Q+A-Japan's fiscal woes deepen, making JGB investors wary

Fri Nov 6, 2009 4:10am EST

By Rie Ishiguro

Nov 6 (Reuters) - Japan's fiscal woes are fast expanding as the new government eyes huge spending to meet campaign pledges, sending bond yields higher on worries about a glut of new debt.

Plunging tax revenues mean they now cover less than half of government spending, adding to the pressure on yields as investors fret about the growing gap in Japan, which already has the highest public debt among developed countries.

Rising yields could also lead to government pressure on the Bank of Japan to boost its buying of government bonds, pushing it back towards a policy of quantitative easing.

Here are some questions and answers on Japan's fiscal woes.

HOW BIG IS JAPAN'S TAX HOLE?

Corporate tax revenues have plummeted since last year, when the global financial crisis pushed Japan's economy into its deepest recession since World War Two.

So, the government paid out more in tax refunds to companies in the six months to September than it gathered in corporate tax revenue, the first such deficit in nearly half a century.

Total tax revenue in the year to March 2010 is sinking to a 24-year low below 40 trillion yen, down 13 percent from the initial finance ministry estimate and less than half of spending.

For a graphic showing the fiscal pressure on Japan, click: r.reuters.com/paw97f

The government hasn't issued a tax estimate for the next fiscal year but it can't count on sharp rises as job and wage cuts hold back household incomes. Welfare costs are rising and the government, facing an upper house election next year, has ruled out any rise in sales tax for four years.

WILL THE GOVERNMENT REIN IN SPENDING?

The government won power in August pledging to increase payouts to households with children and end expressway tolls but it has to cut other spending to make room for these policies.

Ministries want to spend a record 95 trillion yen in 2010/11 but the government aims to trim that to 92 trillion yen -- 18 percent of GDP.

For the current fiscal year, the government is also trying to find funds for its new policies by reallocating money from its predecessor's stimulus spending of 15.4 trillion yen, 3 percent of GDP. So far it has found just 3 trillion yen of the 7 trillion yen it needs to do this.

Some economists worry a lull in spending between the end of old stimulus plans and the start of new policies could push Japan back into recession, in turn hurting tax revenues further and potentially demanding more government bond issuance.

Five of 21 economists in a Reuters poll last month warned GDP would likely fall around the January-March quarter of next year, a "double-dip" recession. [ID:nTKF106695]

HOW MUCH WILL BOND ISSUANCE RISE?

Japan is the most heavily indebted G7 nation. Gross public debt will reach 227 percent of GDP in 2010, more than double the United States' 93 percent, the International Monetary Fund says.

The Japanese government has previously had no trouble issuing debt to cover its deficits but the financial crisis has forced it to spend heavily on stimulus, and investors are getting wary.

Japanese media say the government's new bond issuance may exceed 50 trillion yen this fiscal year, a rise of 14 percent over current plans for 44 trillion yen.

Retail investors are not keen on the low yields offered, prompting the finance ministry to boost wholesale issuance by 2.1 trillion yen. [ID:nT78079]

Adding in the need to roll over maturing bonds and some debt issued by related institutions, the wholesale market is being asked to swallow 132 trillion yen in government bonds this year.

The government has said it will keep new bond issuance in 2010/11 below 44 trillion yen, but analysts doubt this can be achieved without drastic spending cuts -- again raising the risk of a second recession.

WHAT DOES THIS MEAN FOR BONDS, YIELD CURVE?

The benchmark 10-year Japanese government bond (JGB) yield JP10YTN=JBTC hit a three-month high of 1.455 percent on Friday after an auction on Thursday of 10-year bonds saw only lukewarm demand.

The cost of insuring against default in Japanese government debt has risen to its highest since April. Five-year credit default swaps JPGV5YJPAC=MP on Japanese sovereign debt have hit about 66 basis points from about 43 basis points two weeks ago, although they are still below a record of 130 set in February.

The bond yield curve has also steepened over the past month as the market fretted over possible increases in debt issuance.

The two-year/10-year yield spread JP2YTN=JBTC is hovering near its widest level in more than three years. Market players say the yield curve could steepen further in coming months.

This is especially true since short-term notes are seen likely to be supported by market expectations for the Bank of Japan to hold interest rates near zero percent for some time.

Much will depend on how the government will spread bond sales across maturities. If issuance is concentrated on the shorter end of the curve, that could cause shorter-bond yields to rise and gradually push up the entire yield curve.

But if issuance is spread among maturities, long-term bonds will bear the brunt, leading to a steepening of the yield curve.

WHAT DO THE FISCAL WOES MEAN FOR MONETARY POLICY?

The Bank of Japan, which buys 21.6 trillion yen a year in long-term government bonds outright, maintains its buying is aimed at supplying funds to markets, not at curbing bond yields.

But if investor fears push up yields and so increase the cost of financing the budget deficit, the central bank may face pressure to increase bond purchases. The BOJ has already increased the purchases twice since December 2008.

The BOJ does not underwrite government bonds so it's not monetising debt. But more bond purchases from the market would push the central bank closer to quantitative easing, in which it floods markets with excess cash to try to support the economy. (Additional reporting by Shinichi Saoshiro; Editing by Rodney Joyce)