Q+A: Are Japan's public finances at tipping point?

By Stanley White

TOKYO (Reuters) - Rating agency Standard & Poor's cut Japan's long-term sovereign debt rating on Thursday for the first time since 2002, saying the government lacked a coherent plan to tackle its mounting debt.

It reduced the rating by one notch to AA minus -- three levels below the highest possible rating.

Prime Minister Naoto Kan has staked his career on overhauling the social welfare system and raising the sales tax to keep up with the fiscal burden of an aging population and prevent public debt from rising further.

Politicians and ratings agencies have long warned that Japan needs to lower its debt pile. Japan's debt burden is by far the worst among industrial economies, but does it face a crisis similar to what is plaguing Europe's smaller economies?

HOW BAD IS JAPAN'S FISCAL POSITION?

By some measures Japan is in a worse mess than Greece and Ireland, both of which sought bailouts due to their high debt.

Japan is also worse off than countries that investors speculate will need bailouts in the future, such as Spain, Portugal and Belgium.

Japan's outstanding long-term government debt is set to reach 869 trillion yen ($10.57 trillion) at the end of March this year, or 181 percent of gross domestic product (GDP), the Ministry of Finance says.

WHY DOES JAPAN HAVE SO MUCH DEBT?

Japan's debt burden is a legacy of massive government spending in the 1990s to support the economy as it stagnated following the bursting of a massive property bubble.

An aging population means rising social welfare costs add considerably to government spending.

Some analysts say Japan's net debt provides a more accurate picture of the country's indebtedness. This measures gross debt minus government assets such as public pension fund reserves and foreign reserves.

On that basis, debt will reach 120 percent of GDP in 2011, the highest among major economies, the OECD says.

Still, some analysts say Japan would not be much worse off by that measure than Belgium and Italy were in the 1990s, and both of them avoided a sovereign debt crisis.

WILL JAPAN DEFAULT ON ITS GOVERNMENT DEBT?

Unlikely. Japan has a massive pool of domestic deposits to draw on to fund its debt issuance.

Japanese household assets total some 1,400 trillion yen ($17.03 trillion), some three times bigger than its economic output, providing a healthy pool of savings that can be funnelled into Japanese government bonds.

The government has almost no foreign currency-denominated debt obligations and domestic investors hold 95.4 percent of Japanese government bonds (JGBs), according to the Bank of Japan.

Greece's profile is virtually the opposite. About 70 percent of its sovereign debt is held by foreign investors.

Japan also has other avenues to raise funds. It is the world's largest creditor nation, with net external assets of 225.5 trillion yen.

Unlike Greece, it enjoys a steady flow of foreign earnings from a current account surplus.

The yen's status as an important international currency also helps Japan to access external liquidity and markets, and the ratio of Japan's tax burden to national income is one of the lowest in the OECD, leaving it room to raise taxes.

WHAT MIGHT HAPPEN AND WHAT WILL THE TRIGGER POINTS BE?

Fears are growing that Japan's aging population will draw on more on their savings, forcing the government to rely on foreign investors to fund its debt.

The most likely worst-case scenario is a sharp rise in long-term JGB yields. That could force the central bank to increase government debt purchases.

Looking ahead, a trigger point would be if the government were to lose vital sources of funding its debt. One analyst said the current account could swing into deficit by 2016/17.

If that is combined with a significant loss of faith among Japanese in domestic investments, the government would lose its most important source for funding debt.

A significant erosion in the savings rate would force the government to pay higher yields to lure foreign investors.

The savings rate, or savings divided by disposable income, is already falling as the population ages. It stands at about 3 percent, down from more than 10 percent a decade ago.

Yields have been rising since late last year, but this reflects an improving U.S. economic outlook more than concern about a Japanese debt crisis. Problems would occur several years in the future if the government failed to reduce its debt as more savings were by the aging population.

The 10-year JGB yield on Wednesday was about 1.25 percent, compared with 3.42 percent for comparable U.S. Treasury yields. It has held below 2 percent for more than a decade due to deflation and near-zero short-term rates.

Yields on Greece's 10-year debt last stood at 11.52 percent. Ireland's 10-year debt yields 9.01 percent.

WHAT ARE THE GOVERNMENT'S LIKELY POLICY OPTIONS?

The most obvious option is to raise the 5 percent sales tax. But this is unlikely to happen in the immediate future.

Having seen Greece's debt problems turn into a European crisis, Prime Minister Kan is determined to avoid a similar fate for Japan.

The government could raise some 2.5 trillion yen for each 1 percentage point rise in the tax, but a split parliament, low public approval ratings and divisions within Kan's Democratic Party make this difficult.

Many voters accept the idea of a sales tax hike in some form to fund rising social security costs, but the Democrats have so far failed to convince voters of their vision to cure Japan's economic ills with a painful tax increase.

Japan has been cutting public works spending for years. The government will need to get more serious about cutting spending elsewhere and scale back some welfare benefits to improve public finances.

Since Japan's public debt is mostly yen-denominated, Japan has the ultimate option of printing money to prevent a debt default.

($1=82.80 Yen)

(Editing by Michael Watson, Edmund Klamann and Ron Popeski)