Political deadlock may derail a renewed drive to fix Japan's tattered finances, after more than a decade of failed attempts, but the Bank of Japan (BoJ) doubts that another disappointment would trigger a sharp enough bond yield rise to require drastic action.
The central bank has seen no need to draw up contingency plans for a debt crisis like those on the euro zone's periphery, but sources said a spike in yields would spur it to consider various options, including one it has been loath to look at: boosting its purchases of long-term government bonds.
"It's not something the BOJ will do easily," said a source familiar with the central bank's thinking. "But if bond markets become really unstable, it's a possibility." Another source expressed a similar view. Both declined to be identified due to the sensitivity of the matter.
A rise in long-term rates would need to be very sharp, perhaps a spike in 10-year bond yields well above 2 percent from their recent 1.2-1.3 percent range, for the BOJ to consider boosting outright bond buying. With a lesser move in yields, the BOJ would likely settle for more moderate steps such as a verbal warning by the governor or an expansion of its new asset buying scheme, analysts said.
Prospects for any concrete progress in curbing Japan's huge public debt are deteriorating as Prime Minister Naoto Kan struggles to pass budget-related bills through a divided parliament and rally support for fiscal reforms. Kan's own party is divided over efforts to raise the 5 percent sales tax to fund bulging social welfare costs and rein in public debt, while the opposition wants Kan to abandon costly campaign pledges and set out more concrete reform plans.
Some opposition parties agree with Kan that a sales tax hike is needed to restore Japan's fiscal health, although they are unwilling to cooperate on hope that by embarrassing Kan, they could push him out of power. Failure to enact the budget-related bills may cost Kan his job, and a successor may fare no better with opposition parties unwilling to cooperate.
Even if Kan survives, he may have to settle for vague pledges and watered-down targets in fiscal and tax reform plans due to be drafted by June. The most likely scenario is that while Kan will manage to come up with fiscal reform plans, he will keep vague on the timeline for hiking the sales tax and may have to back down on his earlier pledge to cut spending. That may disappoint bond investors and unleash a brief sell off in bonds. But it is unlikely to lead to a sustained spike in yields unless coupled with a market shock from abroad - such as a jump in US Treasury yields that pushed up Japanese yields last December, or renewed jitters over Europe's debt woes - as investors already expect any progress on fiscal reforms in Japan to be very slow. If Kan is forced to quit or call a snap election, which is less likely but a possibility, that may also disappoint bond investors and briefly push up yields. But there is an equal chance political uncertainty will prompt investors to shift money away from stocks and into the safety of bonds.
DEBT WORRIES All this bodes ill for the BOJ, which hoped there would finally be progress in tackling Japan's debt pile as it buys time by supporting the economy with monetary easing. For now, the BOJ shares the dominant market view that Japanese bond yields will not shoot up at an alarming pace even if political deadlock stalls reforms.