This Selected Issues paper examines implications for long-term bond yields in case of Japan. The analysis finds that so far, upward pressure on interest rates from high public debt has been offset by domestic factors, including a stable investor base with a preference for safe assets. As these effects could decline with population aging, yields could rise unless reforms are implemented to stimulate growth and reduce the public debt-to-GDP ratio. In such a scenario, long-term Japanese government bond rates would remain relatively low and stable. The paper also analyzes to what extent rising health care spending poses a fiscal risk to Japan’s economy.


This Selected Issues paper examines implications for long-term bond yields in case of Japan. The analysis finds that so far, upward pressure on interest rates from high public debt has been offset by domestic factors, including a stable investor base with a preference for safe assets. As these effects could decline with population aging, yields could rise unless reforms are implemented to stimulate growth and reduce the public debt-to-GDP ratio. In such a scenario, long-term Japanese government bond rates would remain relatively low and stable. The paper also analyzes to what extent rising health care spending poses a fiscal risk to Japan’s economy.

Determinants of Long-Term Interest Rates in Japan and Implications Under the Government’s New Policies1

This note examines the key determinants of long-term sovereign yields using a panel of the main advanced economies. Empirical results suggest that Japan’s forward rates are determined by fiscal conditions, demography, growth and the inflation outlook, and the investor base of government securities. Deteriorating fiscal conditions would push up long-term rates by about 2 percentage points over the medium term, but the effect is partly offset by higher demand for safe assets amid population aging and increased purchases by the Bank of Japan (BoJ). A widening trade deficit, surprisingly, only contributes modestly to long-term yields, in part because of Japan’s sizeable net foreign assets holdings.

A. Background

1. In April 2013, the BoJ has introduced a new quantitative and qualitative monetary easing (QQME) framework by doubling the purchase size of Japanese government bond (JGB) and extending the average maturity of JGB holdings in an effort to meet the 2 percent inflation target and lift growth (text chart). The QQME is part of the government’s three-pronged approach to revitalize Japan—also known as Abenomics—that includes flexible fiscal policy, aggressive monetary easing, and structural reforms.


Bank of Japan: Monetary Base Target & Balance Sheet Projection

(Trillion yen (LHS), percent of GDP (RHS))

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A001

Source: Bank of Japan.

2. The impact of the new policies on the level and volatility of long-term JGB rates is mixed (Figure 1). The JGB market exhibited unusual volatility in the immediate aftermath of the QQME announcement, about four times the average volatility and the highest since the last spike in 2003. This volatility likely reflects two opposing forces on long-term interest rates: on the one hand, through sizeable purchases under QQME (around 20 percent of GDP for next two years), the BoJ intends to lower long-term interest rates further; but on the other hand, if the BoJ succeeds in achieving the 2 percent inflation target over the medium term, nominal long-term rates are likely to rise from current levels, thereby posing losses to financial institutions holding or buying more long-term JGBs. The uncertainty on the level of future JGB yields matters particularly for institutional investors including domestic banks, insurance companies, and pension funds, which hold nearly three-quarters of outstanding JGBs. As a result, a reassessment of portfolio compositions likely contributes to changes in long-term interest rates, which have risen by 20–40 basis points during April to June. Nonetheless, yields remain low at about 90 and 180 basis points for 10-year and 30-year JGBs, respectively.

Figure 1.
Figure 1.

JGB Market under Abenomics and QQME

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A001

3. Several factors are often cited as contributing to low and stable JGB yields, but their quantitative impact is less known. Hoshi and Ito (2012) pointed out that Japan has been able to “defy gravity”—low and stable yields despite a soaring public debt-to-GDP ratio—over the past two decades. In addition to low growth and lingering deflation, the low and stable sovereign yields could be attributable to several factors (Figure 2):

  • Fiscal conditions—The public debt to GDP ratio has increased markedly for the last two decades. Gross and net debt-to-GDP ratios have reached 230 and 127 percent in 2011, respectively, and are expected to rise over the medium term. The deteriorating fiscal conditions are likely to exert an upward pressure on long-term rates, although this could be mitigated by expectations of drastic fiscal reforms to restore fiscal sustainability well before the public debt exceeds the private sector financial assets.2

  • External surpluses—Unlike most other advanced countries, Japan has sizeable net foreign assets (over 50 percent of GDP) and has run a current account surplus over the past decade, supported by steady and large net-income flows.

  • Population aging—Population aging would reduce labor force participation and potential growth. At the same time, elderly households tend to have a higher risk aversion and prefer holding safe assets such as JGBs, although the elderly tend to have lower saving rates.3 This is likely to exert downward pressure on long-term interest rates.

