Japanese Debt Crisis and How it Continues to Finance Itself?

A lot of economic research suggests that if a country's debt is more than 80% of its GDP, the country is in trouble. However, in Japan's case, till now it has not collapsed, even though its debt is at 220% of it's GDP. This situation has been there for a very long time, and Japan has somehow been able to avoid a debt crisis? Whoever has placed a bet on failure of Japan has failed. People who shorted Japanese government bonds ended up with losses.

This article provides some explanations about how Japan continues to sustain itself and finance itself even under a stagnant economy and high debt.

Japan's Original Strategy

A key factor behind the Japan's current economic structure is the export model it adopted post world war II. After the world war II, Japan's economy was in shatters, and it chose to go with a export model to rebuild the economy, by investing heavily in education, manufacturing and technology. This was accompanies by an easy monetary policy which allowed creation of credit, infrastructure expansion, and lower interest rates.

The Strategy Worked

The Japan's export model worked great as it's GDP expanded with solid exports.

The Failure

The above strategy will work great as long as long as the country's GDP and exports grow. However, if exports stop growing the model, could fail. This is what happened in Japan. The easy monetary policy, instead of fueling exports, led to a failure of stock market and real estate bubble.

Let's look at how this happened.

In 1985, in order to reduce high trade imbalances, the countries such as US, Japan, West Germany, France, and UK, signed Plaza Accord, to lower the value of dollar relative to the major currencies.

The result was the appreciation of Japanese yen by 50% in the next 2 years. This led to a fall in Japan's exports, which sent Japanese economy into recession.

Japan reacted by lowering the official discount rates several times during the next few months. The rates were finally reduced to just 2.5%. The low interest rates and an easy monetary policy led to the creation of stock market and real estate bubble. Finally when Bank of Japan increased interest rates in 1989, everything collapsed, and Japan never recovered from it.

Japan's Financing Techniques

A unique thing about Japan is that even under such debt pressure and low interest rates it has been able to finance itself.

Japan has primarily been using it's current account surplus to finance itself. Japan has more money flowing in the country and flowing out of the country. The majority of net inflow is invested in Japanese Government Bonds.

Let's see how this works.

1. Japan has more exports than imports, therefore, there is more capital flowing in.

2. This trade surplus has allowed Japan to build a portfolio of foreign currencies.

3. Japan invests these foreign currencies in foreign assets such as US Treasury to earn a steady income.

4. Japan also has an income surplus as it earns more money from these foreign assets than it pays to its investors.

5. Both trade surplus and income surplus bring more money for corporates in Japan. The corporates put their money in banking system, which in turn buys Government bonds.

This is how the cycle has been continuing for the past 22 years. However, the economy's profile has been changing over time and Japan is now also facing huge fiscal deficit, which it finances by issuing bonds. At the same time, the demand for these bonds has been reducing because of the aging population of Japan, and reducing savings rates.

Under this given scenario, the Japan's GDP is expected to shrink, while its debt is expected to rise in the years to come.