Japan's back-sliding on fiscal reform puts Bank of Japan in bind

TOKYO (Reuters) - The government's backsliding on promises to rein in spending puts the Bank of Japan in a bind, limiting its scope to expand its massive monetary stimulus when the economy needs it, or ultimately to wind it back without causing chaos in the bond markets.

Government's slow progress in moving toward a balancing of its books has been a disappointment for the central bank, which frets that failure to tackle Japan's huge debt – bigger even than Greece's relative to its economy – could force it to keep buying government bonds for longer than it wants.

But if markets lose confidence in public finances, that would also make it harder for the BOJ to top up asset purchases without stoking fears it is bank-rolling public debt, analysts say.

Government still finances nearly 40 percent of its annual budget through debt, yet the latest draft of Japan’s fiscal strategy, issued by Premier Shinzo Abe on Monday, lacked a mandatory cap on spending and relies on what critics say are overly optimistic economic estimates.

"It's hard to deny the government kicked the can down the road," said a source familiar with the central bank’s thinking. "I don't think Japan can just laugh away what's happening in Greece."

That loose fiscal discipline raises the risk of a spike in bond yields if markets take fright, some government and central bank officials say.

Nearly a quarter of government spending already goes on debt servicing, and the Ministry of Finance estimates that if long-term interest rates rise 2 percent more than projected, it will cost an extra 8 trillion yen by fiscal 2018, completely cancelling out the extra revenue raised by last year's increase in sales tax.

LACKING STRATEGY

BOJ officials say they can continue to keep yields low via aggressive bond purchases, but with the bank already buying nearly all the Japanese government bonds (JGBs) issued in markets each month, there are limits to how much more it can take.

"Once markets become suspicious about Japan's fiscal discipline, it will be tough even for the BOJ to control long-term interest rates," said BOJ policy board member Takehiro Sato earlier this month.

The key test may come late this year, once last year's oil price falls are no longer reflected in the inflation figures.

The BOJ would be caught in a dilemma if doubts over Japan's fiscal discipline amplifies rises in yields resulting from higher inflation.

"It's questionable to what extent the BOJ can keep crushing yields," said Hideo Kumano, a former BOJ official who is now chief economist at Dai-ichi Life Research Institute.

"I don't think the BOJ has a strategy on what to do if inflation is heading toward its target but bond yields spiral out of control."

NO WAY OUT?

Withdrawing the bank's stimulus is even tougher. The BOJ says it will start tapering once inflation is stably at 2 percent, regardless of how much progress Japan makes on fiscal reform.

But the central bank has a record of yielding to pressure. In the late 1980s, political calls to stem sharp yen rises forced it to delay interest rate hikes, fuelling an asset bubble.

There is no guarantee policymakers won't lean on the BOJ again, particularly if concerns over Japan's finances keep the bond market nervous, analysts say.

Even if the BOJ were to taper, it won't unload its huge JGB holdings for years to come. But signs of its diminishing presence would be enough to disrupt the market, given it holds a quarter of all JGBs, analysts say.

There are few players around to fill the hole. Japanese banks are steadily reducing their JGB holdings and won't turn into buyers in times of a bond sell-off.

Government agencies, such as Japan's trillion-dollar pension fund, have also heeded Abe's calls to shift money out of the JGB market into riskier assets.

Hideo Hayakawa, a former top BOJ economist, says tragedy could strike when the BOJ succeeds in hitting its inflation target.

Unless fiscal discipline is restored, bond prices will plunge if the BOJ cuts its bond buying. If it doesn't, fears of debt monetisation will drive funds out of Japan and send the yen into freefall, says Hayakawa, now an analyst at Fujitsu Research Institute.

"The moment markets stops believing that Japan's finances are sustainable, huge market turbulence is unavoidable."

(Additional reporting by Sumio Ito and Yoshifumi Takemoto; Editing by Will Waterman)