Chapter

3. The Dog That Didn’t Bark (So Far): Low Interest Rates in the United States and Japan

Author(s):
International Monetary Fund. Fiscal Affairs Dept.
Published Date:
September 2011
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Borrowing costs remain extremely low for the United States and Japan, even though their fiscal indicators are generally no stronger than those of several countries currently under market pressure. Interest rates for these two economies have remained low throughout the crisis and its aftermath and have declined further during 2011, even after the downgrading of U.S. debt in early August by one rating agency (Figure 1). These low rates—which stem from weaknesses in the expected recovery, expectations of low short-term interest rates, and flight to safety in unsettled global financial markets—are reflected in low borrowing costs and, ultimately, provide sizable benefits to fiscal policy sustainability. The relatively benign treatment by market participants of sovereign bonds issued by Japan and the United States, however, may not fully reflect fiscal fundamentals: current general government debt and deficits, and projected increases in debt over the next five years, are at least as high for the United States and Japan as they are for several euro area economies under market pressure or the euro area in general (Figure 4). In addition, projected long-term increases in pension and health care spending in the United States are larger than in many euro area economies. Japan and the United States face the largest gross financing requirements among all advanced economies this year and are projected to do so in 2012 and 2013 as well, reflecting their large deficits and debt stocks as well as their still relatively short debt maturity profiles (Table 3), notwithstanding some success in lengthening maturities in recent years (Figure 5).

Figure 4Fiscal Fundamentals in the G-7 Economies plus Spain, 2011

Sources: BIS; Bloomberg L.P.; and IMF staff estimates and projections.

Note: The indicators reported are the seven with the best signaling power from Baldacci, McHugh, and Petrova (2011) (see also Box 5). Debt refers to gross general government debt in percent of GDP; GFN is gross financing needs in percent of GDP; ST Debt is short-term debt securities at remaining maturity as a percentage of total debt securities, as of end-2010, as reported by BIS (except for Canada and Japan; see note 1); CAPD is cyclically adjusted primary deficit in percent of potential GDP; Pensions is the change in long-term public pensions spending from 2010 to 2030 in percent of GDP; Health is the change in long-term public health spending from 2010 to 2030 in percent of GDP; and r-g is the average interest rate-growth differential from 2012 to 2016 in percent. As each indicator is expressed in different units, the size-of-the-bars differential is standardized.

1Debt refers to net debt.

Figure 5Advanced Economies: Average Bond Maturity

Average Term to Maturity, September 2011 (Years)

Sources: Bloomberg L.P.; Datastream; and IMF staff estimates.

Note: Average term to maturity is based on government securities.

Table 3Selected Advanced Economies: Gross Financing Needs, 2011-13(Percent of GDP)
201120122013
Maturing debtBudget deficitTotal financing needMaturing debt1Budget deficitTotal financing needMaturing debt1Budget deficitTotal financing need
Japan47.510.357.849.59.158.645.87.853.6
United States17.69.627.322.47.930.422.96.229.1
Greece215.78.023.79.66.916.59.75.214.9
Italy18.54.022.621.12.423.517.71.118.9
Portugal16.15.922.017.94.522.318.03.021.0
Belgium18.03.521.618.93.422.218.53.321.8
France14.15.920.016.24.620.816.24.020.2
Spain13.46.119.615.45.220.615.04.419.4
Ireland38.710.319.05.38.613.98.16.814.9
Canada13.24.317.515.43.218.615.41.917.3
Netherlands12.53.816.313.22.816.014.22.316.4
United Kingdom7.08.515.57.67.014.78.25.113.3
Finland9.81.010.88.7-0.38.38.2-0.38.0
Germany9.11.710.79.41.110.57.40.88.1
Australia2.03.95.93.21.95.13.80.54.3
Sweden5.4-0.84.54.9-1.33.62.2-1.70.5
Weighted average18.77.526.221.66.127.721.04.825.8
Sources: Bloomberg L.P.; and IMF staff estimates and projections.Note: Data on maturing debt refer to government securities.

Fiscal adjustment in the United States and Japan is lagging that in other advanced economies. Some adjustment is expected in the United States this year, with a decline in the cyclically adjusted deficit of about ½ percent of GDP. The overall deficit in 2011 is 1 percent of GDP smaller than projected in the April Monitor, owing to both stronger revenue growth and lower-than-expected outlays. The cyclically adjusted deficit is currently projected to decline by almost 1½ percent of GDP in 2012— largely due to expiring stimulus and lower security-related spending. This would represent a sizable withdrawal at a time when downside risks to growth remain significant. However, these projections do not incorporate the full impact of President Obama’s proposed American Jobs Act (AJA), presented to Congress in September.7 In Japan, the overall deficit is now projected to be the largest among the Group of Twenty (G-20) and bigger than expected in April. The revision primarily reflects the worse-than-forecast growth effect of the earthquake and tsunami. Clearly, the natural disaster has had a substantial impact on public finances, on both the revenue and spending sides. This said, Japan’s fiscal woes predate the earthquake and tsunami, as Japan has for years run one of the largest primary deficits among advanced economies, in addition to having the largest gross debt ratio. (Given the Japanese government’s large asset holdings, however, its net debt is substantially lower; see Appendix 3.)8 In cyclically adjusted terms, the projected deficit’s expansion by ¾ percent of GDP in 2011 (compared with the previous year) would be largely reversed in 2012.

