Introduction
In the narrative of Japan's "lost three decades," along with the commonly heard deflation and economic stagnation, the term "debt" is inseparable. While we previously discussed Japan's monetary policy, which was only half the story, this article focuses on the other half: Japan's debt problem.
The Global Debt Landscape
In 2024, Japan had the highest debt-to-GDP ratio globally, reaching over 220%. Surprisingly, seven out of the top ten countries with the highest debt-to-GDP ratios were developed nations. Singapore's debt-to-GDP ratio ranked third globally, which is quite unexpected. This raises the question of why developed countries have much higher debt levels than others, but that is a topic for another time.
Comparing Debt Ratios
When comparing the debt-to-GDP ratios of Japan, Singapore, and the United States with those of Russia, Argentina, and Turkey, an interesting phenomenon emerges. Russia, a country at war, has an alarmingly low debt level. In 2001, Argentina defaulted on its debt when its debt-to-GDP ratio was only around 40%, while Japan has maintained a debt-to-GDP ratio above 100% for three decades, reaching a peak of 260% in recent years without defaulting. This shows that simply looking at the debt-to-GDP ratio cannot explain everything.
Understanding Debt Crises
To better understand the debt crisis, let's examine the reasons why countries have fallen into debt crises.
Argentina's Experience
In the 1980s, Argentina experienced severe economic stagnation and hyperinflation, known as the "lost decade." The annual inflation rate exceeded 300%, and in some years, it even reached over 1000%. In 1989, it reached a staggering 3000%. To address this, the Carlos Menem government implemented a new liberal economic reform in 1989, with the core being the Convertibility Plan in 1991. This plan fixed the exchange rate of the Argentine peso to the US dollar at a 1:1 ratio and required the central bank to back each peso with an equivalent amount of US dollar reserves. While this initially suppressed hyperinflation and stabilized the economy, it also led to an overvaluation of the peso, making exports uncompetitive. The need to maintain the exchange rate led to a continuous inflow of US dollars. In the late 1990s, the fiscal revenue from privatization dried up, while public spending remained high, resulting in a growing fiscal deficit. The government had to borrow to make up for the shortfall, and the total foreign debt soared from $68.6 billion in 1992 to $150 billion in 2001. Although the debt-to-GDP ratio was less than 50% before 2001, over 90% of the debt was foreign debt. The Convertibility Plan also deprived Argentina of monetary policy autonomy. When the US Federal Reserve began raising interest rates in 1994-2000, it became the last straw that broke the camel's back. In late 2001, the Argentine government announced a suspension of repayment of approximately $93 billion to $132 billion in sovereign debt, becoming the world's largest debtor at the time. In early 2002, it abandoned the Convertibility Plan and allowed the peso to float freely, causing the peso to collapse against the dollar.
The Asian Financial Crisis
The Asian financial crisis in 1997 was similar to Argentina's situation. Before the crisis, the government debt levels of these countries were generally very low, mostly between 10% and 30% of GDP, and their exchange rates were pegged to the US dollar at a 1:1 ratio. However, the problem was not only with the government but also with the private sector. Enterprises and banks in these countries believed that the exchange rate of the local currency to the US dollar was stable, so they borrowed a large amount of low-cost short-term US dollar loans for domestic investment, mostly in the overheated real estate and stock markets. When the US Federal Reserve began raising interest rates, international capital began to flow back to the United States. The high interest rates and appreciation of the US dollar had a double blow to these Asian countries. On the one hand, it increased the cost of repaying US dollar-denominated foreign debt. On the other hand, due to the fixed exchange rate system, the local currencies of these countries were forced to appreciate, resulting in a serious decline in export competitiveness. The direct trigger of the crisis was Thailand's announcement on July 2, 1997, to abandon the long-standing fixed exchange rate system pegged to the US dollar. The Thai central bank exhausted its foreign exchange reserves in an attempt to defend the exchange rate but was ultimately unable to support it, and had to allow the Thai baht to float freely. On the same day, the Thai baht depreciated by more than 17% against the US dollar, causing extreme panic in the market. Under the influence of the Thai baht's fluctuations, the Indonesian rupiah, Malaysian ringgit, and other currencies also depreciated sharply. The crisis then spread to South Korea, Hong Kong, and Taiwan. The currency collapse caused enterprises and banks that had borrowed US dollar debt to go bankrupt overnight. To avoid the collapse of the entire financial system, the government was forced to intervene and rescue, taking on huge private debt and pushing the national finance to the brink of bankruptcy.
