Japan’s Fiscal Plight Draws Scrutiny After BOJ Tweak To YCC

(Bloomberg) -- The Bank of Japan's tweak to its yield curve control mechanism created another reason to take a look at the nation's fiscal conditions, as Tokyo seeks to expand spending on defense and childcare while shouldering a massive public debt.

BOJ Governor Kazuo Ueda's loosening of restraints on 10-year bond yields prompted speculation among some that the end of the YCC program was somewhere on the horizon, and with it the quantitative easing program that allowed the government to grow the national debt to almost 260% of gross domestic product, the most in the developed world. With Tuesday's move by Fitch Ratings to downgrade US government credit, Japan's creditworthiness may also come under question if rates rise.

Ueda's YCC adjustment was “a message to the government that it now will have to do financial management responsibly, because the BOJ won't control yields as firmly as it used to,” said Takahide Kiuchi, economist at Nomura Research Institute Ltd. and a former BOJ board member. “Yields will rise if markets lose faith in their management.”

In the decade since then Bank of Japan Governor Haruhiko Kuroda launched his monetary bazooka in a bid to end entrenched deflation, the central bank has held the spotlight for economists and traders attempting to assess the outlook for Japan's economy.

The prolonged period of rock-bottom interest rates, which predates Kuroda's aggressive actions in 2013, helped turn fiscal policy into something of an afterthought, as the BOJ's version of QE — YCC — ensured that the government could sell as much debt as needed and would always find a buyer.

Now some economists see near-term risks if rising rates complicate financing operations. “If talk emerges of a possible cut to Japan's credit rating, it's possible upward pressure would push yields over 1%,” said Shinichiro Kobayashi, chief economist at Mitsubishi UFJ Research and Consulting.

Japan's credit ratings have been stuck in a downward trend for three decades. S&P last changed its assessment in 2015, when it cut its sovereign long-term rating to A+.

If 10-year yields rise by 1 percentage point from a base case, Japan's debt-servicing payments are expected to increase by 3.6 trillion yen by fiscal year 2026, according to Finance Ministry calculations. Japan is expected to spend 22.1% of its 114 trillion yen ($795 billion) national budget for this year on debt-servicing costs.

Yields on those securities touched a fresh nine-year high of 0.65% Thursday, prodding the BOJ to announce an unscheduled bond-purchase operation for the second time this week in a sign of its determination to support the market.

For now, the mood in the finance ministry is calm. Given the nation's enormous outstanding debt, the ministry needs to issue JGBs in a stable manner over the medium-to-long term without being constrained by short-term financing costs, said a senior official who asked not to be named. He noted that in addition to controlling short-term costs, authorities manage debt policy with an eye on preserving market functionality, so last week's tweak to YCC is in line with the ministry's thinking.

If investors lose faith in Japan's fiscal management, and begin to fret over the safety of JGBs, negative sentiment could build on itself, warned Yasunari Tanaka, researcher at Mitsubishi Research Institute Inc. 

“Foreign investors would shift from JGBs to other countries' bonds if they believed JGBs to be risky,” Tanaka said. “This would lead to higher interest rates, which in turn would lead to a further deterioration of public finances.”

Tanaka emphasized that he doesn't foresee a crisis, but a slow period of deterioration could mean further increases in interest rates lead to “a negative spiral.”

Moody's Investors Service said last week's YCC tweak probably won't create headwinds for the finance ministry. “In the absence of a more fundamental shift in monetary policy toward tightening, we expect that interest rates will not rise so much that they undermine credit conditions for Japanese issuers over the next year,” analysts at Moody's wrote in a report Monday.

A saving grace for Japan is that Japanese investors still own a large portion of outstanding JGBs, with the BOJ itself holding more than 50%. Less than 15% of all public debt was held by overseas investors as of the end of March. Before Kuroda launched his stimulus program in 2013, the central bank held 11.6% of outstanding debt.

Also, the BOJ's failure to reinflate the economy through its ultraeasy policy may prevent problems for fiscal policy. Ten-year yields wouldn't go up to 1% “even if the BOJ says it's OK to get there,” said Kiuchi at Nomura Research. “That means that the BOJ hasn't been able to generate much of an stimulative impact for the economy by holding down yields.”

Ueda's assertion that the YCC tweak didn't represent a first step toward policy normalization will assure Prime Minister Fumio Kishida and the finance ministry that the economy — and the government's funding operations — will continue to benefit from low rates.

“The BOJ won't say publicly, but it's important to consider the impact on Japan's finances,” Chotaro Morita, senior fellow at SMBC Nikko Securities, wrote in a report Tuesday. “It wants to avoid creating the impression there might be an abrupt increase in fiscal costs due to YCC adjustments.”

--With assistance from Emi Urabe, Yoshiaki Nohara and Yumi Teso.

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