  • Stable investor base—Over 90 percent of JGBs are held by domestic investors, which has not changed substantially during the global financial crisis. This is in contrast to other advanced countries, where rising sovereign debts has been met with an increasing reliance on foreign investors, which may pose higher refinancing risks. This advantage, however, needs to be weighed against potential vulnerabilities from increasing sovereign-financial linkages in Japan.

Figure 2.
Figure 2.

Public Debt and Factors Contributing to Low Interest Rates

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A001

While these factors have contributed to low and stable yields, the outlook of long-term JGBs financing is also influenced by policies, which could strengthen or weaken these factors in determining long-term yields. In addition to the QQME, the planned increase of consumption tax rates, a widening trade deficit, and uses of corporate surpluses may change the outlook of long-term financing of JGBs.4

B. A Panel Analysis on the Determinants of Long-Term Interest Rates

4. This section builds on previous analyses on the determinants of long-term yields across advanced countries. Specifically, Ichiue and Shimizu (2012) provides quantitative estimates of factors that determine long-term interest rates, but do not incorporate the recent policy changes nor assess how these factors may evolve over the long term. The current econometric framework also extends on the estimation approach by analyzing the role of the investor base in affecting long-term sovereign yields.

  • Country and sample period. Countries in the panel estimation include Australia, Canada, France, Italy, Germany, Japan, New Zealand, Norway, Sweden, Switzerland, the United Kingdom, and the United States. Euro area countries other than Germany (in some specification for robustness, France and Italy) are excluded as interest rates across euro area were aligned until the European debt crisis broke out.5 The sample period spans from 1990–2012 based on annual data.

  • Dynamic panel estimation.

  • Etit+τ,j=cj+β1EtEXTt+τ,j+β2EtFISt+τ,j+β3EtDGt+τ,j+β4Etyt+τ,j+β5Etπt+τ,j+β6InvBaset,j+εt,j

  • The regression is based on the variables expectation at time t for τ period ahead; j denotes country in the cross-section group. The dependent variable Etit+τ,j is the nominal forward rate of 5–10 years ahead (that is, 5-year forward of 5-year tenor rates).6 EXT and FIS are vectors of variables related to external and fiscal conditions both in terms of flows and stocks. Variables for external conditions include the current account balance and the net external balance (as percent of GDP). Fiscal variables include net government debt and/or, public assets as a percent of GDP as a stock variable and primary balance or cyclical fiscal balance (in percent of GDP) as a flow variable. A dummy variable is introduced to interact with fiscal variables to assess if structural differences occur after the global financial crisis given that sovereign bonds in some countries are perceived as safe haven assets. DG is the demographic factor measured by the (annualized) growth rate of the working-age population ratio. Variables y and π refer to real growth and inflation. InvBase refers to the portion of sovereign bonds held by central banks, foreign official entities, or domestic private financial institutions depending on the specification.

  • A longer time horizon τ for the dependent variable is preferable, but the choice is subject to data availability. The estimation uses 6–10 years ahead for demography variables and at least 2 years ahead for growth, inflation, fiscal and external conditions from Consensus Forecast and World Economic Outlook. The estimation uses Arellano-Bond dynamic panel estimator with a maximum lag of 4.

  • The results include four sets of specifications (1 to 4, Table 1), each including a specific group of investors in government securities (the central bank, domestic financial institutions, domestic entities, and foreign nonofficial investors). For each set of specification, additional estimates are provided for different country groups and different explanatory variables for robustness check.

  • Estimation results.

    1. Fiscal conditions are key contributing factors for long-term sovereign yields across specifications in the panel. For instance, a 1 percentage point rise of net government debt to GDP would increase the long-term yields by 2–4 basis points over the sample, but the rise appears smaller by one-third to one-half after the global financial crisis, perhaps reflecting higher global risk aversion and therefore greater demand for safe government securities. Cyclical or primary balances, however, do not seem to exert statistical significant effects on long-term rates unless the specification uses gross debt terms and gross government assets. The stock of net public debt appears to be more influential in determining long-term interest rates.

    2. External positions appear to affect long-term rates but are seldom statistically significant. This runs counter to the idea that Japan would run into a fiscal crisis when the current account turns into deficits. The estimates suggest that government debt may become unsustainable even when the current account stays in surplus if domestic savers refuse to finance the public debt at a low rate and shift their savings abroad. On the contrary, a fiscal crisis may not happen even when the current account turns to a deficit if that is driven by a strong direct investment inflows that lift up the growth potential.