The Root Cause of Debt Crises
The root cause of these countries' problems is borrowing too much foreign debt. Whether it is the government or the private sector borrowing, the result is the same. Borrowing other people's money, especially money that you cannot print, carries a very high risk of default.
Japan's Debt Situation
So, does Japan have foreign debt? As of the end of 2024, Japan's total external debt was approximately $4.3 trillion, accounting for 110% of GDP. However, most of these US dollar debts were issued by the private sector, including banks and multinational companies such as Toyota and Sony. The government hardly issues any US dollar debt because the interest rate on Japanese government bonds is very low, and it is more cost-effective to finance in yen. In addition, unlike Argentina and the Asian countries during the Asian financial crisis, Japanese banks and multinational companies borrow US dollars for financing because they conduct business globally and earn US dollars while borrowing US dollars. This is completely different from Thailand's model, where Thai enterprises borrowed US dollars to invest in the domestic real estate and stock markets and earned Thai baht. Once the Thai baht depreciated, they could not repay the US dollar debt.
Moreover, we should not only look at Japan's foreign debt but also its external assets. According to the data of the Japanese Ministry of Finance in 2024, Japan's total external assets reached $10.5 trillion, accounting for 272% of GDP. Japan is also the largest overseas creditor of the United States, holding $1.13 trillion in US government bonds. Therefore, from any perspective, Japan does not have a foreign debt problem. On the contrary, it is the world's largest creditor country. Japan lends much more money to the world than it borrows from the world. If we exclude Japan's net external assets, its debt-to-GDP ratio is approximately 160%. Although 160% is still a large number, almost all of this 160% debt is domestic debt.
The Absence of Inflation in Japan
Although Japan does not have a debt default risk, will it one day be unable to repay the debt and resort to printing money to repay it, leading to hyperinflation like Zimbabwe or Weimar Germany? Here, an interesting logical paradox emerges. Japan issued so much debt in the first place to create inflation. If printing money can really generate inflation, why has Japan not had inflation for three decades? This is the most important question in understanding Japan's debt. Many people are worried that now that Japan's inflation has risen, if the Bank of Japan raises interest rates, Japan's huge debt will bring huge interest expenses.
To understand this, we need to go back to the 1990s. After the bursting of the asset bubble in Japan in 1990, the most direct impact was that enterprises were insolvent. Although the value of enterprises' assets plummeted, the money they owed to banks did not decrease. The wave of corporate defaults led to a rapid increase in bad loans in banks, and the value of collateral in banks also plummeted, making many banks actually insolvent. However, they did not go bankrupt immediately but became zombie banks. To cover up huge losses, they dared not write off bad debts but continued to provide new loans to zombie enterprises that could not survive, allowing them to barely repay old interest. This led to a serious credit crunch. Zombie banks were unable to provide loans to healthy and potential new enterprises, and the entire economic credit function was paralyzed, seriously hindering economic recovery. During this period, the government and regulatory agencies' strategy was to deny and delay. Regulatory agencies allowed banks to use various accounting techniques to hide the true scale of bad loans, hoping that over time and with the natural recovery of the economy, the problem would be gradually digested. They bet that asset prices would rebound, but this bet failed. At the same time, the government, out of political considerations, tried its best to avoid using taxpayers' money, that is, public funds, to rescue banks that were considered greedy, which was unacceptable to public opinion. However, the delay made the problem worse. The black hole of bad loans became larger and larger, and zombie banks and zombie enterprises exhausted the vitality of the economy.
