Will Japan Default?

“The debt situation is irrecoverable,” says Carl Weinberg of High Frequency Economics, referring to Japan. “I don’t see any orderly way out of this. They will not be able to fund their deficit. There will be a fiscal shutdown, a pension haircut and bank failures that will rock the world. It is criminally negligent that rating agencies are not blowing the whistle on this.”

Japan, at the moment, looks like it is falling apart. Analysts, for instance, are questioning whether Tokyo will be able to finance its debt this year. Some are even thinking the world’s second-largest economy could go bankrupt by 2011. The best scenario, in the opinion of other observers, is that the country can postpone a sovereign debt crisis for three or four years. And here’s a new phrase you may hear soon: “sovereign ‘Chapter 11.’”

The country’s central bank is also worried, and when one of its officials suggested a default was possible recently, lenders listened. “Markets are increasingly concerned about the risk of deteriorating fiscal balances causing rises in long-term rates and dampening the effect of monetary policy,” said Tadao Noda, a Bank of Japan board member, early last month. “Sovereign risk is one such risk.”

So will Japan default on its sovereign obligations? Despite the recent surge of concern, there are mitigating factors. Interest rates on JGBs–Japanese government bonds–are low. The Oriental Economist’s Richard Katz points out that Tokyo’s debt-service burden is the lowest it has been in two decades. Japan has a big current account surplus and $1.04 trillion in foreign currency reserves. Moreover, the Japanese largely owe the money to themselves. Japan Post Bank, the country’s largest by deposits, has traditionally bought JGBs as has the national pension fund. About 95% of Japan’s debt is financed domestically.

Therefore, some argue that Tokyo can continue to manage despite record government deficits and record bond issuances. “The bears love to beat the Armageddon drum as far as Japan is concerned, but I just don’t see any precipitating event to cause a crisis,” says Katz, one of the most astute observers of the Japanese economy.