly," said Hamasaki, the Toyota Asset Management strategist.


Pessimists suspect any political truce sealed in a moment of national solidarity will be short-lived once reconstruction is under way and the economy is recouping the output lost due to the disaster.

After all, the bursting of Japan's asset bubble in the early 1990s failed to jolt the political class into enacting the difficult structural reforms the economy needed. Japan's nominal GDP is stuck at the level it was at in 1992.

But Noland with the Peterson Institute for International Economics said that successful crisis management on Kan's part would go a long way toward reassuring voters still unsure whether his Democratic Party of Japan is a credible alternative to the Liberal Democratic Party. The LDP has governed Japan for most of the past 60 years. It lost power to the DPJ in 2009.

"Cementing a real two-party system could create 'more normal' politics and push Japan into becoming a truly modern, functioning democracy in the 21st century," Noland said.

"It would make governance more complicated, but it would bring issues such as the coddling of the agricultural sector, immigration reform and defense policies out into the open in a much more transparent, democratic way," he added.

The alternative is that Sendai turns out to be Japan's "Katrina" moment, Noland said, referring to the U.S. authorities' ineffectual initial response to the hurricane that ravaged New Orleans in 2005.

"If they do a bad job, then Japan's aging and risk-averse electorate could go flocking back to the LDP and essentially re-estabalish the status quo ante of the last 60 years," he said.

Seen in this light, the implications for Japan's economy and investment outlook are profound.

Like everyone, Jim O'Neill, chairman of Goldman Sachs Asset Management in London, is waiting to see how fast-changing events at the Fukushima plant play out. But he said the crisis could act as a catalyst in much the same way that the second oil price shock of the late 1970s prompted an all-out national effort by Japan to improve energy efficiency.

"My hunch is that this is so big it will galvanize change and force Japan's leaders to do more," he said in an email. (Additional reporting by Chikafumi Hodo and Stanley White in Tokyo and Noah Barkin in Berlin; editing by Jim Impoco and Claudia Parsons)