The distant chimes of alarm bells are going off about Japan again.

Just a month after Standard & Poor’s downgraded the government’s sovereign debt rating, Moody’s on Tuesday warned that it might follow suit, both agencies citing long-term fiscal unsustainability of its growing debt pile.

The political deadlock that could delay the passing of budget-related bills and progress on comprehensive tax reform to pay for rising welfare costs is certainly not helping confidence.

Tom Byrne, Moody’s senior vice-president, said that his view “takes into account intensifying political challenges facing the [Naoto] Kan government, which may heighten policy formulation and execution risks”.

Domestic investors, which make up 95 per cent of the Japanese government bond market, are watching developments closely.

While they do not envisage a worst-case scenario, whereby the government will be unable to issue a huge mountain of deficit-financing bonds, and they certainly do not expect a bond and currency crisis in the medium term, the opacity of the current political turmoil is creating confusion.

“Risk seems to be more skewed towards the downside on domestic investors’ confidence on the political will for fiscal austerity,” says Tomoya Masanao, a Tokyo-based portfolio manager for Pimco.

“This means I should remain cautious about the JGB market. But we are not in the camp that JGBs are going to blow up because of the fiscal situation.”

The long-term sustainability of Japan’s growing debt pile is a touchy subject that has oftendivided domestic and overseas investors. Mistiming a JGB bond and yen crisis or expectations for a spike in yields have caused numerous foreign investors pain. But that has not stopped some placing a small chunk of their assets on a bet that, as Tokyo’s fiscal stability deteriorates in the future, there are huge gains to be made.

And Kyle Bass of Hayman Capital Management, a well-known JGB bear, this month reminded his investors of a looming bond market crisis in Japan.

Investors are well versed in the numbers and they are not pretty. To name a couple, Japan’s gross debt is set to grow to more than twice the size of the economy this year. Its debt burden is estimated to reach Y997,700bn by the end of March 2012. In addition, new bond issuance is set to exceed tax revenues for the third year running in the fiscal year 2011.

But Tokyo can rely on the huge pool of domestic funds to buy up JGBs for now, particularly as there are few other options for investors in yen. Public and private institutions’ capacity for soaking up JGBs minimises the government’s funding costs.

Benchmark 10-year yields may have risen nearly 50 per cent since the beginning of October to 1.27 per cent, in line with gains in US Treasury yields, but they still remain the world’s lowest.

Nevertheless, there have been signs of movement out of JGBs from the public sector. Japan Post Bank’s outstanding JGB holdings dropped Y6,167bn to Y149,724bn between March and December, amid an increase of just over Y2,000bn in its holdings of dollar- and euro-denominated assets. There is a chance this is just an asset allocation adjustment but the buying fits with a call from Shizuka Kamei, a former minister in charge of the post office, to diversify funds.

Japan’s public pension funds were also net sellers of bonds for the first time in almost a decade last year amid deteriorating demographics, and that trend is only likely to continue. But for now, the bond market has shrugged its shoulders at the shift, partly because it remains incremental.

The most important investors last year were commercial banks, as corporate savings have made up for a slowdown in household savings rates. Signs of an improving economy have raised expectations for increased investment by companies using those savings, but one official at a Japanese megabank says that this is not happening.

“Even if Japanese companies’ profits have been good, it does not mean that the domestic economy is improving, because the growth is coming from external demand,” the official said. “I am not seeing a trend of yen-denominated corporate deposits being withdrawn or loan volume picking up,” he says.

Investors agree. Pimco’s Mr Masanao adds that corporate savings are not a temporary phenomenon because the slower growth and deteriorating demographics suggests that companies need to invest less.

“There may be some capital leakage overseas by large corporations, but it’s still a micro story more than a macro one,” he said.

This theme of falling investment is important when estimating the point at which Japan’s current account surplus could shift into deficit, a key moment for the JGB market, according to Société Générale.

Estimates for when that might happen vary widely, but SocGen says that it is possible that Japan could maintain its surplus for “decades to come”. It points out that despite the drop in the household savings rate the current account surplus appears to be on a rising trend over the past two decades, apart from the sharp drop during the financial crisis

The alarm bells of Japan’s fiscal sustainability may still be distant but that does not mean domestic investors are happy with Japan’s fiscal situation. Ultimately, in the event of a debt and currency crisis, policymakers may be forced to step in and support the market.

“Japan continuing to enjoy a current account surplus does not necessarily mean the government can keep its high debt forever,” says Takuji Okubo, an economist at SocGen. “The more relevant concern . . . is whether the current strong home-bias of Japanese households would subside.”

“The Bank of Japan and Ministry of Finance need to have a sense of crisis,” says the official at the large Japanese bank.

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