    3. The estimated coefficients for inflation expectations are strongly significant as expected and in many specifications the coefficients are not statistically different from one, consistent with economic theory. In that context, real forward rates (nominal net of inflation expectations) are also used as dependent variable for robustness purposes. The coefficients for other explanatory variables remain broadly similar. Volatility of inflation expectations, however, does not appear to affect the level of long-term rates. Coefficients on real growth across specifications are statistically significant and have an expected positive sign. In sum, inflation expectations and growth are key factors in affecting long-term rates.

    4. A reduction in working-age population tends to reduce the long-term interest rates. The magnitude appears to be significant and large.

    5. The composition of the investor base for government securities is important for long-term interest rates. Higher holdings by domestic entities tend to lower interest rates, but the cross-country estimates show that this reduction is mostly driven by central banks’ holdings rather than holdings by domestic financial institutions. Interest rates tend to go up instead if more public debt is held by financial institutions. On the other hand, higher holdings of government securities by the foreign nonofficial sector tend to reduce yields, but do not seem to be statistically significant.

Table 1.

Estimation of Determinants of Long-Term Interest Rates 1/2/

Dependent variable: Long-term interest rate (forward rate 5yr/5yr)

article image

Estimates based on 10-12 advanced countries. Estimation for the 10 groups excludes France and Italy in the euro zone.

*, **, and *** denote the statistical significance level of 10 percent, 5 percent, and 1 percent, respectively.

5. The estimates allow us to quantitatively assess to what extent each factor drives long-term rates over time (Figure 3). As we are primarily interested in the determinants of long-term rates under the QQME and rising public debts, we use estimates from specification (1) to obtain the contributions of each factor.

Figure 3.
Figure 3.

Decomposition of Long-Term Interest Rates

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A001

  • The decomposition suggests low growth, disinflation, and aging of the population since mid-2000s have contributed to the low and stable long-term rates, which more than offset the impact of deterioration of fiscal conditions.

  • The sizeable purchases by the BoJ are likely to keep long-term rates lower by 70–150 basis points for the next few years under the QQME.

  • If the three-pronged strategy is able to exit deflation and lift growth, the long-term rates are likely to increase but at a modest pace.

  • The long-term interest rate, however, is likely to be dominated by the deteriorating fiscal conditions over the medium and long term based on current policies. Long-term rates are expected to rise by 4 percentage points to near 5½ percent between 2012 and 2030, of which deterioration in fiscal conditions contributed to 3½ percentage points (about 3 percentage points from the projected rise of the net public debt ratio from 134 percent in 2012 to near 210 percent of GDP by 2030 and the large fiscal deficits account for ½ percentage points). Inflation and higher growth would add another 2 percentage points, while shrinking external surpluses contributed another ½ percentage points to nominal yields. The net increase, however, would be much smaller because of population aging (-1¼ percentage points), BoJ purchases (-¾ percentage points), and other factors (Figure 3).

6. Under an upside scenario with a full policy package, the long-term interest rates are likely to remain stable in the long run (Figure 3). In line with the model analysis in the staff report, the full policy package assumes credible fiscal policy adjustments and structural reforms that will achieve a declining public debt trajectory and higher potential growth. In addition, this analysis further assumes a gradual exit of the unconventional monetary easing by the BoJ after achieving the inflation target. In this regard, higher growth and lower holdings by the BoJ would push up slightly interest rates over the medium term, relative to the baseline, while the near-term interest rates remain low and stable. Notably, lower public debt ratios, together with a long-term primary surplus, would keep long-term nominal interest rates at stable levels at about 4 percent over the long term.7 This implies that real interest rates would be at a range of 1.2–1.9 percent over the medium term.

Caveats of the estimation and projection

  • Given the BoJ’s new monetary framework, the impact on long-term interest rates may behave differently than predicted by the model, which uses the estimated coefficients from historical correlations. In addition, the estimates focused on long-term interest rates and cannot account for short-term volatility in JGB markets.

  • The panel estimation may not fully capture all the determinants of long-term interest rates, particularly those unique to Japan that have kept yields low and stable over the past decade. Nonetheless, the estimation appears to provide a reasonably good fit for Japan and has shown that some factors, such as the large domestic holdings of JGBs, low growth, and persistent deflation have contributed to low yields despite rising public debts in Japan.

