Japan’s ‘Borrow-to-Invest’ Strategy is Under Strain

By Fumio Ohtake / Special to The Yomiuri Shimbun

11:00 JST, March 27, 2026

Japan’s fiscal deficit is colossal. According to an estimate by the International Monetary Fund, the nation’s general government gross debt amounts to about 230% of its nominal GDP. Textbook theory suggests that it wouldn’t be surprising if we saw a fiscal crisis or high inflation in such a situation.

Indeed, Greece fell into a sovereign debt crisis and Argentina has repeatedly experienced sovereign debt default. But, here in Japan, no serious fiscal crisis has occurred, and government bond yields remain at some of the lowest levels in the world. “Japan’s Puzzle” has mystified economists around the world.

The key to solving this puzzle lies in the Japanese government’s “borrow-to-invest strategy.” In a recent analysis, YiLi Chien of the U.S. Federal Reserve Bank of St. Louis and his colleagues demonstrated how the Japanese government has been managing an enormous fund with borrowed money.

“Borrowing to invest” sounds dangerous. But the method itself is basically the same as a company taking out a loan from a bank for capital expenditure or an individual buying a house with a mortgage. The use of debt for investment aimed at higher returns is called leverage — the principle of the lever.

When it comes to the consolidated balance sheet of Japan’s public sector, including the Bank of Japan and public pension funds, its financial assets stood at about 200% of the country’s GDP as of 2024, while its gross liabilities totaled 270% of GDP. When the government and the Bank of Japan, which holds an overwhelming amount of outstanding government bonds, are seen as a single entity, the majority of real government debt, as seen from the private sector’s perspective, consists of reserve deposits held at the Bank of Japan by financial institutions at zero interest rates.

The government’s investment strategy can be divided into three parts. First, about three quarters of the assets held by the Government Pension Investment Fund (GPIF) and other public pension funds have been invested in equities and foreign securities. Second, the Bank of Japan has purchased massive amounts of government bonds, converting long-duration government debt into short-term reserve deposits. Third, the special account for foreign exchange reserves and GPIF together hold foreign securities worth more than 60% of Japan’s GDP. As those portfolios have not been hedged against foreign exchange rate fluctuations, their value in yen terms will surge if the yen weakens.

This means that the government has been employing a leverage strategy of investing short-term, low-interest borrowed funds in long-duration, risky, high-return assets. The excess returns from the investment amount to more than 6% of GDP annually on average. As a result, although the cumulative deficit of Japan’s primary balance exceeds the equivalent of 130% of GDP, its net debt has risen by just over 50% of GDP, with most of the difference made up by investment returns.

The government’s investment strategy has been working thanks to conditions unique to Japan. These are the continuation of ultra-low interest rates, households keeping about half of their financial assets in deposits and the role of the yen as a low-interest funding currency. It can be said that Japan has been able to escape from a fiscal crisis because of its “national-level hedge fund strategy” of collecting people’s deposits at low cost and investing in the world’s risk assets.

Inherent risk

The Japanese government’s “borrow-to-invest” strategy has been remarkably successful in a low-interest environment. However, this strategy has a significant vulnerability — the risk inherent in leverage. Let’s see how that mechanism evolves by referencing a familiar example of a housing loan.

Let’s assume that you buy a ¥20 million house with ¥4 million in cash as a down payment and a ¥16 million loan.

You pay an interest rate of 0.5% per annum on the loan. Imagine that the housing price jumps 5% over the course of a year. In this hypothetical situation, the annual return on your “investment” with the down payment of ¥4 million surpasses 20%. If you had purchased the house all in cash, the return on investment would have been only 5%, the same as the increase in the housing price. Taking out a loan yields a much higher rate of return. This is the “leverage effect.”

However, it doesn’t always work smoothly. If the interest rate is raised to 5% and the housing price declines by 5%, the return on the down payment of ¥4 million would be more than minus 40%, causing you to lose nearly half of your down payment.

