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By Leika Kihara and Tetsushi Kajimoto
TOKYO, Feb 10 (Reuters) - Japan's ticking debt time bomb
will likely complicate the next central bank governor's task of
steering a smooth exit from ultra-loose monetary settings, with
rising long-term interest rates already forcing policymakers to
amend budget projections.
Prime Minister Fumio Kishida's administration has nominated
Kazuo Ueda, a former member of the central bank's policy board,
as its pick to succeed Bank of Japan (BOJ) Governor Haruhiko
Kuroda, people familiar with the matter told Reuters on Friday.
Kuroda retires on April 8 and leaves behind a policy that
helped keep the cost of funding the country's huge debt pile
extremely low.
Ueda's nomination, if confirmed, would come as the BOJ faces
growing pressure to phase out yield curve control (YCC) with
inflation running hot and its heavy-handed intervention
criticised for distorting bond market pricing.
The stakes are high.
A flurry of big spending packages and ballooning social
welfare costs for a rapidly ageing population have left Japan
with a debt pile 263% the size of its economy - double the ratio
for the United States and the highest among major economies.
As a result, Japan spent 22% of its annual budget on debt
redemption and interest payment last year, more than the 15%
spent on public works, education and defense combined.
The ratio could hit 25% in fiscal 2025 under new estimates
that reflect recent rises in long-term interest rates, according
to the government's projections issued in January.
And yet, the government's spending wish list keeps getting
longer with Kishida announcing plans to boost Japan's defense
spending and payouts to families with children.
"The BOJ must gradually normalise monetary policy. But that
won't be possible unless wages rise and Japan's fiscal policy is
made more sustainable," said Yuri Okina, head of a private think
tank.
Markets see Ueda as somewhat hawkish on monetary policy,
drawing on his remarks in recent years offering a critical view
of Kuroda's radical stimulus programme.
In an opinion piece in the Nikkei last July, Ueda said the
BOJ must consider an exit strategy from ultra-loose monetary
policy and review its extraordinary stimulus programme at some
point.
Japan's precarious debt situation has drawn warnings from
the International Monetary Fund, which said last month that
"interest rates could increase suddenly, and sovereign stress
could emerge" from its rising debt-to-GDP ratio.
While the government's "very comfortable" funding situation
will be sustained as any BOJ rate hike will be gradual, Japan
was facing a "very risky time" managing debt, said Christian de
Guzman, senior vice president at Moody's Investors Service.
"We are looking to see how (the BOJ) manages the transition.
It is an unprecedented situation."
S&P Global Ratings warns a future rate hike could affect
Japan's sovereign debt rating if firms, many of whom are
accustomed to prolonged ultra-low rates, struggle to absorb
rising funding costs.
"Even a 1-2 percentage point (rise in interest rates) is
very big in Japan's context. I'm not sure how well the service
sector could absorb this increase," Kim Eng Tan, senior director
of S&P's sovereign ratings team in Asia-Pacific, told Reuters.
PAYING THE PRICE
Even before the BOJ takes any action towards an exit, rising
bond yields are starting to affect the government's finances.
Last year, market bets of a near-term rate hike drove up the
benchmark 10-year bond yield by 40 basis points to hit a high of
0.48% by year-end. Last month, the yield briefly hit 0.545%, the
highest level since June 2015 and above the BOJ's 0.5% cap.
The increase in long-term rates led the government to revise
up its 10-year bond yield forecast to 1.5% for fiscal 2025, up
from 1.3% in projections made a year ago, and project the yield
to rise to 1.6% in 2026.
Based on the new estimates, a 1% across-the-curve rise in
yields will increase debt servicing costs by 3.6 trillion yen in
fiscal 2026. That is no small rise for a country with an annual
defence spending of 5.4 trillion yen.
The forecasts, used in drafting the budget, are set higher
than market levels to ensure government spending plans have
buffers against an abrupt spike in borrowing costs. Before YCC,
the government's yield estimates hovered around 1.6 to 2.2%.
With inflation - not deflation - becoming a bigger risk for
Japan's economy, Kishida's administration is more open than his
predecessors to the idea of a gradual BOJ policy normalisation,
say government officials with knowledge of the matter.
But it will be sensitive to any BOJ action that upends the
bond market and hampers government spending plans, they say.
That means any Japan's debt situation will be among key
considerations for the BOJ as it eyes an eventual lift-off.
"While it's better for market forces to drive bond moves
more, removing the BOJ's yield cap could destabilise markets and
make investors cautious of buying bonds," one official said.
"That's a scenario we'd like the BOJ to avoid."
Former finance ministry official Kazumasa Oguro, who is now
an academic at Japan's Hosei University, warns the government
will pay the price for delaying fiscal reforms during time
bought by the BOJ's yield control policy.
"The BOJ is gradually being cornered into normalising
policy," he said. "In the end, market forces will prevail."
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Japan's rising debt pile complicates BOJ's exit path Japan's
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(Reporting by Leika Kihara; Editing by Sam Holmes and Hugh
Lawson)
Messaging: leika.kihara.reuters.com@reuters.net))
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