Zen to Zeal: Japan Deals With The World's Most Polite Fiscal Emergency

For years, Japan was the unicorn of sovereign finance. A high-debt, low-yield creature that managed to live peacefully in the wild without alarming investors. With net public debt peaking at 162% of GDP in 2020, and 30-year bonds yielding as little as 0.1%, Japan offered a reassuring lesson: deficits might be forever, and gravity could be optional, provided you printed your own currency and maintained a cultural aversion to panic.

But unicorns, it turns out, grow old too. And lately, the beast has begun to wheeze.

The Bank of Japan, historically the most dependable customer at its own debt auctions, has started to reduce its bond holdings. In the quarter ending March 2025, it trimmed ¥6.2 trillion from its balance sheet, the largest quarterly contraction on record. It was a whisper of tapering in a market where central banks had once shouted stimulus.

For a central bank that spent the last decade treating government bonds like prized collectables, this subtle disengagement is both symbolic and significant. Some would see it as a structural shift, though we may have to wait and see if that materialises, since it’s also, as investors know, fraught with risks. If the BOJ is exiting the stage, who’s left in the audience to control the bond yields? 

The month of May offered a clue. A poorly received 40-year bond auction sent yields rocketing to 3.7% from 2.6% earlier in the year. It was the financial equivalent of polite coughing in a quiet theatre, but brought an existential threat to decades old yen carry trades. Prime Minister Shigeru Ishiba responded with typical understatement: “Our country’s fiscal situation is undoubtedly extremely poor; worse than Greece.”

That comparison, however dramatic, did the trick – at least it seems so. 

The Ministry of Finance hurriedly adjusted its issuance strategy, dialling down long-dated supply and pivoting to short-term bonds. The result? A temporary reprieve: yields dropped back toward 3%. But investors were left wondering if this was clever manoeuvring or the fiscal equivalent of shuffling deck chairs, especially since replacing long-term bond issuances with short-dated ones increases rollover risks.

To its credit, Japan has found one lever that works: inflation. A rare and somewhat accidental surge in inflation has helped to dramatically shrink the debt burden. Tax receipts have surged. In the last quarter of 2024, the country recorded its first fiscal surplus in 17 years.

That should be cause for some sparkling sake, except, of course, that inflation is also behind rising borrowing costs, lower real wages, and political unrest. According to the IMF, interest payments already consume 10% of the central government’s budget. By 2030, they’re expected to double. Investors holding Japanese debt may want to consider adding it to their models, alongside the weather forecast and US election cycles.

Structural shifts in Japan’s bond market offer little comfort. Life insurers, once insatiable buyers of long-dated debt, are now net sellers. Regulatory tweaks, yield starvation, and demographic realities have curbed their enthusiasm. The BOJ may no longer be a guaranteed buyer. And while foreign investors are filling the gap, they’re famously skittish. Tourists, not tenants, now support Japan’s bond market.

It’s the kind of transition that bond vigilantes, long dormant in Japan, dream of. One day, they may even wake up.

As if rising yields weren’t enough, politics has entered its own version of fiscal cosplay. With an upper house election approaching in July, opposition parties are tripping over themselves to promise tax cuts. The 10% consumption tax is the main target. Proposals range from temporary relief on food — currently taxed at 8% —  to complete abolition.

Prime Minister Ishiba has channelled his inner central banker, warning that the country’s fiscal situation precludes such largesse. Yet, on June 13, he proposed something strikingly familiar: a one-time ¥20,000 cash handout to every adult, and double that to children and lower-income households. Sound familiar? It’s a reprint of the infamous “baramaki” (meaning scattering or disseminating in English) tactic from 2009, just with better PR. This time, we’re told, inflation-driven tax revenue will foot the bill!

Worse, the BOJ is now incurring losses on its bond portfolio. Those handsome ¥2 trillion profit remittances to the government may soon dry up. That’s another quiet fiscal contraction, just not one politicians can campaign on.
Too Sacred

It’s not that solutions don’t exist. Japan could deregulate its rice market — rice prices have gone up sharply in the recent past — allowing imports to soften the blow of bad harvests and rising prices. But the country allowed rice imports to become politically too sensitive and sentimental. It could address labour market rigidities or rethink long-term spending obligations. But why endure reform when you can hand out cash with a smile?

To an investor, the message is clear: structural change is not on the ballot. But giveaways are.

Optimists often note that only 12% of Japan’s public debt is held by foreigners. No sudden capital flight, they argue. No crisis. Perhaps. But domestic ownership carries its own risks. If a fiscal crisis does emerge, it won’t be hedge funds that suffer; it will be Japanese households.

Nearly half of household financial wealth is parked in bank deposits. Inflation, currency devaluation, or prolonged fiscal stress would hit these savers hardest. Unlike Americans, who hold both equity and debt, or Europeans with diversified portfolios, Japanese households are uniquely exposed to the risk of falling yen purchasing power.

It’s the kind of internal fragility that doesn’t show up on Bloomberg terminals, until it does.

In many ways, Japan is no longer the exception; it is the prototype. As other developed economies age, inflate, and wrestle with rising interest rates, Japan offers a preview of what happens when you run out of demographic luck, central bank magic, and political will at the same time.

Once, Japan was the world’s safe experiment in post-industrial fiscal coexistence. Today, it’s the first place investors look when they want to see what happens when debt, inflation, and politics start arguing in public. It would be interesting to see if all this would change for the better.

A fiscal crisis isn’t inevitable. But the theatre is packed, the exits are narrowing, and the ushers have stopped handing out programs.