Japan's Gamble is Everybody's Gamble

Simeon Hyman

Japan's got debt - lots of it. The country's government debt-to-GDP ratio is well over 200 percent, roughly twice that of the United States and even higher than Europe's most troubled economies - Greece, Italy and Spain.

Servicing that heavy debt was a lot easier before interest rates nearly doubled in May. The yield on 10-year Japanese government bonds over the past several weeks has gone from around half a percent to closer to 1 percent today. Therein lies the danger.

Japan for years has been fighting a largely ineffective battle against the deflation monster, one of the most crippling beasts any country can face. Deflation - the opposite of inflation - is a general drop in prices driven by a broad decline in demand, and it can kill an economy.

Japanese leaders are trying desperately today to reflate the economy through Abenomics, a series of stimulus programs that have been put into effect this year under Prime Minister Shinzo Abe. These efforts might work, but the downside is that they will probably drive interest rates higher, making the country's heavy debt burden even heavier.

The odds of higher interest rates have risen further now that the U.S. Federal Reserve has put everyone on notice that the beginning of the end is in sight for its own quantitative-easing stimulus program. It's a global economy, and the whole world can catch a cold when the Fed sneezes.

One result of the Fed action is that the yen is likely to continue to weaken, which would create some inflation, but also add another force threatening to lift interest rates. Japan could put some of that pressure toward higher rates by maintaining its own version of quantitative easing. But it probably wouldn't be enough to keep rates from edging upward. In the end, Japan's finances could be strained as never before.

Abenomics is the gamble Japan is making, and it consists of loose-money policies and more government spending. Both of those tactics are intended to help jump-start economic growth and raise enough tax revenue to address the debt-to-GDP imbalance before it gets further out of whack.

Will Abenomics work? It comes down to whether structural reforms - Abe's "third arrow" that adds to the previous monetary and government measures - are enacted. Regulatory change across many industries in Japan is long overdue. Restrictive labor laws hamper economic growth as well, although they might be among the most difficult traditions to change.

Elections next month hold the key to whether Abe is given the political support he needs to pursue these much-needed reforms. The world has a big stake in Japan's gambit. If it works, a healthy and growing Japan would add meaningfully to global growth. If it fails, a Japan that has trouble paying its bills would bring on an unwelcome test of the strength and stability of the post-financial-crisis global economy.

Simeon Hyman is the chief investment officer of BloombergBlack, a new offering available by invitation to affluent investors looking for a smart, easy way to take control of their personal wealth. For more information, visit BloombergBlack. This material is for informational purposes only. It shall not constitute or be construed as an offering of financial instruments by Bloomberg Wealth LLC or its affiliates, or as investment advice or recommendations by Bloomberg Wealth LLC or its affiliates of an investment strategy or whether or not to "buy," "sell" or "hold" an investment.

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