After lengthy debate within the ruling coalition – and almost three months after taking office – Japan’s government has finally announced its fiscal stimulus package, to be implemented in the New Year. The mini-budget will increase spending by ¥7.2trn (about 1½% of GDP), an eye-catching headline number. Specific policies include job subsidies, an extension of programmes to encourage spending on energy-efficient cars and electrical appliances, and resources to support lending, particularly to small enterprises.

It’s never easy getting behind the headlines to decipher the true substance and likely impact of any government budget. And this is certainly true of Japan’s latest effort. But within the headline amounts, transfers to local governments to compensate for lower taxes accounted for ¥3trn. And some ¥2.7trn of new spending was simply re-allocated from existing plans set by the previous government – effectively robbing Peter to pay Paul. So net new public spending amounted only to about ¥1.5trn, roughly 0.3% of GDP. While this may well provide some support to activity in the first half of 2010, it will not boost dramatically GDP growth, which we expect to be modest at best over the coming year.

Arguably the most notable news related to JGB issuance. The vast majority of net new spending will be financed by raiding special reserves, but the government was still forced to announce a sharp increase in bond issuance over the coming three months. With revenues for FY09 now forecast at just ¥36.9trn, the lowest level for twenty-five years, compared to the previous forecast of ¥46.1trn (and down from ¥46.4trn in FY08), the government raised its planned issuance of new JGBs for the remainder of the fiscal year by ¥9.3trn to ¥53.4trn. This was at the upper end of expectations, well above the previous record high annual issuance total of ¥37.5trn in FY99, and also surpasses the level of revenues for the first time since 1946 – and by a very wide margin to boot (see chart).

Japan’s Public Finances

Source: Japan Ministry of Finance

While the very low level of revenues – compared both to the size of the economy and total new bond issuance – seems more redolent of an emerging market country than a mature major economy, we are not overly concerned about the market’s ability to absorb the additional debt to be issued in the first quarter of 2010, or even further sizeable issuance in FY10. Deflation will persist throughout next year and beyond, and the BoJ will leave its main policy interest rate unchanged at just 0.1% into FY11 if not beyond, with further loosening of monetary policy through unconventional measures still looking more likely than not. So, yields, in particular at the short end of the curve where much of the additional issuance will be concentrated, will remain exceptionally low and stable.

Meanwhile, not least due to the weak outlook for fixed investment, demand for government paper from domestic investors (which account for about 94% of total holdings of JGBs) will remain more than ample. Therefore, although global trends – as the world’s other major central banks inch towards rate hikes - will push yields up further along the curve, we are also confident that the rise in JGB yields will be capped as domestic buyers (particularly banks and asset-liability matchers) re-enter the market at their target levels. So, we continue to expect JGBs comfortably to outperform the other major sovereign bond markets in coming quarters.

Additionally, we consider some of the recent press comment about Japan’s fiscal position as alarmist. Japan’s government debt interest costs are still very low, at around 1% of GDP this year, half the equivalent cost in Germany, and less than one fifth of the equivalent cost in Italy. Moreover, the average maturity of Japan’s government debt is very long. However, the government cannot afford to be complacent. With Japan’s savings rate falling steadily due to declining incomes and adverse demographic change, over the medium term the government will not be able to count on domestic investors being either willing or able to absorb an ever-increasing stock of Japanese government debt (which, in gross terms, is set to rise above 200% of GDP).

Therefore, while the economy continues to need support, in the absence of a more assertive role from the Bank of Japan in financing the government’s debt the markets will be looking for Finance Minister Fujii to make good on his earlier aim to scale back new JGB issuance to around ¥44trn in FY10 when he presents his forthcoming budget on 15 December. This, however, would require the postponement of some of the DPJ’s manifesto commitments, and would also face further opposition within the ruling coalition, leaving him with a difficult balancing act. And while much press coverage will be focused on next year’s issuance, the announcement of a broad strategy to consolidate the public finances over the medium term would also go some way to allaying concerns about the sustainability of Japan’s ever-growing debt.

Chris Scicluna, Head of Economics

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