The worrying market denial about Japan

There is a remarkable sense of complacency in the markets about Japan, the world’s third-largest economy. Indeed, as it becomes increasingly clear that Japan’s public finances are on the most unsustainable of paths, the Japanese yen strengthens and the Japanese government manages to finances its outsized budget deficit at record low interest rates.

{mosads}The market’s apparent complacency about Japan would seem to be most unfortunate. It reduces the pressure on the Shinzo Abe government to undertake those economic reforms that might finally put the country on a more rapid economic growth path that is so desperately needed to help the country grow itself out from under its public debt mountain.

In July 2015, the International Monetary Fund (IMF) estimated that, absent a change in economic policies, Japan’s public debt would rise from an already high 230 percent of gross domestic product (GDP) at present to an astronomically high 300 percent of GDP by 2030. For that reason, the IMF urged the Japanese government to redouble its economic reform efforts to boost economic growth and to extricate the Japanese economy from its deflationary trap. It also cautioned that the Japanese government would need to adopt fiscal measures totaling around 6 percentage points of GDP if it were to succeed in restoring public debt sustainability.

Sadly, over the past few months, the Japanese economy appears to have gone from bad to worse. After the briefest of economic recoveries, Japan is again flirting with economic recession as its economy gets hit by a slowing Chinese economy and by last April’s increase in the domestic value-added tax rate. At the same time, falling international oil prices have helped again raise the specter of Japanese deflation. Over the past year, Japanese consumer prices have again shown no increase while inflation expectations are again falling well short of the Bank of Japan’s 2 percent long-run inflation target.

At a time that economic growth is stuttering and that its economy appears again to be falling into a deflationary trap, the last thing that the Japanese economy needs is a strengthening currency. Yet that is exactly what Japan is now getting. Over the past three months, despite the Bank of Japan’s aggressive use of quantitative easing and of negative interest rates to cheapen the currency, the Japanese yen has strengthened by around 10 percent with respect to the U.S. dollar. This has to heighten the chances that the Japanese economy will again experience a meaningful economic recession and deflation over the next few quarters.

All of this should be of the greatest concern to both markets and policymakers for at least three reasons. First, a declining Japanese economy and falling prices will only accelerate the rate at which Japan’s public debt to GDP ratio will rise over the next year from its already unacceptably high level. Second, a weakening economy will make it all but impossible for the Japanese government to proceed with the scheduled April 2017 value-added tax increase for fear of pushing the Japanese economy further into recession. That, in turn, will delay the date at which the government budget deficit might be reduced to a more sustainable level.

And third, over the next few years, the Japanese government will have to borrow as much as 50 percent of GDP a year in order to finance its budget deficit and to repay its maturing debt obligations. That prospect will be all the more daunting considering the very rapid rate at which the Japanese population is aging and at which Japanese domestic savings are now declining.

The fact that the markets are now not signaling how dire is the outlook for Japan’s public finances should not lull Japanese economic policymakers into a fall sense of security. After ignoring a problem for a long time, markets have a tendency to radically revise their views on a dime. For which reason, the Abe government would be well advised to use the space that the market is now affording Japan to beef-up the third arrow of its economic strategy to place the Japanese economy on a higher long-term economic growth path.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.