NRI Papers
No.61   February 4, 2003
  The Risk Premium Warning on Japanese Government Bonds  
Toshiki TOMITA
        The international credit standing of Japanese government bonds (JGBs) has wavered even though they remain the most trusted class of financial assets inside Japan. Few Japanese have noticed that interest rates on local-currency JGBs are now higher than those on yen-denominated bonds issued by the governments of other countries, such as Spain and Italy. The reason may be because yields on JGBs are currently at such historic lows. But the fact remains that capital markets are already demanding a risk premium on Japanese government debt.
     The phenomenon of diminished international confidence in the creditworthiness of JGBs has been observed in the past. For example, in the period after 1932, when Japan started issuing JGBs in large quantities and the Bank of Japan (BoJ) began underwriting this process, yields on sterling-denominated JGBs soared above the yields on comparable gilts issued by the British government. These market warnings went unheeded, and the country pursued a "Financial Fortress Japan" seclusion policy that focused on isolating the country from overseas financial markets to keep interest rates low and thereby enable the continued issuance of a high volume of JGBs.
     Today, the ratio of outstanding government debt to GDP has reached a level comparable to that recorded in the latter stages of WWII in Japan and the United States. The pace of the rise in outstanding debt, however, exceeds that recorded during the Takahashi regime in Japan (1932-36) as well as during the New Deal in the United States--both periods of unrestrained classical Keynesian fiscal expansion.
     Under the policy of quantitative monetary easing that the BoJ has been implementing since March 2001, the influence of zero interest rates has been gradually extending to the market for long-term government bonds, paradoxically restricting the inflation expectations that should naturally be incorporated into long-term interest rates. For this reason, there is concern that the markets may demand an even greater JGB risk premium if such non-orthodox methods as JGB underwriting by the BoJ under an inflation targeting policy--as many currently advocate--are pursued.
     One suggested solution is the adoption of a non-Ricardian fiscal policy, which would couple higher spending to stimulate the economy with promises not to raise taxes in the future. Yet, the high level of existing debt and the rapid aging of Japan's population both suggest that such a policy has a low probability of success. Conversely, the dangers of possible non-Keynesian effects (suppression of economic growth due to higher long-term interest rates) cannot be ignored if investors start to demand a higher JGB risk premium than currently exists.
Contents
I The Creditworthiness of JGBs
1 Credit Rating Lower Than Even Botswana
2 Interest Rates Surpassing Those of Italy
II Risk Premiums on JGBs in the Prewar Period
1 Aggressive Fiscal and Monetary Policy Under Takahashi
2 A Temporary Solution Becomes an Entrenched Policy
3 Internationally Isolated JGB Market
4 BoJ's Collateral Lending Program for JGBs
5 Fiscal Discipline Underpins Sustained Foreign Debt Issuance
6 Insulation of Domestic Financial Markets Results in Slack Fiscal Discipline
III JGB Market Discipline Amid Near-Zero Interest Rates
1 An Astonishing Level of Outstanding Debt
2 Quantitative Easing in a Zero Interest-Rate Environment
3 Suppressed Inflationary Expectations
4 Three Options for Reducing the National Debt
5 Yearning for Inflation: A Fallacy of the Times
6 The Limits of Inflation Targeting
7 Is a Non-Ricardian Fiscal Policy Feasible?
8 Dangers of Non-Keynesian Effects

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