Economy, No.11  May. 26, 2012


Photo : Kojima AkiraThe financial crisis in the euro zone has evolved into an actual economic crisis as a result of the credit contraction it incited. The European Central Bank (ECB) and International Monetary Fund (IMF) to a certain extent delayed the inevitable with their emergency assistance, but this crisis will not be resolved unless the European Union fundamentally reforms the economic and financial structures at their core. For Japan, the crisis in the euro zone is not just fire on the opposite riverbank. This is because Japan’s government debts, including those of central and local governments, have surpassed those owed by Greece’s governments at the epicenter of the euro zone crisis. Japan’s government debts currently total around 200% of the country’s domestic product (GDP). Moreover, social security and related expenses are likely to continue rising in Japan due to a population now aging at the fastest pace in the world. The worst financial conditions among advanced nations could cause Japanese government bonds to crash and throw the country’s economy into chaos unless the Japanese government boldly implements drastic measures for restoring fiscal soundness. Financial problems are time bombs implanted in the Japanese economy.

However, though these problems are frequently discussed in Japan, there is a scant sense of the crisis needed for spurring policy and system reforms aimed at resolving them. Ordinary Japanese citizens want to avoid policies that pain them. Japanese politicians are also making no attempt to look squarely at the critical reality. The Noda administration inaugurated by the Democratic Party of Japan (DPJ) at long last began taking steps based on its policy of “integrated social security and tax reforms,” including a consumption tax increase, but the Liberal Democratic Party (LDP), the largest opposition party, is continuing to demand dissolution of the Diet, instead of asking the ruling party to commence financial reforms. Many Diet members affiliated with the DPJ also oppose a consumption tax increase. Discussions in the Diet have turned into bargaining among political parties, in other words politics with the next general elections in mind, instead of policy debate on the financial problems themselves. The absence of a sense of crisis about the problems has brought about this political situation.

Question Politicians’ Resolve

In their contributions to the March 2012 edition of the literary magazine Bungeishunju, both Chairman Sakane Masahiro of Komatsu Ltd. and Chairman Suzuki Toshifumi of Seven & i Holdings Co., Ltd. expressed their concern over the political climate. Suzuki, viewed as a representative of retailers directly affected by the proposed consumption tax hike, is not opposed to the idea of raising consumption tax itself. Like Sakane, in his contribution he states his sense of crisis about the current financial conditions. Both Sakane and Suzuki criticize the central government procedure for raising the consumption tax and question politicians’ resolve.

Japan’ financial problems are gradually becoming a topic of global concern. The IMF in the spring of 2011 began repeatedly requesting that Japan work on restoring its fiscal soundness. Specifically, it proposed that the Japanese government increase the consumption tax rate in stages, cautioning that domestic savings would fall short of financing Japanese government bonds and this situation would expose the bonds to direct market pressure unless the government carries out taxation and financial reforms. The IMF sponsored a seminar on Japan’s consumption tax problems in Tokyo in the same year.

The Organisation for Economic Co-operation and Development (OECD), also known as the club of advanced nations, pointed out as follows in its report on Japan released in April 2011.

Numerous fiscal stimulus packages and spending pressure related in part to population aging have driven up government expenditure, resulting in 18 consecutive years of budget deficits since 1993. Consequently, gross public debt has risen rapidly to uncharted territory at around 200% of GDP, while net public debt, at around 115%, is also the highest in the OECD area. The impact of the extraordinary level of debt has been mitigated by very low long-term interest rates, currently about 1.25%. However, reconstruction spending in areas devastated by the Great East Japan Earthquake and tsunami will be significant. It is important to finance reconstruction spending by shifting expenditures and by short-term increases in revenues. Over the medium term, fiscal consolidation remains a priority.

Against this backdrop of global concern, the Japanese government made the following public commitment at the G20 Summit held in Cannes, France, in November 2011 under the title of the Action Plan for Growth and Employment.

The Japanese government commits itself to introducing, by the end of fiscal 2011, a bill required for fleshing out and actualizing a plan for integrated social security and tax reforms, in which policies such as raising the consumption tax rate to 10% (from the current 5%) in stages by the mid-2010s are outlined, for achieving the commitment it made in Toronto.

In light of this international commitment, the Noda administration made a cabinet decision on the General Principles for Integrated Social Security and Tax Reform in February 2012. As part of these principles, Prime Minister Yoshihiko Noda presented a scenario for raising the consumption tax rate from the current level of 5% to 8% in April 2014 and then to 10% in October 2015. Based on this scenario, the Japanese government is working to legislate this step-by-step increase. However, many Diet members, including those belonging to the ruling DPJ, oppose tax rate hikes. Opinions on raising the rate are split within the DPJ.

The opposition LDP labels itself a “responsible opposition party,” in an attempt to recapture power. The LDP, however, continually asks the DPJ to seek voter response through general elections before raising taxes, despite its campaign pledge of pursuing policies for restoring fiscal soundness, including a consumption tax hike up to 10%. The LDP is turning its back on constructive policy debate for restoring fiscal soundness.

The fundamental problem is that Japanese politicians have no sense of crisis about their country’s financial condition, which is in some ways worse than those in Greece at the center of the euro zone crisis.

This lack of crisis is because Japan’s financial crisis, due to factors peculiar to the country, has not visibly been brought into the open. This situation is simultaneously lucky and unlucky for Japan.

Luckily, the crisis has not risen to the surface. On the unlucky side, however, the situation has not given birth to the sense of crisis. Japanese politicians, resultantly lacking this sense, are making the crisis that will eventually materialize into an even more serious one by continuing to postpone necessary reforms that will involve pain.

