Japan Is Building The World's Largest Debt | The Reason Why

From the matcha recipes to cherry blossom reels, Japan trends on social media every few months. But this time, it is making headlines for rising yields. After my previous article on the subject, many readers wrote back asking the bigger questions: How did Japan end up with such high debt? What exactly is happening in its economy? Is it a crisis? And so on.

Understanding this requires going back to the 1990s. This piece, read together with the earlier one, will help connect the dots and make sense of the bigger picture. So let’s start.

Japan's asset bubble in the late 1980s was fuelled by easy credit, low interest rates, speculation, and aggressive lending. Property values and the Nikkei 225 index tripled between 1985 and 1989 in real (inflation-adjusted) terms. Many institutional investors believed Japan’s economy could sustain high growth and low rates. But the situation worsened, and prices collapsed. By mid-1992, most gains had disappeared.

The most prolonged impact of this crisis has been on the prices and their expectations. Deflation entered the public memory as many generations did not see prices rise for most of their life. It impacted salary negotiations and kept wages low. However, inflation made a comeback post-Covid, which is expected to stay for some more time.

People and companies focused on savings and repaying loans, rather than spending. The government’s tax revenue started declining. Fearing backlash and instability, it didn’t raise tax rates and resorted to borrowing instead.

Now, to make government borrowing cheaper and encourage consumer spending, the Bank of Japan slashed interest rates. But these policies did not help. The ageing population added more to the trouble as pension and healthcare expenses rose. Gradually, the country entered the vicious cycle of stimulus > debt > weak growth > stimulus, pushing the debt-to-GDP ratio higher while interest rates became lower, even negative for some years.

Japanese folks didn’t earn much due to low interest rates, prompting them to invest in countries with higher interest rates. That’s how the Yen carry-trade began. The process involves borrowing yen at a low cost and investing abroad for higher returns. This made Japan the world’s top creditor to the world.

When savings from Japan flooded the global markets, the demand for global bonds rose. This pushed bond prices up and yields down. Bond prices and yields are inversely proportional. When a reliable buyer keeps pouring in low-cost capital year after year, bond yields remain low for everyone. Thus, loose fiscal and monetary policies provided easy money to the rest of the world. But as Japanese yields are rising today, the yen carry trade becomes unprofitable. Thus, marking the end of an era.

As I wrote earlier, this shift is not a reason to panic — and certainly not the financial doomsday many social-media reels are predicting.

Rather than focus on Japan's 250% gross debt-to-GDP ratio, consider its net debt at 140%. This gap is especially relevant for Japan. By comparison, the US gross debt is 120% and net debt is 96%. Japan is also unique among advanced economies in reducing its debt-to-GDP ratio since 2020.

Another stabilising factor is that almost 90% of Japan’s government debt is held domestically. So, no need to worry about capital outflows. Similarly, Japanese government bonds have long maturities of more than nine years. That means the government will not feel the pinch of rising interest rates immediately. Top rating agencies still see Japan as a safe country (A-rated) to invest in.

Finally, there is no need to worry that Japanese investors will suddenly sell off huge amounts of foreign bonds, like US Treasuries. State Street Global Advisors writes that these investments are made for the long term and not for speculation. So, dramatic selling is unlikely to happen, and thus, there is no need to panic.

Japan’s massive debt is the result of policy missteps, structural pressures, cautious corporates, and political constraints. Out of this environment emerged the yen carry trade. For years, it kept global borrowing costs low and supplied easy money to the world. But every financial shortcut has an expiry date. That said, this transition doesn’t have to be chaotic.