By Leika Kihara and Makiko Yamazaki
TOKYO, Jan 21 (Reuters) – Japanese Prime Minister Sanae Takaichi may struggle to calm a bond market jolted by her vow to cut the consumption tax rate, a taboo even her mentor and former premier Shinzo Abe – known for his “Abenomics” stimulus policies – dared not break.
The damage from rising bond yields is particularly acute for Japan, which already spends a quarter of its budget just to finance a debt burden that is the heaviest among major economies.
However, given the difficulty of back-pedalling during campaigning ahead of the February 8 election, Takaichi may lack effective means to soothe markets that are starting to fear Japan may be losing its grip on its finances.
“The latest rise in yields is a sign markets are losing trust in Japan’s finances,” said a source familiar with Takaichi’s economic policy.
“The premier needs to make clear how Japan will gain market trust and what its future fiscal framework would look like,” the source, who spoke on condition of anonymity, said. “I think she understands this point, so there could be some moves toward this direction after the election.”
Takaichi may not have the luxury to wait that long lest she lose credibility with investors. The yield on the 10-year Japanese government bond (JGB) leapt 18.5 basis points in two days, the sharpest rise since 2022, to hit a 27-year high of 2.380% on Tuesday.
MARKET TRUST IN JAPAN GOVERNMENT PUT TO THE ‘TRUSS’ TEST
Super-long bond yields rocketed to record highs in a rout reminiscent of the “Truss” shock in 2022, when then British Prime Minister Liz Truss’ announcement of large, unfunded tax cuts caused a collapse in gilts and a historic surge in yields.
“Looking at the selloff, it’s hard not to be pessimistic. The super-long JGB market is dead,” said an official who manages market investment at a domestic bank, adding that his bank has barely bought any JGBs this year.
Such views among market participants provide a sobering reminder of the risks to financial stability in Japan whose public debt-to-GDP ratio is the biggest among developed economies, exceeding 230%.
More than 80% of Japan’s public debt is funded by domestic savings. The BOJ owns half of JGBs sold in the market, while foreign investors make up just 6.6% and the rest is held by domestic financial institutions and households.
To be sure, the situation in Japan is different from back when the UK financial markets were caught in a riptide of concerns over unfunded tax-cut plans. The Bank of England was hiking rates much more aggressively compared with the Bank of Japan, which still keeps its key policy rate at an ultra-low 0.75%. Japanese pension funds have limited leverage unlike in 2022 Britain, where highly leveraged pension schemes precipitated the crisis.
Still, Takaichi’s pledge to suspend the 8% food levy for two years unnerved a bond market already lacking investors able to fill a huge hole left by the BOJ, which is raising interest rates and steadily tapering bond purchases.
Until the central bank ended its bond yield control in 2024, politicians could safely compile huge spending plans to appease voters without worrying about a spike in yields.
Still, past administrations held off from signalling – let alone executing – a consumption tax cut for fear of sparking a bond selloff and boosting the cost of funding Japan’s huge debt pile.
Even Abe, who deployed in 2012-2013 a huge dose of fiscal and monetary stimulus to break Japan out of prolonged deflation, postponed but eventually pushed through a hike in the tax rate in 2019.
Since then, Japan has maintained an 8% levy for food sales and a 10% tax rate for other goods and services, generating consistent revenues to pay for rising social welfare costs of a rapidly ageing population.
The dangers of cutting the levy, and the subsequent economic fallout from a bond market selloff, could be amplified by Japan’s demographics and budget structure.
Nearly 60% of Japan’s budget is spent on social welfare and debt-financing costs, both of which are likely to keep rising.
Of Japan’s record 122-trillion-yen ($771 billion) draft 2026 budget, about a quarter is funded by debt issuance and nearly 22% by consumption tax, which is the biggest tax revenue source.
Suspending the 8% food sales levy, which Takaichi described as her “long-cherished dream,” would cost 5 trillion yen per year, roughly equivalent to expenditure for education.
She was vague on how the tax suspension plan would be funded, saying only that it was up to discussions with other parties.
“Even if it’s just for two years, 5 trillion yen is quite a big tax cut,” said Takeshi Minami, chief economist at Norinchukin Research Institute. “It’s very hard to push the tax rate back up once you lower it.”
A draft manifesto of the ruling Liberal Democratic Party (LDP), obtained by Reuters on Wednesday, repeated Takaichi’s vow to suspend for two years the food sales levy.
FEW TOOLS AVAILABLE
The market took a breather on Wednesday from the rout with the yield on the 10-year JGB sliding to 2.300%. But there is uncertainty on whether markets will stay calm, as ruling and opposition parties ramp up calls for big spending and tax cuts ahead of the February 8 election.
And there are few effective tools Japan can use to combat the market volatility.
Yuichiro Tamaki, a former finance ministry bureaucrat who is currently head of an influential opposition party, said Japan can combat yield rises by buying back or cutting issuance of JGBs.
The BOJ, for its part, could tweak its bond taper plan or conduct emergency bond-buying operations – options the central bank has described as tools to deal with extreme market stress.
But the BOJ sets a very high bar for intervention as ramping up bond buying would run counter to its efforts to wean the economy off its massive stimulus, and shrink its huge balance sheet, say two sources familiar with its thinking.
In any case, such measures would have only a limited effect in stabilising markets as the volatility is driven by broader investor concern over politicians’ calls for lax fiscal policy, analysts say.
“Markets will remain unstable as long as the ruling coalition fails to show specific ways to fund spending plans or cut expenditure, and instead compete with opposition parties with a pledge to lower the consumption tax,” said Naoya Hasegawa, chief bond strategist at Okasan Securities.
($1 = 158.1600 yen)
(Reporting by Leika Kihara and Makiko Yamazaki, additional reporting by Takahiko Wada and Tamiyuki KiharaEditing by Shri Navaratnam)
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