  • The explanatory variables are likely to have a nonlinear or a threshold effect on long-term rates that is not captured in the estimation and projection. For instance, interest rates would be subject to abrupt spikes rather than a gradual rise if there was severe loss of confidence in public debts and/or fears of debt monetization by the central bank. The influence of external conditions may play a larger role in determining long-term rates if trade deficits are combined with a net debtor status in international investment positions. Similarly, extensive holdings of government bonds by domestic financial institutions may add to higher fiscal and financial linkages that eventually would add to the risk premium.

C. Implications

7. Steady long-term interest rates are critical for fiscal debt dynamics and financial stability. A rise of long-term rates, if not accompanied by robust growth and inflation, is likely to pose an additional burden on fiscal conditions and financial stability given the high debt level and substantial holdings of JGBs in the financial system. A 100-basis-point rise in interest rates would boost the budget deficit by about ½ percent of GDP over five years according to Cabinet Office estimates (2010). Regional banks that hold a large portion of long-term JGBs may be subject to higher interest rate risks if yields spike. A 100-basis-point rise in the yield curve would pose interest rate risks equivalent to about 20 percent of the Tier 1 capital in regional banks.8


Net Public Debt 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A001

Sources: Cabinet Office; and staff estimates and projections.1/ Net debt of the general government including the social security fund.2/ Interest rate growth differential is assumed at 4 in the long run.3/ Interest rate growth differential is assumed at 2 in the long run.4/ Policy adjustment scenario assumes interest rate growth differential is 1 in the long run.

8. More ambitious fiscal adjustment is necessary over the medium term to contain the risk of a surge in long-term rates. Since 2007, the worsening of fiscal conditions has contributed to an increase of interest rate by more than 1 percentage point. Based on the estimates, credible fiscal adjustments that lower medium-term projections of public debts and deficits can have an impact on the current level of long-term rates through a change of expectation. A successful implementation of Abenomics—that includes ambitious medium-term fiscal consolidation and growth reforms in addition to aggressive monetary easing—will be essential to keep long-term interest rates low and stable at levels broadly similar to nominal GDP growth rates.

9. Monetary policy alone cannot counter a potentially rising fiscal risk premium under current policies. Even if the BoJ expands its balance sheet to near 60 percent of GDP by 2014 under the QQME, the estimates indicate that long-term rates in Japan going forward are likely dominated by the deteriorating fiscal conditions.

10. In that regard, ambitious growth and fiscal reforms are necessary to contain fiscal risks. Without ambitious growth and fiscal reforms in train, the BoJ could face difficulties in maintaining stable long-term rates. Accelerating the pace of reaching the 2 percent inflation target may contribute to reviving growth and contribute to a “normalization” of long-term rates. It is expected the sizeable purchases would keep the long-term rates low and stable, but risks of policy missteps are notable. The path to exit deflation and lift growth may be subject to substantial risks: for instance, inflation expectations may remain subdued or rise without corresponding improvements in wages and growth. Financial institutions may change their investment strategies from JGBs that pose risks to the interest rates.

11. Though there is scant evidence on the role of trade deficits on long-term interest rates, maintaining external stability remains important. Deteriorating external conditions in Japan would imply a heavier reliance of foreign investors in financing the public debt. This may increase the volatility of long-term interest rates even without significantly imposing a risk premium on long-term government bonds.


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Prepared by W. Raphael Lam (APD).


The total tax-to-GDP ratio for Japan is still low at around 30 percent (including payment into the social security system) and has room to increase to a level comparable to European countries to eliminate the financing gap.


In Japan, households hold more than half of financial assets in cash or deposits. Hashiwagi and Lam (2011) examines the saving behavior across age and cohort groups using household survey data and finds that over the medium term, the effect of risk aversion on asset allocation toward government securities among the elderly is likely to exceed the impact of a reduction of elderly saving rates.


These new issues were not covered in earlier studies written on long-term financing aspects of JGBs (Tokuoka, 2010; Lam and Tokuoka, 2011; Hoshi and Ito, 2012; Baba, 2012). Poghosyan (2012) looked into the determinants of short-term and long-term yields across advanced countries.


Regression estimates for two groups of countries are included. Group 1 includes all countries except France and Italy as they are in the euro area that is broadly represented by Germany, while Group 2 includes both France and Italy.


Data on 5-year forward of 10-year tenor rates or 10-year forward of 10-year tenor rates are not available for long periods dated back to 1990 and are difficult to be estimated without 15-year or 20-year sovereign bonds in several countries.


See the accompanying Staff Report for the Article IV consultation with Japan and 2013 Spillover Report.


Including loans, bonds and debt holdings would increase interest rate risks equivalent to about one-third of Tier 1 capital in the regional banks for a 100-basis-point value based on BoJ estimates (Financial System Report, April 2013).

Japan: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept