Exclusive: Japan panel warns of dangers if debt not addressed

TOKYO Mon May 20, 2013 8:57am EDT

Japan's Deputy Prime Minister and Finance Minister Taro Aso attends the Asian Development Bank (ADB) 46th Annual Meeting of the Board of Governors in Greater Noida, on the outskirts of New Delhi May 4, 2013. REUTERS/Adnan Abidi

Japan's Deputy Prime Minister and Finance Minister Taro Aso attends the Asian Development Bank (ADB) 46th Annual Meeting of the Board of Governors in Greater Noida, on the outskirts of New Delhi May 4, 2013.

Credit: Reuters/Adnan Abidi

TOKYO (Reuters) - A Japanese government panel warns there is "absolutely no guarantee" that domestic investors will keep financing the country's massive public debt, citing the risk of a spike in bond yields that could crimp long-term growth prospects, according to a draft report seen by Reuters on Monday.

The warning from the advisory panel to Finance Minister Taro Aso comes at a critical time - when the government bond market has seen volatile price falls, underscoring a delicate balancing act for Prime Minister Shinzo Abe's government.

Abe has unleashed huge fiscal and monetary stimulus to spur short-term growth, sending stock prices .N225 soaring. But at the same time, he is trying to convince investors that over the longer term Japan will tackle a public debt that, at more than twice the nation's annual economic output, is the biggest in the developed world.

Whether Japan can begin to get its fiscal house in order will be key to determining if the early boost to confidence from so-called "Abenomics" can translate into balanced and sustainable growth for the world's third-biggest economy.

The surge in Tokyo share prices in recent months has been heavily influenced by foreign investors betting Abe can break with 15 years of deflation and tepid growth. By contrast, JGBs - more than 90 percent-owned by Japanese investors - were until recently little changed by the government's stimulus plans and massive quantitative easing from the Bank of Japan.

"As financial transactions are being globalised, there's a great deal of freedom for overseas investment, so there is absolutely no guarantee that Japan's domestic funds will be directed towards JGB purchases," the panel's draft report says. "An important requirement is for JGBs to continue to be trusted by markets as safe assets."

The 31-page draft by the Fiscal System Council notes that Japan has repeatedly promised to the Group of 20 big economies that it will halve its budget deficit, excluding debt-servicing costs, over the five years to March 2016.

The JGB market has defied decades of predictions that it was a bubble waiting to burst. Bond prices this week suffered their biggest 4-day rout in years, although this was largely due to concerns over how the market can digest the massive influx of cash from the BOJ. The central bank is buying the equivalent of 70 percent of newly issued bonds in an attempt to spur economic activity and end deflation.

FISCAL DISCIPLINE

The draft report says fiscal discipline is vital to avoid spreading concerns that the BOJ, with its huge debt purchases, is giving the government a blank cheque for profligate spending.

Such warnings of the need for fiscal reform reflect the long-held position of the Finance Ministry and the central bank.

The report is preliminary and could still change before the 30-member panel submits it to Aso around the end of the month as the basis for the government's mid-term fiscal reform plan due in the summer.

Fiscal reform, though on the back burner recently, will likely grab center stage later this year as Abe must decide by October whether to proceed with plans to double the nation's consumption tax to 10 percent over two years.

"If the government fails to firmly tackle fiscal reforms and produce concrete results, that could lead to loss of market confidence in Japan's finances and cause a spike in interest rates, possibly offsetting effects of monetary easing," the panel warned in its draft report, adding that interest rates could deviate sharply from fundamentals, particularly when the BOJ eventually begins to seek an exit from its quantitative easing.

The panel's members are drawn from academia, companies, the media, think-tanks and the labor union movement.

(Reporting by Takaya Yamaguchi; Writing by William Mallard and Tetsushi Kajimoto; Editing by Ian Geoghegan)