Low interest rates in the United States and Japan partly reflect structural factors, including some that do not seem likely to change abruptly in the near term:

  • A substantial share of domestic debt holdings. In Japan, close to 95 percent of public debt is held domestically.9 The share is lower for the U.S. federal government, but rises to 70 percent for the general government. Moreover, the share of debt held domestically increases further for the United States if holdings by foreign central banks are excluded (Figure 6). This is significant, because private nonresidents may be more willing to shift their investments out of a country than are domestic investors, and foreign central banks may follow different investment practices than do other market participants (see Chapter 2 of the September 2011 Global Financial Stability Report [GFSR]).

  • Significant local central bank debt purchases. The U.S. Federal Reserve has purchased 7½ percent of GDP in Treasury securities (cumulative, under its quantitative easing programs), an amount equivalent to 12 percent of publicly held Treasury securities. Government securities purchases under the Bank of Japan’s Asset Purchase Program have so far amounted to 1 percent of GDP. (If transactions undertaken as part of traditional monetary policy operations are included, the share of bond purchases undertaken by the Bank of Japan rises to 17 percent of GDP.) Large purchases by local central banks also took place elsewhere (gilt purchases by the Bank of England under the Asset Purchasing Facility amounted to 11½ percent of GDP, and the purchases by the ECB amount to a large share of securities issued by the countries under pressure). Such purchases mean that not all debt issued by these countries has yet been subjected to a market test.

  • Strong demand by a relatively stable investor base. Institutional investors—including insurance companies, mutual funds, and pension funds— hold 24 percent of government securities in Japan and 12 percent of Treasury securities in the United States. A further 22 percent of U.S. Treasuries and an estimated 2 percent of Japanese government bonds are held by foreign official entities. In addition, more than one-third of U.S. Treasuries issued by the federal government are held by other government agencies, including the Social Security Fund, and 20 percent of Japanese government bonds are held by Japan Post Bank.10

  • Lower banking sector risks. Banking risks, which as the recent crisis has shown can dramatically affect fiscal developments, are perceived to be lower in the Unites States and Japan than in Europe, although in the United States additional contingent liabilities (exceeding 35 percent of GDP) stem from the large government-sponsored enterprises (Box 1).

Figure 6Holders of Government Debt

(Percent of total outstanding)

Sources: Country authorities; Japan Post Bank; Currency Composition of Official Foreign Exchange Reserves (COFER) database; and IMF staff estimates.

Note: Data as of 2011:Q2 for Greece, Ireland, and the United States, 2011:Q1 for Japan and the United Kingdom, and 2010:Q4 for Portugal.

1Includes marketable and nonmarketable debt.

2Holdings by general government institutions.

3For the United States, refers to depository institutions; for Greece, Portugal, and the United Kingdom, refers to monetary financial institutions excluding the central bank; for Ireland, refers to monetary financial institutions and national central bank; and for Japan, includes depository institutions, securities investment trusts, and securities companies and excludes Japan Post Bank.

4Includes Government Account Series securities held by government trust funds, revolving funds, and special funds, and Federal Financing Bank securities.

5Includes bonds, T-bills, and other short-term notes.

6Includes Fiscal Investment and Loan Program (FILP) bonds and does not include T-bills.

7Includes Japan Post Insurance and excludes public pensions.

8Includes public pensions.

The widening crisis in the euro area should nevertheless serve as a cautionary tale for the United States and Japan, as well as other countries with high debts and deficits. Recent developments in Spain and Italy demonstrate how swiftly and severely market confidence can weaken and how even large advanced economies are exposed to changes in market sentiment. (Indeed, Box 2 shows that the budgetary impact of moderately large shocks to interest rates and growth would be sizable, especially in high-public-debt countries such as Greece, Italy, Japan, and the United States.) Low borrowing costs in Japan and the United States have arguably created a false sense of security, but should be viewed instead as providing a window of opportunity for policies to address fiscal vulnerabilities. In the absence of a new round of quantitative easing, higher interest rates could be required to attract new buyers of sovereign debt. (The impact of this could be even larger if central banks are required to begin selling some of their debt holdings to contain the growth of domestic liquidity.) Moreover, in Japan, as more workers retire and liquidate their holdings of government bonds (e.g., through their pension funds), the share of nonresident holdings of government debt may increase significantly. Perhaps most importantly, Japan and the United States have also benefited from large stores of credibility—in other words, the implicit belief among investors that both countries will implement policies to ensure the sustainability of their debt. Such credibility might weaken suddenly if market participants became less convinced that such policies were forthcoming.

