Time Might Run Out on Japan’s Low-Rate Policy

But Tokyo’s three-decades-old effort to shore up its stagnant economy and fight deflation with hefty deficit spending has pushed government debt to the highest among major economies. Any sizable rise in interest rates would boost its debt-servicing costs, possibly triggering a vicious cycle of more borrowing at higher rates, accompanied by market turmoil, some economists say.

The widening differential between Japanese and foreign interest rates has supercharged the yen’s 20% fall this year to near its weakest since the late 1990s. That has swelled import bills and eroded Japanese wages relative to foreign wages, with surprising consequences.

Travel agencies are promoting a “Working Holiday” short-term employment visa program for Japanese youth in Australia, where the minimum hourly wage is twice Japan’s at the current exchange rate. Farms and factories are struggling to retain workers from Southeast Asia whose Japanese salaries were already modest before the yen’s fall reduced them even more. 

Japan was the only big market where

Apple Inc.’s

net sales shrank in the year through September, which analysts attribute in part to the yen’s weakness making iPhones more expensive.

“If the currency is down 30% and stays down, and if talented workers want to move abroad, at some point, the BOJ has to allow higher interest rates to keep Japan’s government running,” said

Adam Posen,

president of Peterson Institute for International Economics, a Washington think tank. “Japan doesn’t have to be growing hugely versus the rest of the world, but it has to have the sense that it’s not rapidly shrinking.”  

While the yen’s current weakness is in part a result of the interest-rate differential, says Hiromichi Shirakawa, chief Japan economist for Credit Suisse, it also reflects the “structural deterioration” of Japan’s economy, particularly the reduced competitiveness of Japanese manufacturers. 

Thus far the Bank of Japan has turned aside pressure to change course; it is expected to keep its minus 0.1% target for short-term rates at its meeting this week.

Japan’s consumer price inflation rate excluding fresh-food prices hit a 40-year-high of 3.6% in October. Excluding food and energy prices, underlying inflation was 1.5%. Wage growth, which the Bank of Japan has long seen as key to achieving its inflation target of 2%, has only recently moved up to 2% from 1%. 

“In the U.S. and Europe, the central banks are raising rates rapidly because they are very concerned about the risk of falling into a negative spiral of wage and price increases,” Bank of Japan Gov.

Haruhiko Kuroda

said at a news conference on Nov. 14. “The situation is quite different in our country.” 

Mr. Kuroda is expected to step down by April after 10 years on the job. Economists are divided on whether the BOJ will tighten policy after that. Many expect a moderate rate increase in the second or third quarter, citing creeping inflation driven by import costs and new leadership.

But Gene Park, a political scientist at Loyola Marymount University who has studied Japanese economic policy, thinks the bank is unlikely to make a big change out of concern about higher rates’ impact on homeowners, a majority of whom have adjustable-rate mortgages, as well as on small businesses.

Perhaps the biggest risk from higher interest rates is to the government itself. After Mr. Kuroda became governor in 2013, the bank sharply increased its purchases of government bonds and other riskier assets, a program dubbed “Kuroda’s bazooka.”

In 2016, the central bank announced the country’s first negative interest-rate policy. It soon augmented that with so-called yield-curve control, through which it seeks to keep the 10-year government bond yield around 0% by purchasing the securities whenever the yield breaks above the range. 

That has allowed the government to borrow massively to pay for frequent economic stimulus and the growing bill for caring for the population’s elderly without driving up bond yields or interest charges. 

The ratio of Japan’s general government debt to gross domestic product has risen from about 60% in 1990 to 263% in 2021, with its generous fiscal spending during the pandemic accelerating the upturn, according to the International Monetary Fund. IMF economists say pension expenditures and healthcare and long-term care expenditures contributed 96 percentage points and 82 points respectively to the 200-point increase in the debt ratio over the three decades.

Japan’s 2021 debt level was the highest among advanced economies and compares with 200% for Greece, 151% for Italy and 128% for the U.S., according to the IMF. And yet Japan pays just 1.5% of GDP in interest on its debt because its rates are so low. If rates were to rise, that interest burden would rise sharply.

The U.K.’s recent experience has renewed questions about Japan’s vulnerability. Its debt stood at 104% when newly installed Prime Minister

Liz Truss

‘s botched fiscal policy package in October fueled concern over the government’s financial health, sending government bond yields soaring and forcing her resignation.

Some economists doubt Japan faces the same risk because so much Japanese government debt is owed to Japanese investors. Cem Karacadag, head of Barings’s emerging markets sovereign debt group, said, “There are countries in the world that can’t sustain 10%, 20%, 30% of GDP in debt. But if people are willing to finance you, much, much higher levels of debt are sustainable.”   

Others are less sanguine. “We can’t keep printing Japanese yen,” said

Takeshi Niinami,

chief executive of Suntory Holdings Ltd., a food and beverage company whose products include Suntory beer and Jim Beam whiskey. “Don’t forget that what happened in the U.K. might happen to Japan.” Mr. Niinami says he supports higher interest rates, when implemented at the right time, because it “creates a healthy economy of this country.” 

