TOKYO—The International Monetary Fund warned in a new report that market concerns over fiscal sustainability could trigger a "sudden spike" in Japanese government bond yields that could quickly render the nation's debt unsustainable as well as shake the global economy.
The fund's Japan Sustainability Report, released on Wednesday, was a signal to Tokyo policy makers that the international community is already worried about fallouts from Japan's potential fiscal problems, after debt problems in some European economies evolved into a Continent-wide crisis.
Japan's public liabilities amount to roughly twice annual economic output—a ratio worse than that of any other industrialized economy, including turmoil-hit Spain and Italy. The Japanese government has been slow to move amid political reluctance to lift taxes, particularly after the March 11 earthquake.
"Should JGB yields rise from current levels, Japanese debt could quickly become unsustainable," the IMF said in the report.
"Recent events in other advanced economies have underscored how quickly market sentiment toward sovereigns with unsustainable fiscal imbalances can shift," the fund said.
Higher government bond yields "could result in a withdrawal of liquidity from global capital markets, disrupt external positions and, through contagion, put upward pressure on sovereign-bond yields elsewhere," the fund said.
Senior Vice Finance Minister Yukihisa Fujita, who oversees budget making with Finance Minister Jun Azumi, said at a news conference on Thursday that he hadn't read the IMF report, and declined to assess what he referred to as a "hypothesis" about Japan's finances.
The paper was prepared by the IMF upon the request of the Group
of 20 industrialized and developing nations so the members could use it for their debate over the issue of global imbalances.
Japan's private net international investment amounts to $1.5 trillion, which mostly consists of investment by Japanese banks, life insurers and corporate pension funds, the fund said.
"Capital losses following a spike in JGB yields could trigger rapid deleveraging from positions abroad" by those players, it said.
If Japanese banks cut their foreign credit lines, G-20 economies, "notably the U.K. and Korea, would be among the most exposed to the loss in funding," the IMF said.
"Given evidence from past bouts of global turmoil, abrupt adjustments in exchange rates of major economies are likely to follow," it added.
In contrast to some European countries, Japan's sovereign debt is 95%-owned by domestic investors. That has helped Japan keep its bonds stable and rates low despite the nation's deteriorating fiscal condition.
Japan's debt market has even been bullish recently as European debt woes and a cloudy global economic outlook drives investors to buy Japanese government bonds.
But the IMF said, "Market concerns about fiscal sustainability could result in a sudden spike in the risk premiums on JGBs, without a contemporaneous increase in private demand."
"Once confidence in sustainability erodes," it said, "authorities could face an adverse feedback loop between rising yields, falling market confidence, a more vulnerable financial system, diminishing fiscal policy space and a contracting real economy."
In 2010, the Japanese government's interest payments were as large as 2% of gross domestic product, the IMF estimated. A one-percentage-point increase in average yields could boost the interest bill by an additional 2% or more of GDP, the IMF said.
For now, Japan plans to double its 5% sales tax by the middle of this decade and halve its main budget deficit by March 2016. But the government has no detailed plans beyond that time, such as steps to lower the debt-GDP ratio, the fund said.
A "more ambitious strategy is required to maintain confidence in public finances," it added.
The IMF indicated a preference to see the tax rate raised to 15% "over several years." There is "little room" to cut spending outside social security programs after years of belt-tightening, it said.