Just as panicked investors sought shelter in the Japanese yen in the immediate aftermath of the U.K. vote to leave the European Union, the country's perceived default risk shot up too, underscoring growing anxiety about a heavily indebted sovereign that has long been considered a safe haven.
On June 24, the day after the U.K. referendum, the yen soared to the highest level in almost two years while yields on Japanese government bonds dropped, as funds shifted en masse to the usual ensemble of safe-haven assets, from stocks and other riskier investments.
At the same time, the cost to insure Japanese sovereign bonds against nonpayment also surged, with the midpoint of quotes for credit default swaps on the country's five-year notes surging 5.5 basis points, the biggest daily jump in more than two years, to a three-month high of 47 basis points, according to S&P Capital IQ data.
"People are putting their money there because Japan still ranks as one of the safest," Kim Eng Tan, senior director of Asia-Pacific sovereign ratings at S&P Global Ratings, said in an interview. "On the other hand, the CDS spreads are widening because people are more risk averse, so they are concerned about uncertainties."
A stronger yen puts policymakers in Japan in a bind, after years of efforts to weaken the currency to stoke inflation and growth. The Brexit fallout may force debt-ridden Japan to rely on borrowings even more for stimulus, threatening prospects for fiscal reform, a key component of Prime Minister Shinzo Abe's economic policies.
"What the market is pricing in for a wider CDS spread for the Japanese sovereign would be a possible expansion of economic stimulus measures that could lead to a further deterioration of Japan's fiscal position," Takashi Miwa, chief economist for Japan at Nomura, said in an email.
Japan's government liabilities are more than double its GDP, on track to exceed 230% in 2016, according to an estimate by the Economist Intelligence Unit. That is the highest ratio among Organisation for Economic Co-operation and Development countries.
The Bank of Japan, for its part, is counting on massive government bond purchases to boost asset prices under an unprecedented quantitative easing program.
It has been unclear how Japan will rein in its fiscal deficit. In June, the government again delayed a sales tax increase on concern that a higher levy could dampen domestic demand in an already stagnant economy. The decision led Fitch Ratings to downgrade its outlook for Japan to negative.
Even before the Brexit vote, since the start of 2016, the yen had been marching higher, undermining policy measures that had been in place to deter currency appreciation. CDS prices for Japan's government bonds, meanwhile, had been on the rise in the preceding two months.
There is "dimming optimism that Japan could rebound strongly, that the economic recovery could be strong, mainly because at the beginning of the year, the yen started to move up very quickly," Tan said.
Japan's GDP growth in real terms is forecast to slow to 0.5% in 2016 from 0.6% in the prior year, according to the EIU.
"The Japanese economy is increasingly showing its true face, structural weakness due to very low potential growth, coupled by unsustainable public finances. Investors, no matter how captive, may start pushing up the price for Japan's country risk," Alicia Garcia-Herrero, chief economist for Asia-Pacific at Natixis, said in an email.
As of June 28, US$1 was equivalent to ¥102.79.
The article is authored by Ranina Sanglap and Ranvir Vala at S&P Global Market Intelligence.