Write to Yuka Hayashi at Yuka.Hayashi@wsj.com and Megumi Fujikawa at megumi.fujikawa@wsj.com

But Tokyo’s three-decades-old effort to shore up its stagnant economy and fight deflation with hefty deficit spending has pushed government debt to the highest among major economies. Any sizable rise in interest rates would boost its debt-servicing costs, possibly triggering a vicious cycle of more borrowing at higher rates, accompanied by market turmoil, some economists say.

The widening differential between Japanese and foreign interest rates has supercharged the yen’s 20% fall this year to near its weakest since the late 1990s. That has swelled import bills and eroded Japanese wages relative to foreign wages, with surprising consequences.

Travel agencies are promoting a “Working Holiday” short-term employment visa program for Japanese youth in Australia, where the minimum hourly wage is twice Japan’s at the current exchange rate. Farms and factories are struggling to retain workers from Southeast Asia whose Japanese salaries were already modest before the yen’s fall reduced them even more. 

Japan was the only big market where

Apple Inc.’s

net sales shrank in the year through September, which analysts attribute in part to the yen’s weakness making iPhones more expensive.

“If the currency is down 30% and stays down, and if talented workers want to move abroad, at some point, the BOJ has to allow higher interest rates to keep Japan’s government running,” said

Adam Posen,

president of Peterson Institute for International Economics, a Washington think tank. “Japan doesn’t have to be growing hugely versus the rest of the world, but it has to have the sense that it’s not rapidly shrinking.”  

While the yen’s current weakness is in part a result of the interest-rate differential, says Hiromichi Shirakawa, chief Japan economist for Credit Suisse, it also reflects the “structural deterioration” of Japan’s economy, particularly the reduced competitiveness of Japanese manufacturers. 

Thus far the Bank of Japan has turned aside pressure to change course; it is expected to keep its minus 0.1% target for short-term rates at its meeting this week.

Japan’s consumer price inflation rate excluding fresh-food prices hit a 40-year-high of 3.6% in October. Excluding food and energy prices, underlying inflation was 1.5%. Wage growth, which the Bank of Japan has long seen as key to achieving its inflation target of 2%, has only recently moved up to 2% from 1%. 

“In the U.S. and Europe, the central banks are raising rates rapidly because they are very concerned about the risk of falling into a negative spiral of wage and price increases,” Bank of Japan Gov.

Haruhiko Kuroda

said at a news conference on Nov. 14. “The situation is quite different in our country.” 

Mr. Kuroda is expected to step down by April after 10 years on the job. Economists are divided on whether the BOJ will tighten policy after that. Many expect a moderate rate increase in the second or third quarter, citing creeping inflation driven by import costs and new leadership.

But Gene Park, a political scientist at Loyola Marymount University who has studied Japanese economic policy, thinks the bank is unlikely to make a big change out of concern about higher rates’ impact on homeowners, a majority of whom have adjustable-rate mortgages, as well as on small businesses.

Perhaps the biggest risk from higher interest rates is to the government itself. After Mr. Kuroda became governor in 2013, the bank sharply increased its purchases of government bonds and other riskier assets, a program dubbed “Kuroda’s bazooka.”

In 2016, the central bank announced the country’s first negative interest-rate policy. It soon augmented that with so-called yield-curve control, through which it seeks to keep the 10-year government bond yield around 0% by purchasing the securities whenever the yield breaks above the range. 

That has allowed the government to borrow massively to pay for frequent economic stimulus and the growing bill for caring for the population’s elderly without driving up bond yields or interest charges. 

The ratio of Japan’s general government debt to gross domestic product has risen from about 60% in 1990 to 263% in 2021, with its generous fiscal spending during the pandemic accelerating the upturn, according to the International Monetary Fund. IMF economists say pension expenditures and healthcare and long-term care expenditures contributed 96 percentage points and 82 points respectively to the 200-point increase in the debt ratio over the three decades.

Japan’s 2021 debt level was the highest among advanced economies and compares with 200% for Greece, 151% for Italy and 128% for the U.S., according to the IMF. And yet Japan pays just 1.5% of GDP in interest on its debt because its rates are so low. If rates were to rise, that interest burden would rise sharply.

The U.K.’s recent experience has renewed questions about Japan’s vulnerability. Its debt stood at 104% when newly installed Prime Minister

Liz Truss

‘s botched fiscal policy package in October fueled concern over the government’s financial health, sending government bond yields soaring and forcing her resignation.

Some economists doubt Japan faces the same risk because so much Japanese government debt is owed to Japanese investors. Cem Karacadag, head of Barings’s emerging markets sovereign debt group, said, “There are countries in the world that can’t sustain 10%, 20%, 30% of GDP in debt. But if people are willing to finance you, much, much higher levels of debt are sustainable.”   

Others are less sanguine. “We can’t keep printing Japanese yen,” said

Takeshi Niinami,

chief executive of Suntory Holdings Ltd., a food and beverage company whose products include Suntory beer and Jim Beam whiskey. “Don’t forget that what happened in the U.K. might happen to Japan.” Mr. Niinami says he supports higher interest rates, when implemented at the right time, because it “creates a healthy economy of this country.” 

Write to Yuka Hayashi at Yuka.Hayashi@wsj.com and Megumi Fujikawa at megumi.fujikawa@wsj.com