Debt Sustainability

INTRODUCTION This educational note explains the looming macro economic and political risks from bloated Government Debt. It is based on 30 years of following the Japanese economy and extensive analysis of the Japanese Government Bond (JGB) market and policies enacted by the government and the Bank of Japan.

Debt sustainability, like Currency Debasement, is a very important subject that is not widely taught or understood. Unfortunately most Governments of Advanced Economies around the world have significantly increased their borrowings in the last 20 years, first after the Great Financial Crisis (GFC) and then during the Covid pandemic. The large outstanding debt stocks are now huge weights that pose risks to future economic growth. Furthermore they are likely to cause future financial crises due to the likely future policies that will be enacted to address the problems deriving from these large debt stocks.

This article highlights the deterioration in JGB sustainability. A later article will focus on the likely policies that will be enacted in the future and explain how they will impact the Japanese economy. The content draws on articles and research provided to clients over the last 2 years which have been warning about this looming issue.

DEBT SUSTAINABILITY - WHAT IS IT?

Spain needed bailing out by the European Central Bank in 2012, when its Debt was a mere 70% of GDP, whilst Japan, whose Debt/GDP was 185% at the time, was completely unaffected by the European debt crisis of that year. Why, when Spain was in crisis, was Japan doing just fine despite its much higher indebtedness?

The first issue to realise is that the widely used ratios of Government Debt/GDP and Annual Interest Costs/GDP tell you absolutely nothing about a country’s ability to service its debt. Much in the same way, you would not determine a company’s solvability by its Debt/Sales Turnover or Interest Costs/Sales Turnover.

After all, if a company

• is profitable, its generated operating cashflow pays interest costs and reduces outstanding debt.

• is lossmaking, then it will have to raise more debt to pay interest costs, and it will have to refinance maturing debt with new debt.

For a company, its Interest Costs/Operating CashFlow ratio is a useful indicator of its ability to sustain its debt (there are numerous other helpful ratios).

Because most governments around the world run deficits (their tax receipts are less than their expenditures), they are similar to loss making companies (*1). The government's equivalent to a company's interest cost/operating cashflow is going to always be negative, as the denominator (net budget position) is negative. This is one of the reasons analysts search for other ratios to ascertain debt sustainability, like the meaningless ratio of Debt to GDP.

Government's therefore have to raise new debt to pay annual interest costs and to refinance maturing debt. This is not dissimilar to using a credit card to pay the mortgage....

There is however an indicator that is key in determining whether a country’s debt is sustainable or not:

• Is the annual interest cost a manageable expense within the government’s overall budget? The trend of the Total Interest Cost/Total Government Revenue will flag whether the interest cost will become too big a burden and start negatively impacting a government’s political agenda.

This indicator is pointing to stress in the Japanese government bond market. 2026 could be the year that a JGB rout brings enhanced volatility to Japanese financial assets and the Yen.

SETTING THE SCENE

I have been following Japan closely since the Nikkei and Japanese Real Estate bubbles burst in 1990. There have been three distinct periods:

1.      The “Lost generation” lasted 21 years (1990 - 2011):

• The private sector deleveraged and the government ran huge deficits, taking Debt/GDP from 45% to 170%

• The Yen held its value, JGBs appreciated as yields declined to 0% and Equity and Real Estate values plummeted until 2010. This was followed by

  
  

2.      “Abenomics” which lasted 13 years (2011-2024):

• The private sector did not expand its leverage, but the government still ran deficits, taking Debt/GDP to 225%. However, the BoJ expanded its balance sheet so that by 2024 they owned 50% of outstanding JGBs though its Quantitative Easing (QE) and Yield Curve Control (YCC) policies

• The Yen started depreciating, JGBs held their value whilst Equity and Real Estate values appreciated. This was followed by

  
  

3.      “BOJ Death Wish” which started in 2024

• The private sector continues to not expand its leverage, and the government still runs deficits. However, the BoJ has abandoned its YCC policy and is no longer buying enough bonds in its QE program to maintain its share of JGBs, thereby enacting a stealth Quantitative Tightening (QT) policy

• JGB yields start to rise, the Yen continues to depreciate whilst Equity eventually appreciated in 2025 after a flat 2024

Throughout the Lost Generation and Abenomics periods, the BoJ cut rates aggressively and introduced a "Zero Interest Rate Policy" (ZIRP). This decline in interest rates lowered the yields on JGBs whilst the debt stock soared. As a result, the total annual interest cost of outstanding JGB debt remained low. The annual weighted average interest rate on outstanding debt declined from 6.10% in 1990 when the debt totalled Yen 320bn, to 0.77% in 2023, when the outstanding debt has grown to Yen1,230. But then the BOJ started increasing rates…...

