Don’t bank on a Japanese debt crisis yet

March 15, 2011, 6:38 PM UTC

There’s a tug of war happening right now between investors who are buying Japanese government bonds (JGBs) as a safer alternative to the sinking stock market, and investors who are buying credit default swaps on JGBs because they believe the country is will soon default on its debt. The price of credit defaults swaps on 5-year JGBs is hitting record highs.

Here’s a quick look at why people are scrutinizing Japanese sovereign debt. Japan has been able to rack up a massive debt load (expected to hit 228% of GDP this year) by selling JGBs to its own banks, insurance companies, and citizens. These lenders have allowed interest rates to stay at a very affordable near-zero percent. But with a debt so large, even a small increase in interest rates would start to eat up an unsustainable amount of the country’s revenues.

Certainly there’s an argument to be made that this situation is unsustainable. According to a report from Standard & Poor’s, Japan’s aging population will push the institutions that hold the most government debt — domestic life insurance companies and the Government Pension Investment Fund — to become net sellers to support pension-related costs.

The demographic shift will someday force the country to borrow from foreign buyers, who will likely charge higher interest rates that Japan can’t afford to pay. And then you have your debt crisis.

But there are two reasons that the earthquake may not trigger a sharp rise in yields.

First, the quake is unlikely to force insurance companies to make massive payments for earthquake damage, since only about 18.5% of Japanese households have earthquake insurance, according to reports. If those insurers don’t have to make massive payments, they probably won’t have to liquidate assets like JGBs.

In fact, Japanese bonds have remained stable and the yen has even strengthened since the disaster. Economists have attributed this phenomenon to speculation that Japanese institutions could sell US Treasuries to raise money, and that domestic companies might repatriate money to pay for earthquake damages. Japan, the largest buyer of US debt after China, could also momentarily stop buying Treasuries while it figures out how much it needs to spend on rescue and clean up efforts.

Second, Japan holds more than 95% of its own debt, according to Bank of Japan data. Even if foreign investors began to unload their bonds, they account for a small part of the overall market.

So while the specter of a debt crisis hangs over Japan as much as it ever has,  it’s unlikely to occur in the immediate wake of the earthquake. The day of reckoning for Japan’s debt problem will come when foreign markets determine the interest rates on JGBs.

Japan’s addiction to credit was fueled in large part by its ability to borrow from its own institutions and people. Now that same dynamic may shield the country from the harsh forces of the market at a time when it needs the protection the most.

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