The overall debt/GDP ratio in Japan is approaching 200 percent, much larger than highly-indebted OECD countries like Greece and Italy, as Figure 1 shows. Unlike the United States, domestic Japanese residents hold more than 94% of Japanese government debt. Despite these high ratios, the government bond market in Japan remains relatively tranquil, with no risk premium demanded by financial institutions purchasing this debt.
This paper investigates the implications for macroeconomic adjustment when financial markets apply a risk premium to this debt. In this case, a wedge between the bond yield and the risk free rate emerges, with the bond yield rising as debt continues to mount. While the central bank manages the risk free rate, this rate will become less and less relevant for interest parity and exchange rate adjustment. Hypothetically, in a period of recession, trivial inflation, and zero interest rates, rising bond rates will trigger heightened volatility of the domestic currency.
At present, this scenario has not played out. Yen-denominated government bonds continue to remain attractive to overseas investors because of higher Euro-bond riskiness in the wake of the crisis in Greece. In addition Japanese banks are holding more government bonds because the demand for bank loans by Japanese firms has declined due to world-wide recession. With the central bank adopting an easy zero-interest rate monetary policy, deposits are continuously flowing into Japanese banks, facilitating the purchase of government bonds by the banking sector. Thus, there is little or no pressure for government bond yields to rise relative to the risk free rate.
Figure 2 shows the persistent stable wedge between the bond yield and the short-term risk-free call money rate since 1994. As Figure 1 shows, it was in 1994 that the debt/gdp ratio in Japan crossed the 100% threshold.
But how long can this scenario hold? If world demand increases, and there is an increased demand for loans by firms, then government bonds will not be as attractive to the financial institutions. In this case the government will be forced to pay a risk premium to the banks, thus increasing interest rates, appreciating the exchange, and thwarting recovery. Furthermore, as interest payments increase due to the risk premium, fiscal deficits will rise even further. In this case the government will be forced to raise taxes and reduce spending, further dampening economy-wide recovery.
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Macroeconomic Dynamics Under High Accumulation of Government Debt: Lessons from Japan
