"We have finally returned to a 'world with interest rates.' We need to change our budgeting approach. There are many areas that need adjustment." This statement from a Ministry of Finance official came after Japan's long-term interest rates surpassed 3% for the first time in 30 years on September 1. While a 3% long-term interest rate may not be shocking in South Korea, it is significant for Japan, which has been managing its finances under ultra-low interest rates while carrying a debt more than double its GDP. What does the return to a 3% interest rate mean for the Japanese government?
■ The Disappearance of Budget Surpluses
The first change will be in budget management. According to the Nihon Keizai Shimbun (Nikkei), the Japanese government has been budgeting for bond interest costs at rates higher than market rates. If actual rates fall below these estimates, the surplus can be redirected to other policy areas, effectively used as a reserve fund. However, that surplus is now disappearing. The 3% rate recently surpassed the estimated interest rate the government had set for the 2026 budget. Market rates caught up with the high estimates set last December before the fiscal year even reached its midpoint. For the second consecutive year, market rates exceeded the estimated 2% for the 2025 fiscal year in December.
In the budget request for 2027, the Ministry of Finance set the estimated interest rate for calculating bond costs at 3.8%, adding 1.1 percentage points to the then-current market rate. As long-term interest rates have risen to around 3%, there are discussions within the Ministry about raising this estimate to 4% when the budget is finalized at the end of the year. This would mean an increase in the estimated interest costs from 16.5888 trillion yen (approximately $143 billion). The total bond issuance requirement, including principal repayments, is 36.6386 trillion yen, already surpassing the 33.6872 trillion yen requested by the Ministry of Health, Labour and Welfare for social security costs. The Yomiuri Shimbun pointed out that rising interest costs are narrowing the government's policy options.
The burden of interest payments will not end with the 2027 fiscal year. Rising rates accumulate over time as governments refinance maturing bonds with new issuances. Japan, having issued a large volume of bonds during the ultra-low interest period, will face significantly higher interest costs when these bonds are refinanced at higher rates. According to long-term projections released by the Ministry of Finance in April, even if the estimated interest rate remains lower than the 3.8% used for the 2027 budget request at 3.6% after 2029, interest costs could reach 35.9 trillion yen by 2035. If the 'risk scenario' materializes and rates rise to 4.6%, costs could soar to 45.2 trillion yen. The return to a 3% long-term interest rate has left a substantial future interest bill.
■ Warning Signs for the 'Growth Will Solve Debt' Calculation
While the increase in interest costs is concerning, rising rates fundamentally challenge the Takaiichi government's aggressive fiscal policy. The primary fiscal balance indicates whether the government can manage policy spending without incurring new debt, excluding repayments of principal and interest on government bonds. Previous administrations aimed to achieve a surplus within a single fiscal year. In contrast, the Takaiichi government has effectively abandoned this goal, instead promoting a stable reduction in the debt-to-GDP ratio. The calculation is that if nominal growth, including inflation, exceeds the interest rates the government pays, the debt can increase while the GDP grows faster, thus lowering the debt ratio. This rationale underpins the aggressive fiscal policy aimed at increasing growth through investment.
If interest rates catch up to or exceed growth rates, this calculation collapses. Masazumi Wakatabe, a former deputy governor of the Bank of Japan and an economic advisor to Prime Minister Takaiichi, argued until May that a declining debt ratio could justify a primary fiscal deficit. However, in July, he retreated, stating that the overall fiscal balance, including interest costs, must also be managed. This indicates that even proponents of aggressive fiscal policy are beginning to recognize the implications of rising rates. Shunsuke Kobayashi, chief economist at Mizuho Securities, predicted that due to inflation and the Bank of Japan's interest rate hikes, conditions in the early 2030s may not allow growth rates to exceed interest rates. This signals the end of the 'fiscal bonus' enjoyed during the era of ultra-low rates. Even if the strategy is maintained, market evaluations will begin immediately. If investors concerned about fiscal deterioration sell government bonds, the government will have to borrow at higher costs.
The market has already begun scrutinizing the government's budget. With requests from various ministries for the 2027 budget reaching a record high of around 143 trillion yen, concerns about fiscal deterioration have resurfaced. This amount exceeds the initial budget for 2026 (122 trillion yen) by more than 20 trillion yen. Compared to the combined 140.6 trillion yen from the 2025 supplementary budget, this is not a drastic increase, but the Takaiichi government has not set limits on growth investments or provided funding solutions, leaving investors uneasy.
As concerns about fiscal stability grow, the number of entities willing to purchase government bonds is decreasing. In the past, the Bank of Japan bought large quantities to suppress upward pressure on interest rates, but it has reduced its purchases. Foreign investors, who had been net buyers of ultra-long bonds for 15 consecutive months until March, sold off in April and June. Domestic financial institutions are also struggling to fill the gap. A Nikkei survey of major life insurance companies found that 13 firms reported domestic bond valuation losses of 30.869 trillion yen as of the end of June, a 60% increase over the past year. These firms are hesitant to buy, fearing that further rate increases will exacerbate their losses. Despite yields rising to 3%, buying interest remains low. A bond dealer from a foreign securities firm questioned, "In a situation where interest rates are rising due to fiscal concerns, who would buy government bonds?"
If demand remains weak, the government will have to accept higher rates when issuing new bonds, creating a vicious cycle of increased interest costs and budget pressure. Prime Minister Takaiichi has stated that the government will manage the bond issuance amount appropriately without relying on deficit bonds for the expected 4.3 trillion yen decrease in tax revenue from food consumption tax cuts. The market views the ability to limit new bond issuance to around 40 trillion yen for 2027 as a critical test. Balancing tax cuts, growth investments, and increased defense spending while controlling bond issuance will be key in the year-end budget formulation.
While a 3% long-term interest rate does not immediately plunge Japan into a fiscal crisis, the era of ultra-low rates that allowed for simultaneous support of multiple policies is over. The Nikkei has emphasized the need to maintain discipline in interest rates and carefully select projects that genuinely contribute to growth. Whether Japan can continue 'responsible aggressive fiscal policy' in this new 'world with interest rates' will depend on gaining the trust of the bond market.
* This article has been translated by AI.
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