Leverage can generate significant profits when interest rates are low and asset prices go higher. On the other hand, when an increase in interest rates coincides with a fall in asset prices, losses can snowball dramatically. This is what is known as a “double-edged sword,” and the government is in exactly that situation.

In March 2024, the Bank of Japan ended its negative interest rate policy. Thereafter, the central bank raised its policy interest rate to 0.25% in July of the same year, to 0.5% in January last year and to 0.75% in December. BOJ Gov. Kazuo Ueda has indicated the policy interest rate will be increased further once its projections for economic activity and prices are met. The country’s interest rates are still low, yet the era of ultra-low interest rates that lasted for almost 30 years has ended, giving way to the normalization of interest rates that is steadily progressing.

In their analysis, YiLi Chien and his colleagues said if Japan’s interest rates rose by 1 percentage point, the government’s net liabilities as a percentage of GDP would go up by about 40%. This means that its net liabilities would soar from about 80% of GDP at present to over 100%.

Why would there be such an enormous impact? The government maintains a huge amount of long-term risk assets, while the majority of its liabilities consists of short-term bank reserve deposits. In the event of an interest rate increase, the value of long-term assets will significantly decrease, while the value of short-term liabilities will remain almost unchanged.

Since liabilities will remain largely unchanged even as asset values fall, net assets would be severely impaired.

The foreign exchange risk, too, is high. If the yen strengthens, the massive amount of foreign currency-denominated assets will suffer huge valuation losses. In August 2024 when the yen rose and risk aversion spread, the Tokyo Stock Exchange’s Nikkei average plunged about 12% in a single day. In the phase of interest rate normalization, foreign exchange rates and asset prices tend to move in tandem and are prone to sharp fluctuations.

Fiscal discipline vital

As explained earlier in the example of a mortgage, when an increase in interest rates occurs simultaneously with a fall in asset prices, the rate of returns shifts into significantly negative territory. The government’s investment strategy is about to face such a dangerous situation.

What becomes critically important here is the direction of fiscal discipline. The government’s initial fiscal 2026 budget is projected to post a primary balance surplus. It is an important step in preparing for rising interest rates. Nonetheless, it can’t be said to have stemmed from the government’s fiscal reforms, as such a surplus is being underpinned by the favorable conditions of stronger-than-expected tax revenue against a backdrop of rising prices. There have been repeated instances where expenditures have ballooned due to supplementary budgets introduced midway through the fiscal year. Whether the primary balance surplus in the initial budget will ultimately be realized on a settlement basis remains to be seen.

Prime Minister Sanae Takaichi, who advocates “responsible and proactive public finances,” has indicated that her administration will seek to be more flexible about the goal of achieving a primary balance surplus. There remains concern that fiscal discipline will further loosen under the pretext of rising prices and an economic downturn.

Japan’s public finances are facing an unprecedented challenge amid increasing social security costs due to an aging population and pressure to increase defense spending.

The true cause of “Japan’s Puzzle,” which has attracted the world’s attention, is a “national-level hedge fund strategy” implemented on one of the largest scales in the world. However, the country can no longer rely upon the past successful experiences of enjoying the benefits of leverage in a low-interest environment.

As Japan’s interest rates are normalizing, what is now needed is a calm and logical policy response that squarely faces the “inconvenient truth.” Takaichi, who swept to a landslide victory in a recent snap lower house election, should fulfill the “responsible” part of proactive public finances through structural fiscal consolidation.

Ultimately, it is future generations of taxpayers who will be forced to shoulder the burden of the enormous risks currently borne by the government. This must never be forgotten.

Fumio Ohtake

Ohtake is a specially appointed professor at Osaka University, where he served as an executive vice president in 2013-15. He was president of the Japanese Economic Association in 2020-21. He specializes in labor economics and behavioral economics.

The original article in Japanese appeared in the March 22 issue of The Yomiuri Shimbun.