BUSINESS | Japan faces rising fiscal risks as yields climb, banks brace for volatility — AMRO Report
The report warns that while near-term conditions appear stable, fiscal vulnerabilities could intensify over the next decade if structural reforms and fiscal consolidation are delayed.
Japan’s public debt remains among the highest in the world even as its banking sector shows improved resilience to rising interest rates, according to the 2025 Annual Consultation Report on Japan released by the ASEAN+3 Macroeconomic Research Office.
The report warns that while near-term conditions appear stable, fiscal vulnerabilities could intensify over the next decade if structural reforms and fiscal consolidation are delayed.
Public debt peaked at 254% of GDP in 2020 during the pandemic and is projected to fall to 227% of GDP in 2024. The primary deficit narrowed sharply from 9.1% of GDP in 2020 to an estimated 1.3% in 2024, supported by stronger nominal growth and tax revenue.
However, AMRO cautions that Japan’s debt trajectory remains highly sensitive to shocks.
“Stress test results show that Japan’s public debt is particularly vulnerable to growth and interest rate shocks,” the report said. Under combined adverse scenarios, public debt “could rise further to 233% of GDP.”
Valuation gap raises concern
Beyond traditional debt sustainability analysis, AMRO extended its assessment using an asset-pricing framework to compare the market value of government liabilities with the present value of projected fiscal surpluses.
The results show a significant gap.
“When compared with the JPY 1,192 trillion market value of outstanding government debt, the fiscal present value covers only about half of the liability, indicating a sizable valuation gap,” the report said.
Although Japan holds approximately JPY 788 trillion in government assets, only about JPY 65 trillion is liquid, meaning asset offsets do not materially close the gap.
The investor base remains a key stabilizing force. Around 40% of Japanese government bonds are held by domestic banks, insurers and pension funds, while the Bank of Japan holds roughly JPY 550 trillion. That structure has helped suppress volatility and anchor yields despite high debt levels.
Still, AMRO warned that as monetary policy normalizes, confidence will depend heavily on policy credibility.
“Moreover, the asset-pricing results reinforce the need for credible fiscal consolidation and clear policy communication to maintain market confidence,” the report said.
Rising yields test banking resilience
Japan’s transition toward higher interest rates has brought both benefits and risks for banks.
On the positive side, profitability has improved. Major banks increased profits attributable to owners by 33.3% in March 2025 from the previous fiscal year, while regional banks improved net income by 36.6%, according to the Financial Services Agency.
Capital buffers remain strong, with capital adequacy ratios exceeding regulatory minimums and liquidity coverage ratios ranging between 125% and 164% among megabanks.
AMRO’s stress testing shows improvement.
“The results suggest that Japanese banks have improved their resilience to rising interest rates, presumably by proactive ALM strategies and better risk management under IRRBB,” the report said.
Banks have reduced bond holdings, shortened duration, shifted securities from available-for-sale to held-to-maturity portfolios and used swaps and other hedging instruments to manage exposure.
Still, vulnerabilities remain, particularly at longer maturities.
“The relatively large coefficients on β3 and β4 indicate that increases in interest rates at longer tenors lead to substantial declines in the system’s EVE,” the report said, highlighting sensitivity to ultra-long-term yield shocks.
AMRO emphasized that while systemwide resilience has improved, continued monitoring is essential as yield-curve steepening and global volatility persist.
Property market stable, but risks uneven
Japan’s housing market, particularly in metropolitan areas, has experienced price increases amid higher inflation. However, AMRO found no immediate nationwide concerns.
“Despite the continued rise in housing prices, there are no significant or immediate concerns about the overall sustainability of Japan’s housing market at the national level,” the report said.
Price-to-income ratios remain broadly in line with the OECD average, and rising vacancies linked to demographic decline may help moderate overheating outside major cities.
Reform window narrowing
Looking beyond 2033, AMRO warns that debt dynamics could worsen if fiscal reforms stall.
“Without fiscal and structural reforms, debt-to-GDP ratio is projected to trend up beyond 2033 in the baseline scenario,” the report said.
Under current projections, the primary balance remains below the debt-stabilizing level. AMRO estimates a consolidation gap averaging about 2% of GDP annually between 2033 and 2040 unless reforms boost growth or revenue.
To stabilize debt without fiscal measures, Japan would need real GDP growth of around 2% per annum beyond 2033 — far above the baseline projection of 0.4%.
“Seizing the window of opportunity to undertake fiscal reforms and structural reforms is crucial,” the report said.
Recommended measures include revenue mobilization, expenditure rationalization, pension and health care reforms to address aging-related pressures, and enhanced public financial management and disclosure.
Balancing growth and stability
Japan’s macrofinancial landscape reflects a delicate balance. Equity markets have attracted foreign inflows, and the banking sector remains profitable and well capitalized. Yet rising global bond yields, domestic fiscal expansion risks and demographic headwinds underscore structural vulnerabilities.
AMRO concludes that sustaining stability will depend not only on market structure and central bank support but also on credible fiscal consolidation and productivity-enhancing reforms that lift long-term growth potential.
Without them, Japan’s high debt burden could become more exposed as monetary conditions tighten and global financial conditions remain volatile.
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