The Greek sovereign risk problem provoked great unrest in stock and foreign-exchange markets around the world in early May. Sovereign risks are fears that the interest and principal on government bonds might not be paid, despite the rule that they must be paid before any other government expenditure.

It is generally considered that Japan would not experience a situation like the one Greece is now facing, because more than 90% of Japanese government bonds are held by domestic investors, whereas about three fourths of Greek government bonds are held by overseas investors. The OECD estimates, however, that the ratio of the total outstanding debt for national and local governments combined against the size of the economy (GDP) as of the end of 2010 will be 197% in Japan, which is even higher than the 123% in Greece. In addition, Japanese governmental debt has already reached 91% of household net financial assets — the asset balance net of liabilities — as of the end of 2008. We cannot optimistically regard the crisis in Greece as something that has nothing to do with us.

In the 2010 national budget, the amount of newly issued government bonds — 44.3 trillion yen — exceeds the tax revenue — 37.4 trillion yen — a situation only seen previously during such extraordinary periods as the Meiji Restoration in the 19th century and the time immediately after the World War II. However, an even more profound structural change occurred in fiscal year 1998: the amount of refinancing bond issuance dramatically expanded because outstanding government bonds had exhausted the cash available for redemption at maturity. Consequently, total government bond issuance including both newly issued government bonds and governmental refinancing bonds has far exceeded tax revenues every year since 1998. Refinancing bond issuance in fiscal 2010 will amount to 102.6 trillion yen.

In this situation, public finance is highly vulnerable to interest rate hikes. Even if the economy recovers and tax revenue increases, interest expenses would rise if favorable economic conditions boost interest rates, which could potentially lead to further expansion of new bond issuance. In other words, interest rate surges have been restrained and fiscal crises avoided so far because many Japanese people and foreign investors expect that the Japanese economy will remain in deflation. In fact, remarkably, while the amount of outstanding government bonds will have increased from 295 trillion yen at the end of the fiscal 1998 to 637 trillion yen at the end of the fiscal 2010, interest expenses are expected to decrease from 10.8 trillion to 9.8 trillion yen during the same period.

The government took various measures to restore fiscal soundness before public finance had deteriorated to such a level. For example, the Fiscal Structural Reform Act was promulgated in December 1997 to provide a ceiling for each broad category of annual expenditure in order to reduce the fiscal deficits of the central and local governments below 3% of GDP by fiscal 2003. Moreover, the Basic Economic Policy approved by the cabinet in July 2006 aimed to achieve a primary balance surplus of the central and local governments in fiscal year 2011. The primary balance — a deficit of 33.5 trillion yen is expected for fiscal 2010 — is calculated by subtracting expenditures excluding redemption of interest and principal on governmental debt from revenues excluding central and local government bonds. A surplus in the primary balance means a first step toward restoring fiscal soundness.

Previous fiscal restoration plans assumed too optimistic economic prospects, presumably to make the required expenditure cuts and tax increases seem smaller than necessary. When the Basic Economic Policy was announced, nominal GDP for fiscal 2010 was forecasted to be 579 trillion yen, which is more than 20% below the prospect today. The government has also attempted to understate the amount of newly issued government bonds by assuming interest rates lower than the growth rate, so that interest expenses are underestimated and tax revenue is exaggerated. Both politicians and citizens may be only seeing what they want to see.

Japan's latest fiscal restoration plan is the Basic Economic Policy of June 2009. No plans have yet been worked out since the change in government last September. The current administration's intention is to establish a fiscal management strategy for the next decade, incorporating fiscal-soundness-related quantitative indicators, and to formulate a midterm fiscal framework that defines rough goals for annual revenue and expenditure for the next three years.

I argue that these plans need to consider the following points. First, they must be based on prudent economic assumptions, learning from the experience mentioned above. The agenda of a review meeting in the National Policy Unit also says that the plans should be “based on careful economic forecasts, putting a priority on honesty.” Second, a target year needs to be stated for achieving the primary balance surplus of both central and local governments as a milestone toward the restoration of fiscal soundness. It should be prior to 2022, when baby boomers begin to reach age 75 and annual expenditures will need to increase sharply due to health insurance obligations. Third, it is desirable that the midterm fiscal framework of the central and local governments for the three years starting with next fiscal year categorize revenues and expenditures into comprehensive and mutually exclusive items that bind the budget request and compilation process.