THE BOJ’S “DEATH WISH”

A Death Wish is a psychoanalytic term that relates to a “conscious or unconscious desire for the death of oneself or another”. This is an appropriate term to describe the BoJ’s action since 2024.

The BOJ has decided to tighten policy by both i) raising rates AND ii) buying a smaller amount of JGBs under its QE program compared to the amount of the BoJ’s maturing bonds in its JGB holdings. It has explained that inflation is the reason behind this policy, despite the fact that core underlying inflation has been very steady and well below the BOJ’s 2% target for over a year. Traditional Core CPI (ex-Food and Energy) has been in a 1.3% - 1.6 range since Jul24, with 4 core sub-indices (Choice, Burden, Services and Goods) ALL below 2%.

The BOJ’s tightening of Monetary Policy has driven nominal government bond yields higher

The ongoing consequence of higher yields is that the government is issuing debt at higher interest rates than in the past. This is both for

1. new debt to finance ongoing annual deficits and more importantly, for

2. new debt that is issued to refinance maturing debt which paid a much lower coupon.

The last budget forecasted that annual interest costs would total Yen10,523 in the current fiscal year - this looks too low given the significant rise in JGB yields this fiscal year. Looking forward, it’s possible to estimate the increased annual interest costs that the government will have to pay.

Assuming that

1. the market's current expectations of future JGB yields materialise and

2. the deficit remains unchanged,

then the annual interest cost will rise to Yen 23,850bn in 2030, an increase of 127%. This is simply because the weighted average interest rate will have risen to 1.9% from the current 1.1%. And what if JGB yields turn out to be 25bp, 50bp or 100bp higher than current market pricing?  Scenarios A B and C in the chart show how the annual interest rate would soar, even if the weighted average interest rate of the debt would still remain at relatively low levels:

Going back to debt sustainability, the key ratio to consider is the annual interest cost as a percentage of annual revenues (primarily the taxes raised by the government). An assumption has to be made about tax receipts – for this exercise I have assumed that the current rate of increase in tax receipts (4.5%pa) will continue into the future.

The chart below shows that the interest cost/budget government revenues troughed in 2023 and subsequently has started to climb aggressively. These trends, including the decline from the commencement of Abenomics in 2011, clearly coincide with BOJ policy. The issue is very clear – if forward rates materialise (Base Case), then interest costs will consume 22% of tax revenues by 2030.

The above chart shows why the BOJ is on a Death Wish. This is their choice and the damage will be severe, even in a benign scenario.

The outcome from the Base Case is bad enough. This only assumes current market expectations for future yields rates and applies some generous assumptions on future deficits and tax receipts. Imagine what would happen if

• PM Takaichi increases the deficit, especially if taxes are reduced

• The economy falters and slows, which would increase the deficit and reduce tax receipts

• The BOJ reduces its balance sheet further

WHY COULD THIS BOIL OVER IN 2026?

Like many governments around the world, the Japanese could easily increase their deficit to boost growth and improve voter popularity . The BOJ has recently reiterated its stance on the Japanese fiscal situation, saying that it is for the government to sort. The BOJ is also saying that it cannot intervene in the JGB market as inflation is too high – perhaps to keep confidence in the Yen and Nikkei.

But the JGB government bond market and YEN are already both reacting in a negative way – yields are rising and the compression of global yields to Japanese yields has NOT brought about a strengthening of the Yen. More financial participants are beginning to realise that Japanese debt is no longer on a sustainable path with rising interest rates. A JGB and Yen crisis seems imminent.    

CONCLUSION

As yields continue to rise, there is a rising risk that investors get concerned about Japanese debt sustainability, as interest costs would rise further and the Interest Cost/Tax Revenue ratio would increase to dangerous levels. This would make Japanese markets unstable and volatile.

It remains likely that when push comes to shove, the BOJ will blink and reintroduce QQE/YCC, using its balance sheet to cap yields at a level that it will deem appropriate and keep the debt sustainable. A largescale currency debasement is the valve through which the pressures of over indebtedness will escape. This has happened time and time again over history and would just be a reaffirmation of Abenomics as a preferred policy to the previous Lost Generation that saw “debt deflation”

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(*1) Clearly some governments in deficit run “primary surpluses” (which exclude interest payments). If they go into deficit because of the interest costs, then they still have to raise debt to pay interest as well as refinance maturing bonds.