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Uneasy peace

11 September 2013 By Andy Mukherjee

The calm in the Japanese government bond market is hiding growing fiscal disquiet. After briefly shooting up to 1 percent in May, yields on 10-year JGBs are back down to 0.74 percent, even as inflation expectations have firmed up. This Zen-like state of affairs is all the more striking considering that interest rates are increasing across the Western world as investors anticipate an end to the cheap money of the post-financial crisis era.

Japanese households and companies, which directly or indirectly own about 80 percent of their government’s 830 trillion yen ($8.3 trillion) debt pile, are being patient in not demanding extra compensation for future inflation. The bondholders’ fortitude is hardly irrational. The Bank of Japan’s massive buying of JGBs has given investors positive total returns even while yields remain abysmally low. Western bond markets, by contrast, have been money-losing bets this year.

But this state of blissful nirvana masks increasing anxiety over Prime Minister Shinzo Abe’s fiscal policy. Abe will decide by early October whether to go ahead with a plan to double Japan’s 5 percent sales tax over the next two years. If he scraps or dilutes the proposal, as some of his advisers are exhorting him to, bondholders could turn tail.

Lower-than-expected tax receipts would force the government to issue more bonds to finance its spending. Though the BOJ could buy more bonds, it will be loath to give up the little independence it still possesses by explicitly responding to higher supplies of government paper. The central bank’s ability to keep yields under control will be weakened.

Abe’s advisers worry that a higher sales tax would stifle Japan’s economy just as it is showing increased signs of life. But the government could offset the tax increase by offering credits for investment. And if consumption does dry up, the BOJ will have a valid reason to print more money.

Fiscal overreach in Japan will lead to higher long-term interest rates, choking off investment. Attempting to lower the inflation-adjusted cost of capital in a society of retirees who like collecting JGB coupons is a tricky endeavour. A slight dent in creditors’ confidence could turn out to be a costly mistake.


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