THE DEATH OF JAPAN

Today (5/220, Fitch Ratings has downgraded Japan two notches to A+ — just above Spain and Italy — citing a surge in public debt since the Lehman crisis and the lack of any plan to restore fiscal probity.

Key indicators are deteriorating on almost every front, raising concerns that the world’s third largest economy is running aground after two "Lost Decades".

Japan’s debt has jumped by 61 percentage points of GDP since 2008, compared to eight points for the AAA bloc. Public debt is expected to reach 239% of GDP this year, uncharted levels for a major economy in peace-time. `Net debt’ – subtracting Japan’s vast holdings of foreign bonds – is nearer 137% but this is rising at an even steeper trajectory.

"Japan’s addiction to public sector spending is way beyond the boundaries or remedial `austerity’," said Dylan Grice from Societe Generale. "Political pressure on the Bank of Japan to crank the printing presses into top gear will become irresistible. We see no alternative."

Japan has been even more nonchalant than the US in efforts to rein in spending. The budget deficit will remain above 7% of GDP late into the decade. Fitch said the pace of fiscal consolidation is "leisurely" and prone to "political risk". Plans to raise VAT from 5% to 10% face a battle in the Diet.

Japan still enjoys "exceptional financing flexibility" but is vulnerable to shocks. Even a small rise in borrowing costs would play havoc.

The IMF said Japan is the only advanced country to let its "cyclically adjusted deficit" rise further this year. Gross financing needs are 59% of GDP in 2012, compared to 14.8% in the UK and 8.9% in Germany.

The central bank has stepped up stimulus but is fighting to defend its independence, so traumatically lost in the 1930s. It is wary of uncorking inflation, fearing a catastrophic stampede out of government debt. Better the devil it knows of chronic deflation.

Mr. Grice said it would take a fiscal squeeze of 13% of GDP to stabilize debt, a tall order for a country with the world’s oldest population. The workforce has been contracting since 1995. Nominal GDP has been falling at 0.5% a year. Tokyo expects the population to fall from 128m in 2010 to 87m by 2060.

Previous downgrades a decade ago were shrugged off by the markets. Yields on 10-year bonds kept falling as the economy slid deeper into deflation. They are now 0.85%, the world’s lowest. There was no flicker of change after Fitch’s announcement. There is a graveyard full of `Japan bears’ who warned of a debt debacle too early.

It may prove different this time. Japan has exhausted its buffers. The savings rate has collapsed to 2% of GDP from 16% when the bubble burst in 1990. This has vastly reduced the pool of captive savings that can be tapped by the state.

Taxes cover half total spending. The rest is borrowed. Japanese banks and life insurers are still buying the bonds, but Jonathan Tepper from Variant Securities doubts that they can do so much beyond 2014. The Government Investment Pension Fund – the biggest holder of debt – became a net seller last year to cover redemption claims.

The historic current account surplus of 3% of GDP has evaporated. Last year’s Fukushima disaster was the coup de grace. Japan will switch off its last nuclear reactor in May, leaving the country dependent on oil and gas imports to power its industry.

David Rea from Capital Economics said Japan will run a trade deficit this year. It may also tip back into contraction soon after bumper growth in the first quarter driven by the one-off effects of eco-car subsidies and post-Fukushima reconstruction. Retail sales fell 1.2% in March. Core machinery orders fell 2.8%. Export orders have withered, reflecting the sharp slowdown in China.

Monetarists say that Japan’s 20-year battle with stagnation is a warning to the West. The country failed to purge its banks swiftly and relied on Keynesian fiscal projects to prime pump the economy each time growth stalled.

The result was a string of false dawns, with public debt ratcheting ever upwards. The Bank of Japan dabbled with quantitative easing, but too little and too late. The bonds were purchased from a moribund banking system, a recipe for failure since this has little effect on the M3 money supply. "Japan was never early enough or ambitious enough in its use of monetary stimulus," said Jamie Dannhauser from Lombard Street Research.

It let asset prices slide, and let nominal GDP contract. The result has been rising debt on a shrinking economic base. "Once this starts it is very hard to stop. That is the danger for Ireland and Spain," he said.

For Japan, the lost decades are turning into a lost century.

Ambrose Evans-Pritchard is the International Business Editor of the London Telegraph.