In the last week, Standard & Poor cut Japan's sovereign credit rating, citing that the government lacked a coherent strategy to deal with its rising debt levels. There is clearly concern over the long-term fiscal health of Japan. The ratio of government debt to GDP is above 100% and rising. For many years now, Japan has been running large budget deficits, continuing to add to the total amount of outstanding debt.
A simple conclusion would be that Japan is going to face troubles going forward. This could potentially turn into another sovereign debt crisis. Given the size of the Japanese economy, this would be catastrophic. The rating agency certainly believes that Japan could face problems in the future.
Do the markets share this view too? Could Japan become the next Greece or the next Ireland? When investors become worried about the ability of Greece or Ireland to service their debt, their government bond yields went up. The rising yields were a result of the fact that investors believed the debt was getting increasingly risky; that the possibility of default was going up.
Is the same thing happening with Japan? Let's look at some benchmarks: the ten-year government bond yield for the US is 3.41%. The same for Germany is 3.19%. The UK's bond yield is 3.69%. The bond yields for Greece are over 10%, a clear indication of its debt problems. Japan's bond yield should be high too, right?
The ten-year government bond yield for Japan is a tiny 1.22%! It is the lowest for any major economy. The market very clearly believes that the risk of Japan defaulting is no more than the US, or no more than Germany. Perhaps it is even lower. So while rating agencies may downgrade Japanese debt, Japanese bond holders are hardly running for the exits.
So how is it that Japan has such high debt levels, yet such low bond yields? Why do no investors believe that Japan will default? A big difference between Japan and other countries with high debt levels is that Japan's debt is primarily held domestically. Foreigners hold just 5% of Japan's government debt. So even if foreign investors became worried about a potential default, their impact on the bond market, and the currency, would be minimal.
In a way, Japan is self-financing. The savings of the private sector are large enough to fund public sector liabilities. They run a large trade surplus too. This is in stark contrast to a country like Greece, where other European countries primarily held their debt. Even with the US - China and other countries hold a large portion of their debt.
While Japanese debt levels are certainly high, there is no indication that it has led to any loss of confidence. Japan is in a safer position than most other countries with debt problems, and this is likely to reduce the likelihood of anything catastrophic occurring.
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!