Credit: IMF PHOTO/KIM HAUGHTON
Context makes all the difference in evaluating fiscal prospects
RAHUL ANAND is an assistant director in the IMF’s Asia and Pacific Department.
SHUJAAT KHAN is an economist in the IMF’s Asia and Pacific Department.
Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.
For decades, Japan was a cautionary tale of stagnation: chronically low inflation, flat wages, weak economic growth, and interest rates near zero. Its shrinking and aging population fueled persistent concern about the country’s long-term economic prospects.
Yet the economy has continued to adapt. Despite acute demographic pressures, including the world’s highest share of elderly people and persistently low birth rates, productivity growth has strengthened—supported by automation, adoption of technology, and a changing labor market—and output per hour worked picked up more than in other major economies. Meanwhile, rising labor force participation, particularly among women and older people, has also helped offset the drag from demographic factors.
Japan is now in a strikingly different place. Inflation exceeded the central bank’s 2 percent target for three years before moderating this year, wage growth has strengthened, and inflation expectations are converging to the target. That’s letting the Bank of Japan raise rates for the first time in a generation—with major implications for government finances.
The economic transition is also raising fresh questions about one of the world’s most watched fiscal challenges. For decades, borrowing costs near zero made Japan’s very large debt stock relatively inexpensive to finance. That environment is changing. At about 207 percent of GDP, Japan has the highest public debt ratio among advanced economies, roughly double the G7 average. Higher interest rates will eventually make that debt more expensive to service.
But Japan’s transition is taking place in a broader context. Public debt also depends on the economy’s capacity to support borrowing over time. The headline debt figure can therefore obscure the bigger picture. And Japan’s fiscal story is more nuanced than often assumed.
The transition has coincided fortuitously with a remarkable improvement, more recently, in Japan’s fiscal position. Indeed, following its extraordinary fiscal response to the pandemic, Japan managed to reduce its primary deficit from 8 percent of GDP in 2021 to an estimated 1 percent in 2025—among the lowest in the G7.
Three factors helped. First, Japan’s debt portfolio had been locked in at very low interest rates and long maturities. The average maturity of government debt is about nine years, meaning that higher yields take time to feed through into the budget. The result is that the effective interest rate on the public debt was only 0.7 percent last year, while the economy expanded by 4.5 percent. Second, the return of inflation and nominal wage growth boosted tax revenues. After years of weak nominal growth, stronger wages and prices led to higher government receipts without the need for major tax increases. Third, spending restraint helped contain deficits, even as the government introduced support packages to cushion people from a rising cost of living.
Together, these factors produced a favorable combination rarely seen in highly indebted countries: Nominal GDP growth substantially exceeded the effective interest rate on government debt. That combination can lower debt ratios even without large primary surpluses.
As a result, Japan’s public debt is projected to continue declining. Under current policies, it would reach a low of about 190 percent of GDP in the mid-2030s before demographic and interest rate pressures reassert themselves.
Public discussions of Japan’s finances often focus exclusively on liabilities. But debt is only one side of a balance sheet.
Japan’s public sector has accumulated a large stock of assets over decades—as YiLi Chien, of the Federal Reserve Bank of St. Louis, and coauthors document—including cash, loans, and securities. Other assets include equity holdings and public sector investments. One institution, the Government Pension Investment Fund, is among the world’s largest institutional investors and carries particular weight.
These assets paint a different picture. Gross public debt exceeds 200 percent of GDP. But government holdings include substantial financial assets, which means that net debt is considerably lower. How much depends on which assets are counted.
Looking at a narrow measure that deducts only the most liquid assets, such as cash and deposits, reduces gross debt only modestly, to about 186 percent of GDP. However, a broader measure that also nets out the full range of government held debt claims, including loans and debt securities, reduces net debt to about 137 percent. An even broader measure, which includes the government’s sizable equity and investment fund holdings, lowers it further, to roughly 89 percent. Japan’s debt remains high even on this basis, but it’s closer to levels in other G7 economies.
There is, however, a limit to how much these assets can be used to service debt. A significant share of the public sector’s wealth is legally or institutionally earmarked for specific purposes. Pension assets, for example, are intended to help meet future pension liabilities. They are public wealth, but they cannot be freely used to finance current government spending.
A useful analogy is a household with a large mortgage and a substantial retirement account. Looking only at the mortgage would exaggerate the household’s financial vulnerability. Looking only at the retirement account would ignore future obligations. A full assessment must look at both sides of the ledger—just as it does for Japan.
For fiscal pressures that build over decades, public assets can play an important role. In some cases, asset management or asset sales could reduce the need to accumulate additional debt to finance services demanded by an aging society. But assets are not a substitute for fiscal adjustments. Rather, they are part of a broader assessment of the public sector’s financial position.
