Japan today carries public debt exceeding 230 per cent of GDP—the highest among advanced economies. Yet for more than three decades, it largely escaped the debt crises, runaway inflation and surging borrowing costs that conventional economics would have predicted.
Government bond yields remained close to zero, inflation was virtually absent, and investors continued to regard Japanese Government Bonds (JGBs) as among the safest financial assets in the world.
It was one of the greatest macroeconomic anomalies of the modern era.
That anomaly is now beginning to fade.
The return of inflation after 2022 has fundamentally altered the environment that allowed Japan to sustain exceptionally high public debt at exceptionally low borrowing costs.
The country is not confronting an imminent sovereign debt crisis.
Rather, it is confronting something arguably more difficult: the gradual erosion of the economic conditions that made its unconventional fiscal and monetary model sustainable for over thirty years.
Japan Is Not Greece
Any discussion of Japan’s debt must begin by recognising that Japan is fundamentally different from previous sovereign debt crises.
Unlike Greece during the Eurozone crisis, Japan borrows overwhelmingly in its own currency.
More than 90 per cent of Japanese Government Bonds are held domestically by households, banks, pension funds, insurance companies and, increasingly, the Bank of Japan itself.
Japan also remains the world’s largest net international creditor, with overseas assets exceeding ¥500 trillion, providing a substantial external financial buffer.
These characteristics have allowed Japan to sustain debt levels that would almost certainly have triggered financial crises elsewhere.
Markets have remained confident not because Japan’s debt is small—it is extraordinarily large—but because investors have confidence in Japan’s institutions, monetary sovereignty and vast domestic savings.
The Bank of Japan’s Extraordinary Intervention
Japan’s current fiscal position cannot be understood without appreciating the unprecedented role played by the Bank of Japan (BOJ).
Following the collapse of Japan’s asset-price bubble in the early 1990s, the economy entered decades of weak growth, stagnant wages and near-zero inflation.
Successive rounds of quantitative easing saw the BOJ purchase enormous quantities of government bonds to support economic activity and maintain exceptionally low borrowing costs.
Today, the BOJ owns roughly half of all outstanding Japanese Government Bonds, while its balance sheet has expanded to more than 100 per cent of GDP —an unprecedented scale among major advanced-economy central banks.
For many years, these extraordinary measures appeared remarkably successful.
Inflation remained close to zero, borrowing costs stayed negligible and the government continued financing large fiscal deficits without significant market disruption.
Inflation Has Changed the Rules
That environment changed dramatically following the global inflation shock beginning in 2022.
For much of the previous three decades, Japan experienced almost no inflation, interest rates remained close to zero and government debt-servicing costs were exceptionally low despite the country’s enormous debt burden.
Those conditions allowed Japan to postpone difficult fiscal adjustments while maintaining financial stability.
Today, however, headline inflation has generally remained above the BOJ’s long-standing 2 per cent target. Wage growth has accelerated, unionised workers have secured annual increases of around 5 per cent in recent years, and external shocks—including higher energy prices and geopolitical tensions—continue to exert upward pressure on prices.
At the same time, yields on Japanese Government Bonds have risen to levels not seen for many years. As older debt matures and must be refinanced at higher interest rates, the government’s debt-servicing burden will inevitably increase.
The challenge therefore lies not simply in the size of Japan’s debt, but in the interaction between an enormous debt stock and gradually rising borrowing costs.
The Yen’s Decline Reflects Diverging Monetary Policies
The return of inflation has also transformed Japan’s exchange-rate dynamics.
While the United States Federal Reserve and the European Central Bank responded aggressively by raising interest rates, the Bank of Japan proceeded with exceptional caution, only ending its negative interest-rate policy in 2024.
The widening interest-rate differential encouraged capital to flow into higher-yielding assets abroad.
The consequences have been striking. The Japanese yen has depreciated from around ¥103 per US dollar in early 2021 to approximately ¥160–163 per US dollar more recently—a depreciation of roughly 55 to 60 per cent.
Although a weaker yen benefits exporters and tourism, it also raises the cost of imported food, energy and industrial inputs, placing additional pressure on households and businesses.
The Impossible Triangle
Japan now confronts a policy dilemma that resembles an impossible triangle.
On the one hand, higher interest rates are needed to contain inflation and stabilise the yen. On the other, higher rates raise government borrowing costs at a time when public debt exceeds 230 per cent of GDP.
Meanwhile, renewed large-scale monetary easing to suppress bond yields would risk further weakening the currency and reigniting inflationary pressures.
The Bank of Japan therefore finds itself balancing three objectives that are increasingly difficult to achieve simultaneously: maintaining exceptionally low borrowing costs, preserving currency stability and containing inflation.
Managing one objective inevitably complicates the others.
This is not evidence of policy failure. Rather, it reflects the reality that the macroeconomic environment supporting Japan’s policy framework has fundamentally changed.
The Demographic Headwind
Japan’s fiscal challenge is ultimately driven by more than monetary policy alone.
Nearly 30 per cent of Japan’s population is aged 65 or above, the highest proportion among major economies. The country’s population has been shrinking since 2010, reducing labour-force growth while increasing expenditure on pensions, healthcare and long-term care.
An ageing society inevitably slows potential economic growth even as public spending rises.
Over time, this combination places increasing pressure on government finances regardless of the level of interest rates.
Monetary policy may alleviate these pressures temporarily, but it cannot reverse demographic realities.
A Lesson Beyond Japan
Despite increasingly difficult trade-offs, Japan remains unlikely to experience an acute sovereign debt crisis. Its deep domestic investor base, monetary sovereignty and extensive overseas assets provide important buffers that distinguish it from historical debt crises elsewhere.
Yet the broader significance of Japan’s experience extends well beyond its own borders.
For much of the past two decades, exceptionally low global interest rates encouraged governments across advanced economies to accumulate unprecedented levels of public debt at relatively modest financing costs.
As inflation returns and monetary policy gradually normalises, those assumptions are being tested.
Japan may simply be the first advanced economy confronting this new reality—not because it borrowed the most, but because it reached the limits of unconventional monetary policy before anyone else.
The lesson is therefore not that Japan’s debt crisis has finally arrived. Rather, it is that the extraordinary economic conditions which sustained exceptionally high public debt for more than three decades are steadily disappearing.
The challenge ahead is less about avoiding imminent default than about adapting fiscal and monetary policy to a world where inflation, higher interest rates and demographic change have fundamentally altered the rules of economic management.
That may prove to be the more enduring test—not only for Japan, but eventually for many advanced economies.