OECD says Japan risks rise in long-term rates

TOKYO Nov 28 (Reuters) - Japan is at risk of a rise in long-term interest rates due to growing government debt, which could damage the economic outlook and rule out additional stimulus spending if growth falters, the OECD said on Monday.

Japan should respond to a spike in yields by improving on its plan to achieve a primary budget surplus by the end of the decade and should rely on the sales tax for additional revenue, the Organisation for Economic Cooperation and Development said in its twice-yearly Economic Outlook report.

A sharp deterioration in the global economy would also harm Japan's prospects, and the Bank of Japan would have to expand asset purchases and fund-supply operations to bolster the economy, the OECD said.

"If such downside risks materialised, the OECD has identified ... key macroeconomic policies, as well as structural reforms which, while desirable in any case, would become essential to raise growth," the Paris-based organisation said.

Japan's long-term rates have remained low for some time as domestic investors hold almost all outstanding debt, but a sudden rise in borrowing costs could squeeze already weak public finances.

Japan's economy will contract 0.3 percent this year after the March 11 earthquake and tsunami, which triggered a radiation crisis at the Fukushima Daiichi nuclear power plant northeast of Tokyo, the OECD said.

This is a much smaller contraction than the 0.9 percent decline the OECD forecast in May.

Japan's economy will likely grow 2.0 percent next year, versus a previous forecast of 2.2 percent growth, as the government plans to spend around 19 trillion yen ($244.6 billion) rebuilding areas devastated by the March disaster, the OECD said.

Growth will then slow to 1.6 percent in 2013 as reconstruction spending peters out, but domestic capital spending and a pickup in global demand will support Japan's export-focused economy, the report said.

Reconstruction spending is worsening Japan's public finances in the short term, and the ratio of debt to gross domestic product will rise to almost 230 percent in 2013, pushing public finances further into "uncharted territory", the OECD said.

Japan's public finances, already the worst among developed economies, would deteriorate even if the government met its target of halving the primary budget deficit by fiscal 2015/16, the OECD said. A primary budget balance excludes debt servicing costs and income from bond sales.

The government also hopes to achieve a primary budget surplus in fiscal 2020/21 but needs to come up with a plan detailed enough to reassure investors on edge due to Europe's sovereign debt crisis.

Japan should improve its existing plan by creating an objective body to evaluate fiscal policy, the OECD said.

Japan will raise income and corporate taxes to pay for reconstruction and separately plans to raise the sales tax to cover rising welfare spending. It would be better to lower corporate taxes and raise the sales tax to increase revenue, as that would be less harmful to the economy, the OECD said.