Japan gyrations underline economy's vulnerability

TOKYO (AP) -- Japan's financial markets gyrated wildly Thursday, underscoring the vulnerability of its economy to a loss of investor confidence as Prime Minister Shinzo Abe attempts shock monetary easing to end two decades of stagnation.

Interest rates, or yields, on 10-year Japanese government bonds briefly topped 1 percent for the first time in a year on Thursday, following news that some U.S. Federal Reserve officials are willing to scale back the American central bank's stimulus efforts as soon as June if the economy perks up.

Thursday's spike, which came despite the Bank of Japan's aggressive efforts to keep borrowing costs down, is unnerving some investors at a time when Japan's already overburdened government finances are vulnerable to rises in interest rates. A sustained rise would push up the cost of borrowing for the government.

"Japan really has a long-term debt problem," said Franklin Allen, a professor at the Wharton School at the University of Pennsylvania. "There will be a financial stability problem" if long-term government bond yields rise to 2.5 percent to 3 percent, he said.

The bond gyrations, along with fresh data showing China's recovery is faltering, led to a 7.3 percent tumble in the benchmark Nikkei 225 stock index, as investors cashed in on recent sharp gains. The Nikkei lost 1,143 to 14,483.98, its worst drop since the March 2011 tsunami disaster.

The Bank of Japan has been grappling with unexpected swings in the government bond market since early April, when its new governor, Haruhiko Kuroda, announced a drastic shift in policy aimed at doubling the amount of cash circulating in Japan's economy. That move should in theory stop yields from rising. The central bank's goal is to attain a 2 percent inflation target within two years, the main tenet of Abe's economic program, dubbed "Abenomics."

"We've never seen this volatility ... that we're seeing today in the Japanese market," said Ken Courtis, a former Goldman Sachs vice chairman and investment banker.

Since taking office in December, Abe has also raised government spending and promised reforms to make the world's No. 3 economy more competitive. Like the Fed, the Bank of Japan is buying massive amounts of government bonds, seeking to keep interest rates low to encourage people and businesses to borrow and spend more.

The government has yet to achieve its aim of breaking out of a deflationary rut of sagging prices that has slowed investment and is thought to be discouraging consumers from spending. Since rising prices would mean money spent now will go further than later, the government hopes to get Japanese to step up spending, especially for big ticket items like cars and houses.

The effort to "reflate" the economy has pushed share prices sharply higher, while the value of Japan's currency has fallen by 25 percent against the U.S. dollar since late last year. The yen was trading at about 101.8 to the dollar on Thursday after briefly passing 103 to the dollar.

Some say the success in boosting stock prices and weakening the yen could sap momentum for difficult economic reforms that are crucial to the success of Abenomics. Abe also wants to carry out political reforms such as changing Japan's constitution which enshrines pacifism.

"The incentive to carry out structural reforms is weakening. There might be a sense that nothing more has to be done," said Shinichi Ichikawa, chief market strategist at Credit Suisse in Tokyo.

"It requires a lot of strength for the prime minister to change the constitution. And of course a lot of power is needed to start the structural reform of the economy. I don't believe that one prime minister can achieve both at the same time."

Whether Abenomics succeeds or fails, Japan's government must ultimately reckon with its years of deficit spending and mountainous debt.

If the central bank revives inflation, it eventually will have to raise interest rates to keep price rises in check. Government debt amounts to over twice the size of the economy and higher rates would vastly increase the government's repayment burden as it continually sells new bonds to finance its deficits.

Paying interest on the government debt already consumes a quarter of government spending, said Courtis.

"What will Japan do," he said, "when interest rates go up and debt servicing starts to swallow the entire budget?"

The level of Japan's debt is higher, relative to its economy, than even some of the crisis-stricken European countries. But because it is mostly owned by domestic investors, especially huge banks and insurance companies, the country's credit rating has remained steady.

But many Japanese financial institutions, especially regional banks and credit cooperatives, would be unable to keep such large holdings of government bonds if the value of those bonds drops too far, Allen said. Individual buyers are likewise seeing their retirement savings evaporate.

The BOJ has pledged to help quell the turbulence in the market. On Thursday, it added an extra 2 trillion yen in liquidity, seeking to counter the jump in bond yields. But the volatility raises questions over how much influence the BOJ wields over the market, despite soaking up about 70 percent of all new bond issuance.

Japan's economy expanded at a faster-than-expected annual pace of 3.5 percent in the last quarter, a development many supporters view as a vindication of Abe's approach. The Bank of Japan ended a two-day policy meeting on Tuesday with no change in policy, saying the economy was "picking up," despite the lack of any change in price trends so far.

Critics contend that keeping interest rates artificially low to encourage borrowing merely encourages companies to waste money and avoid improving their efficiency and competitiveness.

Abe's government needs to produce a convincing program for the reforms needed to sustain growth, and to coax business into raising wages and investment, or face further punishment from investors, said Courtis.

"When people see the economics could be very problematic, in effect, if there's no big structural long-term release of domestic demand, all this really amounts to is a big devaluation," he said. "That's the monetary equivalent of a Pearl Harbor."

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Associated Press writer Malcolm Foster contributed to this report.