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Alarm bells ring over Japanese debt

The yen has remained supported as escalating fears over global growth have driven haven demand for the currency, but worries over the sustainability of Tokyo’s finances could well reappear on the market’s radar.

On Thursday, as a reminder that debt concerns were not just confined to Europe and the US, both Standard & Poor’s and the International Monetary Fund highlighted the long-term challenges faced by the Japanese government. S&P warned that Japan’s public finances continued to deteriorate, saying it was moving closer to a downgrade.

The ratings agency, which last cut Japan’s sovereign rating to AA- in January and has placed it on negative outlook since April, warned that Tokyo lacked a “comprehensive approach” to help contain its debt burden, estimated to be in excess of JPY 1,000 trillion in the year through March.

Meanwhile, a report released on Thursday from the IMF warned that market concerns about fiscal sustainability could result in a sudden spike in the risk premium on Japanese government bond yields that could pose a potentially severe threat to Japan’s economy.

The IMF’s financial vulnerability index showed Japanese banks’ exposure to Japan’s sovereign debt exceeds 80% of GDP and that rising JGB yields could therefore undermine the country’s banking sector.

The report said that a sudden spike in yields could result in the “withdrawal of liquidity from global capital markets and risk disruptive adjustments in exchange rates”.

“While these risks remain real, and are rising due to global debt dynamics, we don’t anticipate disruptive near-term developments in the Japanese government debt market in the near-term,” says Lee Hardman, currency strategist at Bank of Tokyo Mitsubishi.

The structure of the Japanese government bond market, with 95% of government debt held by domestic investors, helps provide stability, as does the large proportion of household assets held in currency deposits.

“In these circumstances, we expect the yen to continue strengthening in the near-term, boosted by safe-haven demand resulting from Japan’s sizeable current account surplus,” adds Hardman.

Hans Redeker, global head of FX strategy at Morgan Stanley, says: “A higher JPY is less of a threat to Japan compared to rising bond yields. For this reason, we think Japan will rather lay conditions for repatriating foreign asset holdings instead of allowing its bond yields to rise.”

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