Growth and foreign fervour for yield give Japan fiscal wiggle room

By Rae Wee and Vidya Ranganathan

SINGAPORE (Reuters) -A weekend election in Japan has made real the prospect of bigger government spending and deficits in the world's most indebted developed nation, although for now foreign investors and a growing economy could keep its bond yields from spiking sharply.

Japan's upper house election on Sunday dealt a big blow to the ruling coalition and Prime Minister Shigeru Ishiba ahead of a looming tariff deadline with the United States.

Investors are bracing for scenarios ranging from Ishiba continuing to run a minority government, a deal with a smaller opposition party or even his ouster, but one thing they are certain of is that Japan is heading for tax cuts and a wider fiscal deficit.

Under normal circumstances, that should lead to a selloff in bonds and higher yields as investors demand to be compensated for risk to lend to a country with debt exceeding $8 trillion, or nearly 2-1/2 times the size of its economy.

But while Japanese long-term bond yields have been rising, they are nowhere near levels reflecting such government profligacy. Thirty-year bonds fetch just 3%.

A weak yen and a legacy of low interest rates, Japan's return to inflation, huge domestic savings and the Bank of Japan's policies have worked to anchor Japanese government bond (JGB) yields. Analysts expect some of that support for bonds will continue.

"With some of the proposals at the margin, with the changed political dynamics, potentially you could see more clamour for fiscal support including consumption taxes," said Michael Wan, a senior currency analyst at MUFG.

But Wan and other analysts point to Japan's economic growth and emergence from deflation in the past three years as reasons the debt burden is manageable and likely to decline in the coming years.

Japan’s fiscal situation isn’t as dire as many think," Marcel Thieliant, Capital Economics’ head of Asia Pacific, said in a note. While Japan's gross debt to GDP is the highest of any major economy, net debt is much lower, he said.

"Relative to other countries, Japan is a net creditor. So you do have, in theory, a lot of funds on the sidelines, from domestic institutions who have invested abroad, which could cap any sharp and dislocation in yield spikes over the medium term," MUFG's Wan said.

FOREIGN BID

Its role as one of the world's biggest creditors sets Japan apart from other G7 nations with debt and rising bond yields, such as Britain and the United States.

Together with pension giant GPIF and life insurance firms, the country has about $3.6 trillion dollars invested overseas, of which half is in U.S. assets.

While Japan can tap into its huge pool of domestic savings if needed, for now its low yields and weakening currency are luring foreign investors, who can switch dollars or euros for yen and earn a spread on the currency swap.

Swapping dollars to yen to invest in one-year JGBs, for instance, yields about 30 basis points more than the 3.9% yield on one-year U.S. Treasuries.

"Global managers or index guys actually look at the developed market as a relative value play, like whichever bounces up the most," said Rong Ren Goh, a portfolio manager in the fixed income team at Eastspring Investments.

"Of course it makes more sense for me to rotate out and do my asset swapping to get the best swap-adjusted return."

The steepness of the Japanese government curve has helped entice bond investors. Foreigners have poured more than 15 trillion yen ($101.17 billion) into Japanese bonds so far this year.

Thirty-year yields are up 80 basis points (bps) at all-time highs this year and the yield curve is at its steepest in years, with the spread between 10-year and 30-year bonds above 150 bps.

Thieliant still expects the 10-year JGB yield will rise to 2% by the end of 2026 from current levels around 1.5%, but that he said is based on a hawkish monetary policy view.

($1 = 148.2600 yen)

(Reporting by Rae Wee and Vidya Ranganathan in Singapore; additional reporting by Gaurav Dogra in Bengaluru.Editing by Shri Navaratnam)