It was not until the Asian financial crisis in 1997 that the fragility of Japan's financial system was fully exposed. In November 1997, Hokkaido Takushoku Bank, Japan's tenth-largest bank, and Yamaichi Securities, Japan's fourth-largest securities company, went bankrupt one after another, completely breaking the myth of "too big to fail." Market confidence collapsed, and a systemic crisis broke out. Seeing that the entire financial system was about to collapse, the government finally could not sit still and had to intervene to save the market. In 1998 and 1999, the government passed legislation to establish a financial regeneration fund with a total amount of 60 trillion yen and began to inject public capital into large banks to strengthen their capital and prevent bankruptcy. During this period, because the Bank of Japan had already lowered interest rates to zero and could not lower them further, traditional monetary policy failed. So they invented quantitative easing (QE), a monetary policy. Yes, Japan is the originator of QE, and the QE of the whole world later learned from Japan. That is, the Bank of Japan injects a large amount of liquidity into the financial market by directly purchasing long-term government bonds and other assets on a large scale to combat deflation and stimulate the economy. This has caused Japan's debt-to-GDP ratio to soar. From 1990 to 2005, in just 15 years, it almost tripled. However, it was too late at this time. The bank crisis in the past ten years has made the whole society no longer active. Under the pressure of survival, the goal of all enterprises has changed from profit maximization to debt minimization. Their top priority is to repair their damaged balance sheets rather than expand. Therefore, even if the central bank lowers interest rates to zero, enterprises are no longer interested in borrowing money for investment but use all cash flow to repay debts. As a result, wages do not rise, and prices remain at a very low level, and even a price stickiness has been generated. That is, enterprises are extremely afraid of being the first to raise prices because in a deflationary environment, any price increase will be considered unethical and will lead to a large loss of customers. Therefore, everyone would rather maintain prices unchanged by reducing costs and profits. Although the central bank has carried out quantitative easing and Japan's debt has tripled, the money has not flowed into private sector consumption and investment but has been used to repay debts and flow into inefficient public projects such as building bridges and paving roads. Therefore, Japan has not had inflation until the epidemic period.
The Inflation during the Epidemic
Many people explain that the inflation during the epidemic was caused by the energy crisis caused by the Russia-Ukraine war in 2022 and the supply chain impact of the epidemic. However, this statement does not hold much water. Before the epidemic, Japan was not without supply shocks. For example, in the first half of 2008, international crude oil prices soared and reached a record high of nearly $150 per barrel in July 2008, which was higher than the peak after the Russia-Ukraine conflict in 2022. As a country that is completely dependent on energy imports, Japan was hit by a huge cost shock at that time. Domestic gasoline prices, electricity bills, etc. all increased significantly, and Japan's inflation rate did rise briefly and significantly, but it soon fell back to the deflationary zone. Similarly, the Fukushima nuclear power plant accident in 2011 was an unprecedented huge impact on Japan's domestic supply side. The Tohoku region of Japan is an important production base for the automotive and electronics industries. The earthquake and tsunami destroyed a large number of factories, leading to the interruption of the global supply chain of automotive parts and electronic components. This impact is no less than the supply chain impact during the epidemic. Whether it is an energy crisis or a supply chain impact, it is a relative price increase rather than a general price level increase. What is a relative price? For example, if the price of oil rises, your monthly fuel expenses will increase, so you have to save money on eating and watching movies. As a result, although the price of oil has risen, the price of movie tickets and catering may actually fall. This is a change in relative prices, which will not cause inflation because it is not a general price level increase, that is, not all commodities are rising in price.
So, what caused the inflation during the epidemic? The answer is simple: the government directly gave money to the people during the epidemic. Japan distributed 100,000 yen (approximately $930) to all citizens, including foreign residents, in 2020. Otherwise, your budget is fixed. If the price of oil rises, you have to spend less in other places. But now that the government has directly given you money, it means that your total budget has increased, and you do not need to spend less in other places. This means that the prices of all commodities will rise, resulting in inflation.
