Japan's lack of debt plan seen pushing up rates

A man walks towards the Bank of Japan building in Tokyo March 19, 2009.

TOKYO (Reuters) - Japan's main ruling and opposition parties are vying to persuade voters they are best qualified to handle the country's finances, but critics say they share a fatal flaw -- lack of a credible plan to cut the massive public debt.

Whoever wins an election just months away, worries about the country's long-term fiscal health could add to concerns over short-term spending, boosting interest rates and raising the cost of financing ballooning government spending.

Japan's outstanding public debt is already around 170 percent of GDP and the OECD has forecast it will rise to 197 percent next year. That compares to a U.K. government forecast of 90 percent for Britain in 2013/14, up from about 55 percent in 2008/09.

"With debt at 200 percent of GDP, there is absolutely a need for an exit strategy," said Martin Schulz, a senior economist at Fujitsu Research Institute.

"So far with zero rates, the cost of paying interest (on the public debt) is below 1 percent of GDP," he said. "But the moment the economy recovers a bit, interest rates will increase and the public debt will become unsustainable."

An election for parliament's powerful lower house must be held by October and many analysts expect a snap poll in August.

Opinion polls show the opposition Democratic Party of Japan (DPJ) has its best-ever shot at ousting the long-ruling Liberal Democratic Party (LDP).

"Neither side at this point has a clear fiscal reform strategy," said Robert Feldman, chief economist at Morgan Stanley in Tokyo.

The Democrats have pledged not to raise Japan's 5 percent sales tax for 4 years, arguing they can fund a raft of projects aimed at boosting disposable income merely by cutting waste, using special reserves and rejigging spending.

In the short-term, that makes a Democratic Party win more worrisome for bond markets, although analysts wonder whether the party would keep all of its costly campaign promises.

"Based on what is being said now, I think fiscal spending by the Democratic Party would clearly be higher," said Katsuyuki Tokushima, chief fixed income analyst at NLI Research Institute.

SEVEN-MONTH HIGHS

Concerns about increasing government debt issuance to fund revenue shortfalls along with recent signs of a moderation in Japan's economic recession lifted 10-year JGB yields to a seven-month high of 1.550 percent last week.

Since the rise in long-term JGB yields coincided with Tokyo shares hitting eight-month highs, market players say the Bank of Japan seems unlikely for now to further increase its outright buying of long-term JGBs. It decided in March to raise such purchases to 21.6 trillion yen ($219.7 billion) per year.

Although the BOJ has said it is not aiming directly at pushing down bond yields, market players suspect that part of the reason it may have increased its outright JGB buying was to prevent rising debt issuance from pushing up yields.

Any further increases in JGB sales this year could refocus attention on whether the BOJ will step up its purchases.

"The chances of a further rise in outright JGB buying will increase if long-term yields were to rise on concerns about debt issuance, and if that occurs at a time when the economy is floundering," said Shuntaro Take, manager for Tokio Marine & Nichido Fire Insurance Co Ltd's global investment department.

REAL TEST

Democrat Secretary-General Katsuya Okada, a possible pick for finance minister, has advocated a future hike in the sales tax, now 5 percent, to fund pension reforms, but party leader Yukio Hatoyama has said the topic need not be discussed for the next four years.

Nor has the often-fractious party forged consensus on long-term steps to address the bulging public debt.

"The DPJ wants to cut expenditures in areas close to the LDP and replace it with spending for their own interest groups. But there is very little talk of deficit reduction," Feldman said.

"The DPJ recognizes this as a problem, but given its own political environment, it hasn't been able to deal with it."

The LDP has cast itself as the fiscally responsible party despite a record 88 trillion yen budget for the year from April and a 13.9 trillion extra budget to try to ease Japan's worst recession in 60 years.

Key to the LDP claim is a proposal to raise the sales tax in 2011, if the economy recovers.

"Social security costs ... are rising. This cannot by any means be financed with the current sales tax," Secretary-General Hiroyuki Hosoda told Reuters last week. "The budget deficit is increasing. That is the reality.

Prime Minister Taro Aso's government already appears to be preparing to push back the goal posts.

The Nikkei business daily and other Japanese media reported on Tuesday that the government was likely to delay its goal for achieving a surplus of its primary balance to within the next 10 years, backsliding on its previous target of March 2012.

"They lose credibility by changing it (the target)," said Kyohei Morita, chief economist at Barclays Capital Japan. "But the biggest risk would be to set no target at all, because it would look as if they had abandoned fiscal reform."

Others, however, worry that the LDP won't sign on to a new target with an election looming, and argue that a target without a concrete road map of how to reach it is meaningless.

"It's fine to have a nice goal, but what are they going to do to achieve it?" Feldman said.

Analysts say the first test for whoever wins the election will come in autumn, when a second extra budget will almost certainly be needed to cope with a shortfall in tax revenues.

Bond market players expect JGB issuance to rise by another 5 trillion yen or so this fiscal year to cover the shortfall.

A new government might be tempted to add funds for fresh stimulus, while a DPJ-led administration will need to find money for promised spending, including aid for farmers and parents.

That means the Democrats would need to set a long-term target for improving state finances or risk a rise in interest rates.

"If the perception is that the debt burden will simply worsen, long-term interest rates would rise," Morita said.

"So they need to set a long-term target to address those concerns," he added. "They won't say so before the election, but that doesn't mean they aren't thinking about it."

(Editing by Kim Coghill)