Japan used to be regarded as the world’s most reliable lender. Now, the economy of Japan is in trouble on multiple fronts.
A collapsing Japanese bond market, inflationary stress, external shocks resulting from a possible trade war with the US and an impossible debt load are all contributing to what could be Japan’s worst economic crisis in decades.
Slowly but surely the economic situation in Japan is beginning to shake global markets.
The shattering a fiscal illusion
Maybe the signs have been there for a long time. Japan has had a deficit larger than any developed economy.
Its debt-to GDP ratio has been hovering above 260%. It paid almost nothing for borrowing.
Investors didn’t mind. The Bank of Japan was always present.
The massive domestic savings pool was seen as a safety net. The markets assumed that it would always be able to fund itself.
This assumption is beginning to crack.
In the first quarter 2025, GDP decreased by 0.2%. The economy shrank by 0.7% compared to a year ago.
The inflation rate rose to 3.5% in the third quarter, exceeding the central bank’s target of 2% for the first time in over a decade.
Real wages fell. Consumption stagnated. Exports, especially to the US, which is Japan’s biggest trading partner, declined.
The economy isn’t just slowing down. The economy is showing signs of stress. The bond market is showing signs of stress.
Investors are walking out
The most recent auction of Japan’s 40-year government bonds was the weakest for nearly a full year.
The bid-tocover ratio dropped from 2.21 to 2.21. The yields increased to 3.135% – the highest since the 1990s. Just days earlier, the demand for a 20-year auction was at its lowest level since 2012.
These are not minor fluctuations. These fluctuations are a sign of a decline in confidence in Japan’s long-end yield curve.
The paper losses of major buyers, notably insurers and pension funds, are steep.
Japanese life insurers reported unrealized losses of more than $60 billion last quarter. Nippon Life took a $25 Billion hit.
The Ministry of Finance floated the idea of reducing the issuance of ultra long bonds to calm down markets.
It worked for one day. But the fundamental dynamic has not changed. Investors no longer show up as they used to.
No longer the world’s largest creditor
Japan no longer holds the title of the world’s largest net-creditor nation. This title now belongs Germany.
Japan’s net foreign assets reached a record of Y=533 Trillion at the end of 2024. However, they were still behind Germany’s Y=569.7 Trillion.
The gap was widened by Germany’s strong current-account surplus, which reached EUR248.7billion, and the 5% euro/yen currency movement.
The Japanese finance ministry attempted to minimize the shift. Technically, Japan is still growing in terms of assets, mainly due to foreign direct investment, primarily from the US and UK. But the mix is important.
Japanese capital is now more concentrated in foreign businesses, such as banks, insurers and retail, than in tradable assets. This means capital is more sticky. It’s harder to get your money back if a crisis strikes.
Ironically, Japan’s globalization has made its position more fragile. Investors are aware that the liquidity of these foreign assets is limited. They’re pricing it in.
Too much debt and not enough growth
The numbers are staggering. The public debt of Japan now exceeds Y=1,400 Trillion ($9 trillion).
This is more than twice the size of its economic output.
Low interest rates and central banks buying bonds kept the cost of this debt manageable for years. This safety net is disappearing.
The Bank of Japan has reduced its bond purchases. Interest rates are not near zero any more.
Long-term returns are increasing. The cost of servicing debt is increasing at the worst time possible.
Japan cannot grow its way out. The population is shrinking.
The workforce is ageing. The potential growth is limited to about 1%. The Q1 contraction may not have been a one-off.
The illusion that Japan’s debt did not matter worked as long interest rates remained low. This illusion is crumbling.
Trade pressure is making the situation worse
While Japan struggles with internal weaknesses, the external pressure is increasing.
In April, President Trump imposed 25% tariffs on Japanese automobiles as well as a 10% duty on other imports.
He also threatens a reciprocal tariff of 24% if a deal cannot be reached by July.
It’s not just about trade friction. The US is Japan’s largest export market. The auto industry is a major part of Japan’s economy.
Toyota expects to lose $1.3 billion in earnings within just two months. Nissan is already preparing for the shutdown of domestic production and shifting output to the US.
These tariffs don’t just hit corporate profits. These tariffs are affecting investor expectations, complicating the monetary policy and limiting the government’s ability to respond.
Politics is fraying and policy is trapped
Elections are scheduled for July. Prime Minister Shigeru Shiba has refused to reduce the consumption tax.
Others in his own party claim that not cutting taxes could cost him power. Protesters are gathering outside the Finance Ministry. This is almost unheard-of in Japan.
Japan has managed political pressure for years by public spending.
Subsidies and transfers, as well as infrastructure projects, helped to avoid the populist backlash that was seen in other wealthy countries.
This tool is becoming more difficult to use.
The rising cost of borrowing forces a decision. Cut back on spending and risk social unrest. Spend more and risk further bond pressure. There is no easy middle way.
The yen is also not moving.
A weaker currency can be helpful in many crises. It increases exports, reduces debt, and promotes growth. But Japan cannot afford that right away.
The yen has already fallen to levels not seen in decades. A further decline would worsen inflation.
It would also increase Japan’s current-account surplus, which Trump has already criticized.
If the Bank of Japan eases further, it could lead to more US tariffs.
This puts monetary policies in a difficult position. Raising rates could choke off growth. A reduction in rates could lead to an increase in inflation and trade tensions. The central bank is currently doing neither.
A message to the rest of the World
Japan’s bond markets used to be the most secure in the world. It has remained stable throughout crises, recessions and deflation.
But 2025 will be different. Inflation has returned. Growth is slow. Debt is expensive. Buyers are no longer showing.
This is important far beyond Tokyo. Japan is the largest foreign owner of US Treasuries. If capital starts to flow home, in search of higher yields at home, the effects on global bond markets will be felt.
Treasury yields have already begun to move.
What’s happening in Japan doesn’t only concern the Japanese. It’s a warning to all borrowers that the era cost-free debt is coming to an end.
This post Japan’s economy is facing a breakdown that investors didn’t foresee appeared first on The ICD
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