Japan’s Takaichi Challenges Bond Markets With Spending Program

Recently-elected Japanese Prime Minister Sanae Takaishi has proposed an ambitious 21 trillion yen (US$135 billion) spending program that will put new pressure on already strained government coffers and raise the specter of a Liz Truss-style market shock. For international investors, this adds more uncertainty, but for the Japanese bond market, it has happened all over again.

The plan fulfills Takaishi’s campaign promise of a “proactive fiscal policy” designed to pull Japan out of its long slumber since the collapse of the bubble economy in 1990. Taking public opinion polls into account, much of the spending will go toward helping people cope with rising prices through various subsidies rather than taking more painful steps to control inflation itself.

Recently-elected Japanese Prime Minister Sanae Takaishi has proposed an ambitious 21 trillion yen (US$135 billion) spending program that will put new pressure on already strained government coffers and raise the specter of a Liz Truss-style market shock. For international investors, this adds more uncertainty, but for the Japanese bond market, it has happened all over again.

The plan fulfills Takaishi’s campaign promise of a “proactive fiscal policy” designed to pull Japan out of its long slumber since the collapse of the bubble economy in 1990. Taking public opinion polls into account, much of the spending will go toward helping people cope with rising prices through various subsidies rather than taking more painful steps to control inflation itself.

Although Japan’s inflation rate remains low by global standards, consumers are feeling the inflation rate at around 3 percent, especially since most of the increase is coming in higher food costs, which rose 6.4 percent in November compared to levels a year ago, including a 40.2 percent increase in the daily price of rice. Takaishi proposed measures including subsidizing electricity and gas bills in addition to providing cash assistance to families with children.

In addition, it wants to make targeted investments in sectors such as semiconductors and shipbuilding, plans reminiscent of the glory days of Japan’s state economy in the 1950s and 1960s, when the powerful Ministry of International Trade and Industry played a key role in the economy — and arguably helped create the post-war “economic miracle.”

While few would dispute hopes for a fast-growing Japanese economy, there seems little reason to believe that Takaishi will succeed where pretty much all of her predecessors have failed. Previous attempts at fiscal stimulus, especially those in the 1990s focusing on major infrastructure projects, did little for overall economic growth while pushing debt burdens ever higher.

Despite regular lip service to the idea of ​​“fiscal responsibility,” over the past 30 years administrations have found it easier to spend than to save. The government debt burden rose from just 48% of Japan’s annual GDP in 1980 to a peak of more than 258% in 2020, according to International Monetary Fund data. By contrast, the much-debated US debt burden is 125% of GDP, according to the International Monetary Fund.

Takaishi has said that her additional spending would not be a problem, because it would create higher growth and thus higher tax revenues.

“As we build a strong economy and raise our growth rate, we will be able to reduce the government debt-to-GDP ratio, achieve fiscal sustainability, and ensure market confidence,” she confidently predicted when she introduced the program in late November.

Markets were skeptical, and analysts were quick to compare Takaishi’s claims to the debacle that resulted from a similar attempt by British Prime Minister Liz Truss in 2022. Shortly after taking office, Truss announced an aggressive spending package that she claimed would be a cure-all that ailed the economy. The market reaction was rapid, with a sharp fall in the value of British government bonds and rapid market intervention by the Bank of England, followed by Truss’s swift removal from office by her party.

Such talk about Japan’s looming debt crisis is not new at all. As the debt burden has risen steadily to ever-higher record levels over the past 35 years, there have been regular and justified predictions about how the debt burden, the highest ever recorded by any major economy (Britain came close during the Napoleonic Wars and immediately after World War II), might create a panic in government bonds. The markets are still waiting.

During this period, interest rates in Japan were also among the lowest in the world, making debt servicing less expensive. This division led to one of the most memorable comments about Japan, made by a visibly frustrated Willem Buiter, then Citigroup’s chief economist, who mentioned Japan at a New York meeting in 2010, when the debt level reached 220% of GDP. “Japan is the most difficult economy in the world to understand,” he said. “If this were physics, gravity wouldn’t work in Japan.”

