"In Friday's comment you expressed an interest in Debt/GDP ratios for 2010. The attached chart includes projections for Japan for 2010/2011. I must say that looking at this chart, especially in the context of ongoing political and demographic problems, I am struggling to think of a scenario where we can avoid a sovereign debt crisis at some point. It is often said that Japan is unlikely to suffer the same kind of market pressure as the likes of Greece because 95% of JGB investors are domestic (graphic attached), however in the absence of such pressure, the politicians are very unlikely to do anything about it, making matters worse in the long run.

"Even the chairman of the Government Pension Investment Fund has warned that we will reach a tipping point in 5 or ten years:


"At the moment the politicians are squabbling and the ruling party is struggling to pass bills needed to issue debt which will make up 42% of the budget:


"It does look like consumption tax will be raised from the present 5%, but it may be too little, too late and the last time consumption tax was raised (from 3%) in 1997 the country fell back into recession. It seems extremely unlikely that Japan can grow its way out of trouble. Outright default would mean defaulting on pension obligations and, I guess but I do not know, the collapse of insurance companies who hold 20% of JGBs and banks that hold 45%. And an insolvent government would be unable to bail them out.

"The most likely course of action would be to inflate, but they have so far failed to do so and BOJ Governor, Shirakawa who has a mandate until 2013 is against setting an inflation target and is not a great believer in QE:

"There must also surely be a point where trying to inflate away debt is counter productive because interest rates also rise increasing the debt faster than it can be inflated away, but I suppose that depends on factors such as the size and duration of the debt.

"I am certainly no expert on these matters so I would be very interested to know how you, David or the Collective think this will play out. As a long term resident of Japan and unwilling contributor to the national pension scheme, I would be only too delighted if you could give me cause to be more optimistic.

"Thank you once again for your excellent service."

Eoin Treacy's view Thank you for this informative email contributed in the spirit of Empowerment Through Knowledge. Japan's government debt, inability to stoke the domestic economy, sclerotic administrative structure and looming demographic tsunami are all legitimate worries for investors.

Japan's low interest rate environment has kept the cost of servicing its enormous government debts manageable for longer than many had expected. Fiscal surpluses have also helped to mitigate pressures on the sovereign bond market. While higher inflation would be desirable as a way of depleting the debt burden and fostering investments rather than savings, it definitely falls into the "be careful what you wish for…" category. Higher interest rates would make servicing Japan's debts much more difficult, without a corresponding strong pick up in the domestic economy. This is not beyond the bounds of possibility, but significant reform would be required to enact such a development.

As you point out, the vast majority of Japan's debt is held internally. Therefore despite the debt problems, a default is unlikely because the BoJ can always print more Yen. This means that in the event of a sovereign crisis, the currency is the most likely victim. The Yen remains at an extraordinarily high level relative to the country's economic health. Interest rate differentials remain tight when compared to the USA, Eurozone, Switzerland and the UK but are unlikely to remain so beyond the short to medium term. The Yen carry trade gained popularity in the years prior to the financial crisis as investors leveraged up. It could become viable once more as interest rate differentials begin to widen.

Despite the torpor of the domestic economy, Japan is home to a large number of globally competitive companies that dominate their respective niches. The strength of the Yen, particularly against major competitors such as the Korean Won or the Chinese Renminbi has acted as a headwind for the stock market. As a result, following an almost two-year rally on Wall Street, the Japanese large cap market remains rangebound. However, signs are beginning to appear that Japan is beginning to attract investor interest.

The Topix 2nd Section Index of small caps, which has often led, hit a new 2-year high earlier this month and appears to be in the process of consolidating in the region of the upper side of its base.

The Topix Banks Index has firmed impressively since November, found support at the 200-day MA in January and the MA is also starting to turn upwards. However, it remains in a medium-term downtrend and will need to sustain a move above 150 to break the progression of lower major rally highs and indicate a return to demand dominance beyond the short-term.

Japan has a number of problems but the question for investors is whether these represent short, medium or long-term threats. At present, I suspect that Japan is viewed more as a catch-up candidate by investors which could be helped substantially by a weaker Yen.