Japan's debt crunch

Fears that times could get even worse may discourage shoppers

By BBC News Online's Orla Ryan

Japan's biggest economic problem may not be the fact that it is on the brink of its second recession in two years.

Or even that its banks are owed trillions of yen by companies that are struggling to repay it.

It could yet be the money that the government itself has borrowed - now thought to be equivalent to about 18% of the world's gross domestic product.

"It is the biggest bubble in the world, more important than the one that exploded on Nasdaq," is how Ken Courtis, vice president of Goldman Sachs Asia, described Japan's debt.

Recession fears

This week, Japanese officials are widely expected to indicate that the economy contracted in the second quarter in the world's second largest economy.

This will technically mean that the economy is in recession.

Last week, finance minister Masajuro Shiokawa admitted: "It is true that weakness in economic conditions have gone beyond our expectations."

Bank of Japan could use some of its money to buy bonds

So far the government has shied away from structural reforms and this is one of the reasons Japan has struggled to find its way out of a recession triggered by the collapse of asset prices in the 1990s.

The government has borrowed heavily, hoping their spending packages could spur the economy into growth.

Too late?

The new prime minister Junichiro Koizumi has pledged not only to reform the economy but also to cap borrowing.

But observers fear it could be too late.

Japan has only been able to sustain its heavy borrowing because of low interest rates and its captive lending base.

If this was to change, it could turn the world's economy on its head, observers argue.

Prime Minister Koizumi promises to tackle reform

Similar deficit crises in the US in the eighties saw investors pour all their money there to the detriment of other parts of the world.

If this happened in Japan, it could create problems for the US, which is relying on those investors to finance its deficit.

"With a current account deficit [the balance of trade in goods and services] of well over $400bn, America would be particularly vulnerable to a surge in Japanese interest rates or a disruption of capital flows from Japan," one economist said.

Borrowing crunch

So far, Japan has not had to pay high interest rates, because there is high domestic demand for its debt.

Finance Minister Masakura Shiokawa has warned of recession

The poor performance of the stock market has meant that for many investors, Japanese government bonds or JGBs are their best investment option - even though interest rates on 5-year bonds are as low as 0.39%.

As well, a limited system of social benefits has encouraged many people to save and much of this money is funneled, via the postal savings system, into government bonds. But this could change - and trigger a crisis - for a number of reasons.

• Firstly, if perception grows that the Japanese government may never repay its debt, then it is likely to have to pay higher rates.

• If the new premier Junichiro Koizumi does force through financial reform, Japanese investors may find they have more options over where to put their money and may choose not to put it in JGBs.

• A recovering economy - as distant a prospect as it seems at present - could also mean that Japanese stocks and companies are a more attractive bet.

"If they can finance it as they can with 10 year interest rates at 1.2%, it is not so much of a problem, but if they get their economy right, then interest rates will clearly rise, at that stage the governnment will have a problem about how it finances its debt," Paul Mortimer Lee, head of global market economics at BNP Paribas.

"[At the moment]There are more than enough savings being generated in Japan to finance the government," he added.

But if it needs to look outside Japan, it will need to pay higher rates.

But even then, the Japanese government could rely on its pension fund and the Bank of Japan to buy up JGBs, says Fuji Research Institute's Takamo Kiso, and this could result in higher inflation.

"If you look at the figures compared with OECD countries, it is certainly the worst," Fuji's Takamo Kiso said. " [But]...the Japanese economy has a current account surplus and pension fund surplus. Under these two conditions, I do not really think that the Japanese fiscal debt will implode."