Can Japan escape its debt trap?

There is a way, but the Yen will need to fall a lot further for Japan to embrace it

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At any point in time, there’s temporary as well as more structural forces driving global government bond yields. The spike in oil prices and resulting anxiety over inflation is a temporary force that’s pushed up yields across the G10. As soon as the war with Iran ends, this source of upward pressure will fade and yields will fall. Central bank action to artificially cap yields is a more permanent force for yields to rise. That’s because - if yields are being kept artificially low - markets will constantly be trying to push yields higher in what’s akin to a speculative attack on a misaligned exchange rate peg.

Japan is stuck in this place. Every month the Bank of Japan (BoJ) buys ¥3 trillion in Japanese government bonds, which amounts to five percent of GDP on an annualized basis. This is down from 22 percent back in 2016, but - even at this reduced rate - this keep yields below where they would be if the BoJ weren’t constantly buying. It’s these bond purchases that are simultaneously causing the Yen to fall and yields to rise. The fact that yields are so far below their equilibrium level puts depreciation pressure on the Yen. The BoJ is aware of this and is slowly trying to reduce its bond buying, which puts upward pressure on yields. All this is happening super slowly to prevent a sharp upward spike in yields, which gives us what we’re seeing: a gradual drift up in yields even as the Yen falls steadily.

If all this sounds hopeless, it isn’t, but Japan does need a “come-to-Jesus moment.” The current approach of periodic FX intervention just supplements artificially low yields with an artificially strong Yen. It therefore doubles down on the denial that currently defines Japan. This can’t and won’t work. Instead, as I’ve suggested previously, the government should sell its ample holdings of financial assets and use the proceeds to pay down debt. This might seem obvious in theory, but it isn’t in practice. There’s lots of vested interests that don’t want the status quo to change, most obviously all the folks managing the government’s financial assets. This is why, in my opinion, the Yen must fall a lot further before Japan is ready to do what’s needed.

Today’s post lays out in four bullets Japan’s debt trap and the solution:

• Yen weakness is now extreme: the blue line in the chart above shows the real effective Yen, which in April 2026 fell below the Turkish Lira (black line). This should alarm everyone in Japan. The Turkish Lira has been the world’s weakest currency for over a decade, thanks to Erdogan’s shambolic policies. For the Yen to fall below this is not a small thing. It signals that something is profoundly wrong.

• Japan’s yields are still much too low: the easiest way to see this is to compare Japan’s 30-year government bond yield (red line) in the chart above with that of Germany (blue line). Both are basically the same, even though Japan’s public debt of 240 percent of GDP is almost four times that of Germany’s 65 percent. This is the best visualization in my opinion of just how massively distorted Japan’s yields are. They’d be MUCH higher without ongoing and large BoJ purchases of debt.

• A “Liz Truss” crisis since 2024: the UK in 2022 saw bond yields spike even as the currency fell, in what’s since become known as the “Liz Truss” bond market blow-up. That crisis was short-lived - it ended within a few week - but what’s crazy is that Japan has been in exactly this kind of crisis since 2024. The blue line in the chart above shows the differential of Japan’s 30-year yield versus the rest of the G10. The black line is the trade-weighted Yen using the same weights as for the rate differential. The decoupling between the two - which is unprecedented - speaks to the scale of fiscal distress in Japan.

• There is a way out: if all of this seems intractable, it isn’t. Japan’s government holds vast amounts of financial assets, which is why net debt is so much lower than gross debt. The chart above shows this. The horizontal axis shows that gross debt stands at 240 percent of GDP, while the vertical axis shows that net debt is only 130 percent. The difference is financial assets that can be sold, with the cash used to pay down debt. Even a small step in this direction would get huge acclaim in financial markets, reducing upward pressure on yields and depreciation pressure on the Yen.

So - if there’s an obvious way out - why isn’t it being taken? The reason is that there’s vested interests that like the status quo, notably all those managing the government’s financial assets. The Yen will need to fall a lot further before this equilibrium gets disrupted. In the meantime, any use of official FX intervention is be a reminder that - for now - Japan is in denial.