There are several practical reasons for this dilemma. The first is that although the Japanese government has accumulated a high debt burden, it has not hesitated to accumulate assets. This means that the net debt burden, taking into account what the government owns, is 134 per cent more manageable. This percentage is still high, but it is at least within the range of other countries, including Italy at 125 percent and the United States at 97 percent. As economist Jesper Kohl pointed out in June, when bond concerns were back in the news, Japan has been the world’s largest creditor country for the past 37 years.

Equally important, Japan owes this money to itself, with foreigners holding only 12% of the public debt, compared to 33% for the US Treasury. This actually means that there is no debt problem, but rather a balance sheet problem. The government could cancel debt simply by taking advantage of its frugal citizens and cash-strapped companies by imposing higher taxes. This will have its own domestic repercussions, but international markets will be largely isolated.

Another factor is the nature of capitalism in Japan. Although traders have become more aggressive in recent years, and Mongolian corporations and foreign hedge funds are nothing new, major Japanese companies largely work with the government, not against it. This means that they take their large profits (especially with the weak yen appreciating the value of their overseas profits) and invest them back in Japanese government bonds. This provides a small but steady profit and means they are prepared for a global downturn, such as the 2008 financial crisis, when Japan’s largest bank, Mitsubishi UFJ Financial Group, bailed out US investment bank Morgan Stanley and helped stop a complete collapse in the markets. It is inconceivable that these giant companies would cause a crisis in Japan, even if they could benefit individually.

That doesn’t mean Takaishi’s plans are a good idea. Indeed, the same approach has been attempted repeatedly by previous governments, which is precisely why Japan has a debt (and, unfortunately, balance sheet) problem. One of the most prominent initiatives was the “Abenomics” program introduced by Takaishi’s mentor, the late Shinzo Abe, Prime Minister of Japan from 2006 to 2007 and from 2012 to 2020.

His “three arrows” of fiscal stimulus, massive monetary easing, and structural reform were meant to lift the economy out of its lackluster long-term growth rate of 1% to 1.5%. When he left office, the growth rate was about the same. In fairness, this is not a bad outcome for an aging society with a shrinking population, especially when inflation is at zero.

Economists also question the unconventional idea of ​​trying to tackle inflation by increasing spending.

“Aggressive fiscal policy increases financial risks, which in turn contributes to a weakening of the yen through lower confidence in the currency,” Takahide Kiyuchi, an executive economist at Nomura Research Institute, said in an interview. “This could lead to higher prices and offset the effectiveness of the anti-inflationary measures that form the pillar of the economic stimulus package.”

Another major player in the drama is the Bank of Japan, which is widely expected to push short-term interest rates up by a quarter point to a still modest 0.75% when it meets on December 18-19. Takaishi said a year ago that higher interest rates would be “stupid”, but Japanese media suggest she now supports the idea of ​​preventing a weaker Japanese yen from worsening inflation expectations.

While a sell-off in the bond market is highly unlikely at the moment, economic fundamentals will eventually take hold in Japan as elsewhere, requiring the government to fill the growing gap of new debt. One basic principle is that inflation rewards borrowers at the expense of creditors. Although Japan’s $14 trillion in total individual savings will take a hit in a high-inflation environment, the government will emerge as the winner. It remains to be seen whether she seizes the opportunity to finally make a big down payment on years of generosity or takes the money to repay voters again.

Despite concerns about rising prices, inflation may not be political suicide for Takaishi. Japan’s biggest savers are retired baby boomers who managed to stash away their money in the high-growth years before 1990.

Members of the new generation, who have experienced low growth and stagnant (or negative) real wages throughout their careers, are unlikely to shed a tear at the declining real value of the wealth stock of the older generation. While younger voters have historically been less likely to vote, their numbers are rising and they are becoming an increasingly important political voice. For now, at least, they seem to like Takaichi’s populism.