This balance sheet perspective helps explain why Japan has been able to sustain such high debt without the fiscal stress many observers might otherwise expect. It also shows that gross debt alone gives only a partial picture of fiscal risks.
Higher inflation and interest rates will transform Japan’s public balance sheet. As yields are more market determined, assets and liabilities will become more sensitive to interest rate moves. Currency fluctuations matter too, given the country’s sizable overseas assets. Inflation can reduce the real value of nominal debt while boosting nominal asset values, and an aging population will gradually alter the pattern of savings and investment. This means that Japan’s balance sheet will be a dynamic part of the fiscal story rather than a static backdrop—which bolsters the case for looking beyond gross debt to consider overall finances.
Despite recent progress and significant public assets, Japan’s fiscal challenges remain substantial. Above all, today’s favorable debt dynamics are likely temporary for two reasons.
The first is rising interest costs. The longer maturity of government debt has slowed the pass-through of higher market yields to effective borrowing costs. But interest payments are poised to roughly double from 2025 to 2031 as debt is refinanced at higher rates. This pass-through may also accelerate as yields are determined more by the market, reflecting the Bank of Japan’s smaller balance sheet and greater foreign participation. This would help the market function better, but could also raise borrowing costs faster.
The second pressure is demographics. As the population ages health-care and long-term-care spending will continue to rise. Since the government finances a large share of these expenditures, much of the resulting burden will fall on public finances.
These developments highlight an important distinction between short-term and long-term fiscal risks. In the short term, Japan benefits from several strengths that help contain rollover, liquidity, and currency risks. Its government debt market is deep and liquid. Debt maturities are long. Debt is issued almost entirely in yen, a major reserve currency. Public sector assets are an additional buffer.
The longer-term picture is more challenging. Rising interest costs and spending pressures related to aging will eventually outweigh the forces that are currently reducing debt. Without additional policy measures, debt is projected to begin rising again in the mid-2030s.
Fiscal sustainability depends on confidence maintained over decades, not months. The advantage of slow-moving pressures is that policymakers have the opportunity to address them before they become acute. Small adjustments implemented early can have large cumulative effects over time.
A broader balance sheet perspective also has fiscal implications. Reducing gross debt remains important, but policy should also focus on strengthening the overall public balance sheet, which can contribute to fiscal sustainability.
Growth is particularly important, but it should not distract from the need to address Japan’s long-term fiscal challenges. Debt dynamics depend not only on borrowing but also on the economy’s ability to generate income. Growth-friendly structural reforms can strengthen public finances while improving living standards, often without imposing significant fiscal costs. What matters is the composition of adjustment rather than its size: Reallocating toward high-quality public investment, alongside health-care and pension reforms and unwinding poorly targeted subsidies, can mitigate the near-term growth impact of fiscal adjustments while opening up fiscal space and raising long-term potential. At the same time, measures to cushion households should be budget neutral, temporary, and well targeted. The key is to ensure that policies do not undermine long-term fiscal sustainability or credibility.
The Japanese government bond market is among the world’s largest and deepest and remains an important safe haven for investors when conditions deteriorate. Combined with Japan’s open capital account, sizable international investments, and growing foreign participation—including in mutual funds and hedge funds—this makes for strong global financial ties. As a result, developments in the Japanese debt market can affect other markets, just as shocks in the United States and euro area affect conditions in Japan and beyond. For example, the IMF’s Yan Carrière-Swallow and coauthors show that shocks to Japanese sovereign yields tend to transmit to global sovereign debt markets, with spillovers strengthening as the participation of Japanese investors in the domestic market rises.
That’s why Japan’s fiscal outlook matters not only for domestic policymakers but also for investors and governments around the world.
The lesson from Japan is that debt must be viewed in an appropriate context. Gross debt is an important indicator, but it is not the whole story. Assets, maturities, investor attributes, currency denomination, market structure, and institutional credibility all shape fiscal sustainability.
Japan’s debt remains exceptionally high, and long-term pressures from aging and higher interest rates are real. But simple international comparisons can obscure the economy’s strengths.
So how much should we worry? Enough to recognize that fiscal adjustments are needed. But not enough to mistake the headline debt ratio for the entire balance sheet.
Japan’s challenge is less about avoiding abrupt fiscal stress than about managing a gradual transition toward higher interest rates and an older population. Managing this shift requires steady policy adjustment, careful use of public assets, and reforms that support growth while preserving confidence in the public finances.
Carrière-Swallow, Yan, Gene Kindberg-Hanlon, and Danila Smirnov. 2025. “Macroeconomic Effects and Spillovers from Bank of Japan Unconventional Monetary Policy.” IMF Working Paper 227, International Monetary Fund, Washington, DC.
Chien, YiLi, Wenxin Du, and Hanno Lustig. 2025. “Japan’s Debt Puzzle: Sovereign Wealth Fund from Borrowed Money.” Journal of Economic Perspectives 39 (4): 3–26.
