Absence of safe assets and fiscal crisis

Abstract

This paper provides a fiscal crisis model that explains the low interest rates of Japanese government bonds. The key ingredient is the absence of safe assets in the sense that investors have no access to any asset that hedges fiscal risk. The interest rate is insensitive to any change in fiscal conditions and does not fully reflect the risk premium. This finding explains the low interest rates of Japanese government bonds even though the risk of fiscal default looks fairly high. The poorly-functioning bond market created in this way contributes to the low interest rate followed by a low default probability, and allows the government to sustain its large debt. This finding explains the mechanism under which the low interest rate coexists with Japan's large outstanding debt. Welfare implications are mixed. The well-functioning bond market does not always contribute to welfare enhancement because the market makes it difficult to sustain the debt. We show the implications for fiscal sustainability of some policies, such as financial market reforms and growth enhancement policies.

Debt Intolerance: Threshold Level and Composition*

“…This implies that domestic investors are insensitive to expected public debt. In other words, domestic investors may not require a risk premium against large debt when there is strong home bias without any other assets hedging fiscal risk, which is line with Japan’s debt literature (Sakuragawa and Sakuragawa, 2016).…”

“…Meanwhile,Broner et al (2010) show that secondary markets both reduce the probability of default on foreigners and make it difficult for the government to discriminate among creditors.4 Asonuma et al (2015) also show that higher home bias mitigates the upward pressure of the increase in public debt on bond spreads, using three home bias indicators: (1) Banks' holding of domestic sovereign claims / Banks' total assets, (2) Banks' holding of domestic sovereign claims / Banks' holding of sovereign claims and (3) Banks' holding of domestic sovereign claims / Public debt of sovereign. Their result is line with the fiscal crisis model ofSakuragawa and Sakuragawa (2016) that explain why domestic investors do not require a risk premium against large outstanding debt when there is a strong home bias in the asset portfolio of domestic bondholders. The reason is that these investors turn out to have no access to any assets that hedge fiscal risk Ongena et al (2019).…”

Debt Intolerance: Threshold Level and Composition

“…This implies that domestic investors are insensitive to the expected public debt. In other words, domestic investors may not require a risk premium against large debt when there is strong home bias without any other assets hedging fiscal risk, which is line with Japan's debt literature (Sakuragawa and Sakuragawa (2016)). hand, the corresponding impact would be small and stable in large economies or countries with the capital control or higher home bias because the share of foreign private investors remains low.…”

Secular Stagnation and Low Interest Rates under the Fear of a Government Debt Crisis

“…However, their simulation results show that government debt will exceed private sector financial assets within 10 years, and thus they warn of a potential fiscal crisis. Sakuragawa and Sakuragawa (2016) use the absence of safe assets to explain the low government bond yield. Caballero and Simsek (2017) point out a secular increase in risk intolerance.…”