The debt is inflated, the currency is weakening and the spiral in the fourth largest economy is worsening

The world’s fourth largest economy is in turmoil. The currency is weakening, the debt is swelling, the government bonds are falling, the product is shrinking, inflation is refusing to reach the target – and above all there is the danger of escalation against one of the most powerful forces in the world. If so, in the following lines we will try to understand: what is happening to the Japanese economy?

The urgent economic challenge

But the government’s plan sent the fourth largest economy into a tailspin. Japan’s most pressing economic challenge is viewed from the direction of the currency. In the last month, the yen weakened by more than 4% against the US dollar, reaching a level of 157 yen to the dollar – for the first time since January. Over the weekend, Japan’s finance minister expressed deep concern about the yen’s rapid depreciation against the US dollar – in what was described as the “strongest warning” issued since the devaluation cycle began.

The Governor of the Bank of Japan also warned that the devaluation of the currency leads directly to higher import prices, which will translate into inflation in the country. According to him, the effect of exchange rate fluctuations on prices may be more and more pronounced.

These price pressures are joined by an inflation rate that rose in October to an annual rate of 3% – which resulted in 43 consecutive months of missing the 2% inflation target. Core inflation in Japan rose in October at the sharpest pace since July. The tensions (which we will get to later) with China – Japan’s main source of imports – are expected to increase prices in the country.

If that’s not enough, the alarming inflation figures meet a weakening of Japan’s economic growth, with GDP in the three months to September contracting for the first time in six quarters. The economy shrank by 0.4% compared to the previous quarter, while it shrank by 1.8% on an annualized basis, according to official data released last week.

The markets against the government

The stimulus package approved by the government, in an attempt to make things easier for the citizens and encourage economic growth, stands on three legs: dealing with rising prices, achieving a strong economy and strengthening defensive and diplomatic capabilities. The local media say that this incentive package is the largest since the corona epidemic.

In addition, the cabinet also announced that it will increase the amount of grants and provide subsidies for electricity and gas bills, as well as abolish taxes on gasoline. These measures will take effect in January, and will amount to about 7,000 yen ($44) for a standard household over a three-month period.

Japan also plans to establish a 10-year fund to improve shipbuilding capabilities, and to take steps to increase defense spending to 2% of its gross domestic product by fiscal year 2027. According to the government, it will “quickly formulate” a supplementary budget bill to finance these measures, and plans to approve it by the end of the year with the help of the opposition parties.

And how did the markets react? They really didn’t like the show. Against the background of the expectation that the government will be required to raise significant debt to finance its plans, Japanese government bonds fell sharply, and the yield on ten-year government bonds climbed this week to its highest level since June 2008, at the time of the global economic crisis. A similar trend was recorded in the longer bonds.

According to the latest data from the Securities Dealers Association of Japan, large investors – including domestic banks, insurance companies and overseas accounts – reduced their net purchases of Japan’s 10-year government bonds to the lowest level since October 2023.

The head of Deutsche Bank’s global currency market research department, George Serbelus, even warned that Takaichi’s spending plans raise fears of a wild capital flight, reminiscent of the upheaval that nearly broke the British bond market in 2022. In Britain, let’s recall, the same rampage in the bond market led to the quick resignation of former Prime Minister Liz Truss three years ago.

And in Japan, the bond market is of particular importance. For most of the past decade, bond yields have been its economic focus, and by March 2024 the central bank there had become the owner of almost half of the country’s government bonds. In fact, it is a particularly inflated debt market in Japan: its debt-to-GDP ratio stands at 230%, much more than any other developed country.

Deployment of missiles against China

But Japan’s troubles are far from over here. As we reported in Globes, tensions recently erupted between her and China, her largest trading partner, and of course one of the most significant powers in the world. The inter-power conflict in the East emerged over Taiwan, when Japanese Prime Minister Takaichi stated that a Chinese attack on Taiwan, which could endanger Japan, might justify a military response. This ignited an acute diplomatic crisis: Beijing reacted with fury and called on its citizens to avoid traveling to Japan, while Tokyo responded with parallel measures and warnings to citizens staying on Chinese territory.

The escalation also reached the military arena. Chinese coast guard ships entered the territorial waters around the Senkaku Islands, which are controlled by Japan but claimed by China, and were driven away by Japanese forces. At the same time, Japan launched fighter jets after China operated a drone between Taiwan and Yunaguni Island.

Later, Japan’s defense minister visited a military base close to Taiwan, and said plans to deploy missiles at the base would advance as tensions rise between Tokyo and Beijing over the East Asian island. “The deployment can help reduce the chance of an armed attack on our country,” he said in a statement to the media at the end of his first visit to the base on the island in southern Japan.

The economic effects

Economic crises in Japan tend to spread outside of Asia. As you may remember, last August the Japanese economy experienced a shock – and this led to a shock in the markets and sharp declines in the world’s stock exchanges. Therefore, it is difficult to rule out outright a scenario in which the current crisis will also expand all over the globe.

And if the crisis within Japan is expected to have wide-ranging effects – then the crisis with China all the more so. Already among experts, fears are increasing that the worsening of tensions could damage the heart of the supply chains, slow down industrial production and create shocks that will affect other economies in the region. In recent days, the Chinese Minister of Commerce announced that the cooperation between China and Japan in trade matters has been “seriously damaged”.

This is another worrying sign for the Japanese economy. China is Japan’s second largest export destination (after the USA), and the value of exports from Japan to China amounted to 125 billion dollars in 2024. The main exports are industrial equipment, semiconductors and vehicles.

According to Reuters, Tokyo may struggle to find alternative markets if China closes its doors to Japanese goods, as South Korea – Japan’s third largest export destination – buys only $46 billion worth of goods from it.