Japan’s Serious Financial Condition

The draft budget for fiscal 2012 (April 2012 – March 2013) now under deliberation in the Diet is like an illustrated version of Japan’s serious financial condition. The country for three years in a row failed to cover half its annual revenue with tax yields. Government bonds issued, which equated to new debts, surpassed tax revenues in value. With government bonds projected to supply 49% of revenue, the budget under deliberation relies on debts at the highest rate in Japan’s history.

Outstanding government bonds are estimated to total 707 trillion yen by March 31, 2013, the end of fiscal 2012. This means they will have risen 540 trillion yen over the roughly 20 years since fiscal 1990. By factor, annual expenditure increase and tax revenue decrease are forecast to respectively account for 240 trillion and 190 trillion yen of the balance growth. Outstanding long-term debts owed by central and local governments are estimated to reach 940 trillion yen at the end of fiscal 2012.

The Japanese government plans to issue state bonds worth 44 trillion yen in fiscal 2012. This will bring outstanding government bonds, including existing bonds converted upon maturity (refunding bonds), to 150 trillion yen by the end of fiscal 2012. Despite this prediction, market players are at the present silently absorbing the government bonds. Japan’s financial condition declined further as a result of the Great East Japan Earthquake, though interest rates for long-term government bonds have stabilized at around 1%. The resultant market stability and structural economic and market factors that support it are conditions that are both lucky and unlucky for Japan.

To start with, 92.3% of Japanese government bonds are absorbed domestically. The ratio of such bonds owned by investors in other countries is extremely low, for example around 48% in the United States. Treasury bonds are about 54% for German government bonds and 28% for British government bonds. High domestic ownership is possible because there are abundant savings in Japan.

As observers frequently point out, in Japan individuals own financial assets worth about 1,400 trillion yen. For that reason, they maintain that domestic savings can absorb long-term central and local government debts even in a situation where their balance is growing increasingly close to 1,000 trillion yen.

The low income tax ratio compared with other countries and large room for raising tax rates are other factors pointed out. In other words, a sense of security remains in the markets and a large volume of issued government bonds is absorbed smoothly because domestic savings are still abundant and large room remains for annual revenue expansion through tax rate increases.

Government bonds have undoubtedly been absorbed smoothly up to this point, but a problem lies in the very structure of their domestic absorption. Financial institutions are taking in deposits and insurance premiums in large volumes. They are applying these surplus funds to the purchase of government bonds, which they have considered risk-free assets, in the absence of sufficient investment targets. Banks are buying government bonds that yield interest of only about 1% because they have a large volume of practically cost-free funds thanks to the zero-interest-rate policy adopted by the Bank of Japan (BOJ), which keeps deposit interest rates near zero.

Intermediation or diversion of deposits received to loans must be the basic function that banks play, but banks are in fact reducing their lending. Banks, life and nonlife insurance companies, and households respectively accounted for 45%, 20% and 5.5% of Japanese government bond owners at the end of 2010. From a structural viewpoint, financial institutions own the greater part of government bonds.

This situation is also an outcome of the passive stance banks and other financial institutions in Japan take in connection with loans designed to identify companies that have potential for excellence and to support superior risk-takers. In 2010, the BOJ set up a special loan ceiling for finding new business fields with growth potential and revitalizing the Japanese economy. However, only private financial institutions fall under the scope of this BOJ loan ceiling. The BOJ initiative has no effect unless private financial institutions make aggressive efforts to look for and identify borrowers.

What concerns me is the outlook that withdrawals from past savings will grow with sustained aging of the Japanese population and cause overall household savings to sooner or later begin to decline. Members of the post-war generation, known as baby boomers, are now retiring from work. An increasing number of these retirees are moving into this savings withdrawal process. Before long, their retirement will cause the picture of abundant domestic savings enabling smooth government bond absorption to fall apart. Moreover, low growth will continue for the Japanese economy and prevent tax revenue from increasing should banks continue calm purchasing of government bonds without providing sufficient support to programs for vitalizing the economy and ensuring its growth.

The proposed consumption tax rate increase by five percentage points currently under discussion is just a milestone on the road to restoring the soundness of overall public finance. The increase is calculated to generate additional tax revenue of about 13 trillion yen, with about 9 trillion yen going to the national treasury and the rest to local governments. In the meantime, annual expenditure will keep swelling at the rate of 1 trillion yen per year when only social security benefits are taken into consideration. Annual expenditure will rise with a consumption tax rate hike because amounts equivalent to the tax increase will be added to central government payments for buying goods and services. Expenditure for servicing government bonds, centered on interest payments, will expand because the balance of government bonds will continue to grow.

Starting point for a long and demanding road

Therefore, positive effects on the fiscal balance that the five-point tax hike produces will be reduced proportionately and available only for a short period. The Japanese government is saying it will divert annual revenue increase from the latest consumption tax rate hike entirely to social security expenditures (pension, medical service, nursing care and childcare programs), but a drastic system review, which helps curb the rising social security costs, is essential. Growth strategies, which have never left the discussion stage, are also essential.

Sakane and Suzuki, representing opinions in the Japanese business community, questioned the resolve of politicians. As a litmus test for their preparedness, the two business leaders asked the politicians to reduce the legally fixed number of Diet members, decrease the number of public servants and cut their salaries. We can view these requests as reflections of their sense of irritation about the politicians’ lack of such comprehensive long-term visions and their current actions limited to makeshift discussions and policy responses. Both Sakane and Suzuki expressed their dissatisfaction with “politicians discussing the restoration of fiscal soundness from the viewpoint of matching numbers only through addition and subtraction.” Japan is now called upon to choose policies and reform systems in such a comprehensive way. The consumption tax issues do not end with the 5% tax rate increase. As a matter of fact, the increase is just the starting point for a long and demanding road to comprehensive system reform.