Thus in both the United States and Japan the immediate priority is to ensure continued confidence that steps will be taken to resolve these countries’ unsustainable debt dynamics.

Box 1United States: Government-Sponsored Enterprises and Contingent Liabilities

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are large government-sponsored enterprises (GSEs) that were chartered by the U.S. Congress to provide a stable source of funding for residential mortgages. They purchase home loans from originators and package those loans into mortgage-backed securities (MBSs). Those securities are then sold to investors, along with a guarantee against losses from defaults on the underlying mortgages, or held as portfolio investments financed by issuing debt.

Until recently, the obligations of Fannie Mae and Freddie Mac had no federal government backing and their operations were not reflected in the federal budget. However, there was a perception of an implicit government guarantee because of the GSEs’ size and federal charter. That guarantee was made explicit in 2008 when Fannie Mae and Freddie Mac were placed under conservatorship. Under the terms of that arrangement, the Treasury provides sufficient capital to keep their net worth at zero in exchange for senior preferred stock and warrants. At the same time, the institutions are obliged to gradually wind down their portfolio holdings of mortgages to reduce losses to taxpayers. Moreover, the U.S. administration’s recent recommendations about housing finance reform focus on winding down the GSEs by raising their insurance guarantee fees, reducing their investment portfolios, and lowering the ceiling for conforming loans (see the April 2011 GFSR).

Contingent liabilities are large. The U.S. Office of Management and Budget (OMB) treats Fannie Mae and Freddie Mac as nongovernment entities for budgetary purposes. As such, debt securities or MBSs issued by the GSEs are not incorporated into estimates of federal debt.1 However, these are contingent liabilities for the government amounting to over 35 percent of GDP (of which liabilities amounting to 8¼ percent of GDP are held outright by the Treasury and the Federal Reserve), although clearly not all of these would result in fiscal outlays, as the GSEs have matching assets.

But fiscal outlays have been small so far, amounting to 0.9 percent of GDP net of dividend payments. Nevertheless, according to the Federal Housing Finance Agency, additional capital needs could reach 1¼ percent of GDP under a negative house price scenario. Still, uncertainty remains as the GSEs are undercapitalized.

Sources: Federal Housing Finance Agency; Federal Home Loan Mortgage Corporation; and Federal National Housing Association.

Note: GSE = government-sponsored enterprise; MBS = mortgage-backed securities.

1 Projections taken from U.S. FHFA (2010). The scenarios assume different house price paths, with a peak-to-trough decline in house prices of 31 percent under Scenario 1; 34 percent under Scenario 2; and 45 percent under Scenario 3.

1 For budgetary purposes, the OMB records only cash transfers between the Treasury and the two GSEs, such as equity purchases or dividend payments.

Box 2Risks to the Baseline

The projections in this Fiscal Monitor are based on certain macroeconomic assumptions. This box discusses the sensitivity of the baseline projections to growth and interest rates.

Risks to the global growth outlook remain squarely on the downside (World Economic Outlook, September 2011), with significant fiscal implications. Under a low-growth scenario, in which annual growth is 1 percentage point below the baseline scenario, average debt in the advanced economies would jump by 13½ percent of GDP by 2016 (see figure below). Greece, Japan, and Italy would experience the highest increases (close to 20 percent of GDP) because of their high initial debt stock. Several European countries, including Belgium, Denmark, France, the Netherlands, and Portugal, are also vulnerable to growth shocks due to large automatic stabilizers. In emerging economies, a low-growth scenario would lead to a relatively moderate increase of medium-term debt with respect to the baseline: 6 percent of GDP on average. However, countries with the highest stock of initial debt (such as Brazil, Hungary, and Poland) could see their debt rise by about 10 percent of GDP.

Impact of a Negative Growth Shock on Gross General Government Debt, 2016

(Percent of GDP)

Sources: IMF staff estimates and projections.

Note: Shock assumes that GDP growth is 1 percentage point below the baseline scenario from 2011 to 2016.

