Moody's: Bank of Japan emerging as main source of affordable funding for government

Moody's Investors Service says that the Bank of Japan (BOJ) is emerging as the main source of highly affordable funding for the government of Japan (A1 stable). Structural factors weighing on net savings rates will constrain the private sector's capacity to fund new government debt in the future.

Moody's conclusions are contained in its just-released report, "Government of Japan - Debt Affordability to Remain Strong as Central Bank Purchases Will Offset Shifts in Private Financing".

Moody's identifies the constraints on the ability of the private sector to fund future issuance of Japanese government bonds (JGB) as downward pressure on household savings rates; diversification in corporate asset allocations into non-financial assets; portfolio rebalancing by private investors away from domestic securities; and the inability of foreign demand to substitute slowing private domestic interest in JGBs.

With household savings ultimately serving as the primary source of private funding for the government, the stabilization of the long run upward trend in net financial asset accumulation by households indicates a risk that private demand for JGBs will lag their supply, leading to interest rate volatility.

As the BOJ continues on its current policy track, its share of the government bond market will continue to trend upward, rendering the government's fiscal accounts ever more sensitive to recalibrations in central bank policy, even as the average remaining time to maturity increases due to a shift to longer-term issuance. The BOJ held 35% of outstanding general government debt at the end of 2016, or more than double its share in 2013.

An abrupt shift to sales of the BOJ's government bond holdings, a highly unlikely scenario in the current environment, would expose the government to a risk of material but gradual weakening in debt affordability, if not matched by consolidation in the fiscal accounts.

Instead, our baseline view is that the central bank will pare down its bond purchases very gradually, which would have a moderate and manageable impact on yields.

At this time, even if the BOJ were to gradually pare down its bond purchases, the average interest rate paid on outstanding debt would likely still trend down as older, more expensive debt is retired and replaced with debt issued at sub-1%, likely sub-0.5%, rates.

Considering the wide spread between current yields and effective interest rates on outstanding debt, as well as the outlook for the government's net funding needs relative to available liquidity, an outright suspension of net purchases would also likely have a manageable impact on debt affordability.

Under such a scenario, the room for reducing debt servicing costs would shrink considerably, but immediate upward pressure on costs would be unlikely to emerge.