Here, we need to clearly distinguish what quantitative easing is. Because we often have a misunderstanding that quantitative easing is the central bank printing money, but in fact, it is not. We can look at the complete process of quantitative easing. First, the Ministry of Finance needs a lot of money, so it issues a large amount of government bonds. However, because the amount is too large and there is insufficient liquidity in the market, it cannot buy all the government bonds. At this time, the central bank begins quantitative easing, that is, it buys government bonds in the market. Note that the central bank does not buy government bonds in the primary market but in the secondary market. This means that although the central bank has printed money, it only uses the money it has printed to buy government bonds from the public. For us ordinary people, it is simply understood that before I bought government bonds in the bank, now these government bonds have become cash, which is not much different. You will not feel that you have more money just because the government bonds you bought have become cash. If we regard the central bank and the Ministry of Finance as a collective of the government, the government's balance sheet has not changed at all. Suppose the Ministry of Finance issues one trillion yuan of government bonds. Then, on the central bank's balance sheet, the asset side will increase by one trillion yuan of government bonds, and the liability side will increase by one trillion yuan of base money. The Ministry of Finance's liability, that is, the one trillion yuan of government bonds, has not changed, but now the debtor has changed from the public to the central bank. In short, it is just moving from the left pocket to the right pocket. The government's external debt has changed from long-term interest-bearing government bonds to short-term almost zero-interest cash. Therefore, rather than calling it quantitative easing, a more accurate name is actually asset substitution. That is, before the epidemic, whether it was Japan's quantitative easing in the past few decades or the three quantitative easings carried out by the Federal Reserve after the financial crisis in the United States, they all belonged to asset substitution. Therefore, we can see that neither the United States nor Japan had inflation due to quantitative easing in the past because asset substitution does not necessarily generate demand and therefore does not necessarily generate inflation.
The epidemic is different. The biggest difference during the epidemic is that it has changed from asset substitution to helicopter money. Because during the epidemic, the government directly issued checks to the public. The public received a sum of money out of thin air, and they did not need to exchange any assets for it, nor did they expect to pay more taxes in the future for this sum of money. Obviously, at this time, inflation naturally went up.
The Sustainability of Debt
When we look at a country's debt problem, we need to consider its sustainability. The sustainability of debt is not only about the debt-to-GDP ratio but also about the market's confidence in whether you will repay the debt responsibly in the future. This is easy to understand. It is like a person who borrows a lot of money to start a business and then repays the creditor immediately after making money. Then, the creditor will be willing to lend money to him again when he is short of money next time. On the other hand, if a person borrows a lot of money but uses it for consumption, the creditor will not be willing to lend money to him again next time.
Another reason why Japan's debt is safer is that 90% of Japanese government bonds are held by domestic investors, mainly savings of the public and institutions. They are more patient, and these government bonds are long-term holdings for them, so it is not easy to have a panic selling. In contrast, a large number of US government bonds are held by foreign investors, who may be more short-term speculators rather than long-term holders.
The Future of Japan's Debt
Now, many people are worried that if inflation rises again, the central bank will have to raise interest rates, and then the government may not be able to repay the debt. However, will inflation really soar again? I am very skeptical. The main factor that has recently driven up Japan's inflation is the soaring price of rice. But as I just said, this is only a relative price increase, not a general price increase. Therefore, even if inflation remains at a relatively high level now, I believe it will come down.
I am not saying that Japan's debt is completely risk-free. On the contrary, it has a hidden risk. The huge government debt makes fiscal and monetary policies tightly bound together. In the future, fiscal needs will dominate the direction of monetary policy. What does this mean? You think about it. When a country's debt scale reaches 250% of GDP, what does this mean? As long as the central bank raises interest rates by 1%, the government's interest expenses will increase by 2.5% of GDP. Therefore, when the central bank considers raising interest rates, it cannot only look at inflation but also has to consider whether the Ministry of Finance can afford it. Raising interest rates is no longer a simple monetary policy but has become a huge fiscal problem. Similarly, when the central bank considers raising interest rates, it must consider financial stability. Because if raising interest rates leads to bank failures, the government will ultimately have to intervene and rescue, which is another huge fiscal expenditure. Therefore, if inflation comes again next time, the central bank may find that it is unable to respond by raising interest rates. Raising interest rates may not only fail to effectively curb inflation but may also add fuel to the fire by increasing interest burdens.
Debt itself is not gunpowder but just gasoline spread on the ground. If China attacks Taiwan or there is another epidemic, these crises will become the sparks that ignite the gasoline, and a debt crisis is likely to really occur. But if that happens and the powder keg is ignited, it may not be just Japan that falls.