An increase in interest rates—brought about, for example, by a shift in global liquidity conditions—would lead to higher interest payments on new debt, with an especially strong impact on countries with high rollover needs. Given the relatively long maturity of debt in advanced countries, the effect would be felt only gradually. If the interest rate on new debt issuances were 100 basis points higher than in the baseline, after one year the interest burden would rise by ¼ percent of GDP, on average, in the advanced economies; the increase would be ½ percent of GDP after three years and ¾ percent of GDP after five years. In the case of emerging economies, the impact over five years would be ½ percent of GDP on average, owing to lower overall refinancing needs as a share of GDP than in the advanced economies. However, countries with higher debt and shorter maturity structures would be relatively vulnerable (figure on next page).

Interest Rate Shock

(Percent of GDP)

Sources: Bloomberg L.P.; country authorities; and IMF staff estimates and projections.

Note: Cumulative increase in interest bill from the second half of 2011 to 2016. Bubbles represent average years to maturity as of September 2011. Shock assumes that the interest rate on new issuances is 100 basis points higher than in the baseline.

Box 3Fiscal Developments in Oil-Producing Economies

For oil-producing economies generally, higher oil prices are resulting in sizable oil-related revenue gains. These amounted to 4½ percent of non-oil GDP in 2011, on average, from 2010 and 8¾ percent from 2009, for a sample of 28 oil-exporting economies for which oil-related revenues represent a significant share of total revenues. Combined with a slight worsening in non-oil primary deficit ratios, this has yielded an improvement in the overall balance by 6½ percent of non-oil GDP in 2011 from 2009 (see first figure). However, projected overall surpluses are below their 2008 level, suggesting that some countries may now have somewhat smaller fiscal buffers to deal with potential price declines than at that time.

Fiscal Trends in Oil-Producing Economies

Source: IMF staff estimates.

The extent to which oil revenue gains have been devoted to building buffers rather than to finance increases in non-oil deficits has varied across countries. But in many cases budgets have been revised to allow for higher spending, including to address social needs. This tendency has been stronger in economies where fiscal institutions are relatively weak. Within the oil-producing group, larger non-oil primary deficit expansions are envisaged in 2011 compared with 2009, for the most part, in economies with greater oil-related revenue gains. Examples include Kuwait, Oman, and Saudi Arabia; in some cases (e.g., Bahrain, Qatar, and Syria), the expansions are equal to or larger than the associated increase in oil revenues. By contrast, some economies (e.g., Kazakhstan, as well as Russia—notwithstanding a recent supplementary budget) are either improving upon or maintaining their 2009 non-oil primary balances, despite sizable increases in oil-related revenues (see second figure).

Oil-Producing Economies: Change in Non-oil Primary Balance and Change in Oil Revenues over 2009-11

(Percent of non-oil GDP)

Source: IMF staff estimates.

  • In the United States, the recent approval of measures to cut the deficit in the context of increasing the debt ceiling is a positive first step, but substantial further work will need to follow.11 Specifically, the bipartisan congressional committee needs to agree on additional adjustment measures, and the authorities will need to implement these and further measures to stabilize the debt ratio by mid-decade and gradually reduce it afterward. Any credible strategy needs to include entitlement reforms that will address the growth of spending on pensions and especially health care (see the April 2011 Monitor). Measures to contain the growth of other mandatory spending would also be desirable. Nevertheless, given the magnitude of adjustment that will be required, revenue ratios will also need to rise. Widening tax bases by phasing out tax expenditures would be a good way to start. The adoption of an appropriate medium-term fiscal adjustment strategy would allow for a more gradual pace of consolidation in the short run (with offsetting additional consolidation later) and the adoption of measures targeted to labor and housing markets, state and local governments, and infrastructure spending. Even with a less ambitious medium-term strategy in place, the pace of fiscal consolidation should reflect the need to sustain the weak recovery, with a fiscal withdrawal of 1—1½ percent of GDP, and include the extension of unemployment benefits and payroll tax relief.12 In either case, the automatic stabilizers should be allowed to operate fully. Furthermore, the institutional framework could be enhanced to support fiscal consolidation, including by clearly specifying a medium-term fiscal framework formally endorsed by Congress and making use of the real GDP growth forecasts of private sector and other outside institutions as a cross-check for the budget’s underlying assumptions.

  • In Japan, relief and reconstruction to address the social costs of the natural disaster are the key short-term priorities, but the associated deficit increase only strengthens the case for laying out a specific, detailed set of measures whose medium-term impact is commensurate with the major fiscal challenges the country confronts. A tax and social security reform plan, featuring a consumption tax hike to 10 percent from 5 percent by the mid-2010s, is expected to be put forward for parliamentary consideration later this fiscal year. These important steps would reduce the primary deficit to a still-large 4¾ percent of GDP in 2016 in the IMF staff’s projections and would start to bring the debt ratio to a downward path from 2021. However, faster adjustment, including via a larger increase in the consumption tax, would be preferable, in order to bring the ratio down by the middle of this decade.

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