Kiel Institute Focus 12

Japan: Getting Out of the Vicious Circle*

by Rolf J. Langhammer

Japan’s image as an aging, low-growth, highly indebted country has become even worse recently due to the Tsunami in March and the subsequent nuclear power plant catastrophe. According to the IMF, Japan’s economic growth will shrink to 1.4 percent in 2011, half of what it was in 2010, but will rebound to about 2 percent 2012. The level-of-debt ratio is forecast to rise to 250 percent of GDP by 2016, which would be a record not only for Japan but also for the industrialized world.

Since most of Japan’s debt is held by the Japanese, the question arises as to whether Japan’s aging population will (1) want and will be able hold debt until it falls due, and thus to prevent a sudden drop in debt prices, and (2) provide fresh capital to redeem old debts. If not, the government will have to raise taxes drastically or cut expenditures in order to service the debt.

But the situation in Japan is not quite as bad as its image would seem to indicate. One can easily find positive aspects to the situation in Japan. For example, Japan has the second largest foreign currency reserves (following China) in the world, namely $1,100 billion (according to March 2011 figures), and in spite of the slow worsening in its balance of payments, it still has a positive balance of payments amounting to about 2 percent of GDP. Thus, Japan is still a net creditor country.

However, this does not mean that Japan is in safe waters. Its dollar-denominated debt and the yields on this debt have to be seen in relation to its Yen-denominated obligations to its own population. The Yen has appreciated considerably in the last two years, and it is expected to continue to appreciate if Japanese investors start cashing out their investments abroad in order to invest in rebuilding their country. Appreciation of the Yen, however, will depreciate the value of Japan’s currency reserves, in Yen terms, and the value of the currency reserves is of paramount importance when debts are held and serviced in Yen. The magnitude of the depreciation is considerable: a nominal appreciation of the Yen against the dollar by approximately 20 percent, as happened in the last two years, would cause the currency reserves to depreciate in value by ¥20,000 billion (approximately $250 billion), which amounts to approximately the currently estimated damage to the capital stock in the three prefectures hit the hardest by the recent catastrophes, namely Iwate, Miyagi, and Fukushima. Japan would have to increase its net export earnings considerably to compensate for such a depreciation in the value of its currency reserves, but appreciating the Yen would not allow it to do precisely this.

Japan is not the only country to face a currency mismatch, i.e., to have low earnings on fixed-rate investments denominated in foreign currencies while having debts in its own currency. China also faces a currency mismatch. However, China can cope with this problem better than Japan because its public debt is considerably lower and its growth potential is much greater. Fortunately, however, Japan can reduce its currency mismatch to some extent on its own, and has been doing so for some time. The economic power of its population and its capital is increasingly due to the internationalization of the Japanese economy rather than to what it produces at home. Japan’s growth in direct investment abroad is greater than its growth in domestic investment, and thus the gap between the Japanese gross national product (i.e., what Japanese capital and Japanese labor produce everywhere in the world, including Japan) and the gross domestic product (i.e., what the Japanese and foreigners produce in Japan) is widening continually. The difference between the growth rate of the gross national product (GNP) and the growth rate of the gross domestic product (GDP) is larger in Japan than in other country, which is certainly an indicator that Japan’s economy is an aging economy. This difference is largely due to the labor and capital income (factor income) it derives from abroad. Its factor income currently amounts to 2.5 percent of GDP, whereas it was 1.5 percent in the period 1997–2004 and only 0.8 percent in the period 1989–1996. The IMF projects that it will even reach 2.8 percent in the period 2013–2016. The German and US factor incomes, for purposes of comparison, are at least one percentage point lower. Japan is not Norway or Russia and thus cannot invest resource income globally via sovereign wealth funds. Instead, it has to rely on Japanese companies making large profits abroad that flow only into Japan, and on these inflows taking place under conditions of exchange rate neutrality.

Whether Japan will be able to service its debt will depend more than ever on the ability of Japanese companies to produce innovative products abroad and less than ever on what they produce in Japan. Only by being innovative abroad will Japan be able to deal with its debt.

(Slightly revised version of an article published in "Financial Times Deutschland" on May 3, 2011, under the title "Ab ins Ausland.")

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*The Kiel Institute Focus Series presents papers on current economic policy topics. Their authors are solely responsible for their content and their views or any policy recommendations they may make do not necessarily represent the views or recommendations of the Institute.