Which Country Defaults Next?

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It seems "debt," "Greece," "crepe," or any other words that might relate to the current Euro crisis prompts a flurry of activity on stocks around the world. But if you thought Greece's and Italy's debts were high, there exists a country with an even higher debt-to-GDP ratio. Surprisingly, it also has some of the lowest government bond rates in the world. Let's take a look at this macro mystery.

Land of the rising debt
Japan's 2011 gross public debt as a percentage of GDP is estimated by the IMF at 234%. Compare this to down-but-not-yet-out Greece's at 139% and Italy's at 119%, and the United States' at 99%. With those numbers, you may ask how Japan hums along while investors berate Europe for their lack of strict budget controls and U.S. politicians wrestle to cut the deficit.

This is because of one main difference: 95% of Japan's debt is Japanese-owned. Compare this to Greece, which owns 29% of its debt. The Japanese have been happy to fund their government at incredibly low bond rates, currently around 1.1% for a 10-year bond. Why don't the Japanese invest elsewhere for higher returns? For one, Japan likes to keep its yen in the country. This is due to a natural bias to favor one's domestic investments (home bias), the strength of the yen, and domestic institutions' required participation in bond auctions. Also, it's difficult to find domestic positive returns. The Nikkei, since Japan's trouble in the early 1990s, has lost about half its value:

What changed?
To keep Japan bond rates low and the interest paid on its large debt manageable, the Japanese must continue to loyally purchase bonds as they have in the past. However, some think the conditions that sustained cheap government borrowing cannot exist for much longer. First, Japan's declining savings rate dropped from 10% to 3% from 1981 to 2009. Second, Japan has the highest proportion of elderly citizens in the world, and it is only getting older with low birthrates. With less Japanese working and saving their income, less money will be available to tax and purchase bonds to fund a growing demand on social security and the general government.

If these changing conditions cause Japan to run into difficulty selling bonds domestically, foreign buyers most likely will demand a higher return. This higher return would add to Japan's interest expense, driving debt to potentially unsustainable levels, and tightening the noose around any future Japanese growth.

On the other hand, Japan -- unlike Greece and Italy -- controls its own currency, giving it more power to handle any crisis. Currently, the Japanese government is working to plug the deficit through legislation that doubles the consumption tax over four years. These higher taxes paired with economic growth pave the way to lower debt -- if economic growth forecasts prove true.

But if Japan is the new Greece...
Japan is a special case with massive debt but tiny borrowing costs. Through the years, many investors made the "widow-maker" trade of shorting Japanese bonds, only to lose. But in the worst-case scenario, who would be affected? Of course, the banks who buy up Japanese bonds, like Mizuho Financial Group (NYS: MFG) , Mitsubishi UFJ Financial Group (NYS: MTU) , and Sumitomo Mitsui Financial Group (NYS: SMFG) . Companies with a large share of total revenue from Japan, like salesforce.com (NYS: CRM) (an estimated 8-9% from Japan) and Adobe Systems (ADBE) (an estimated 10-15% from Japan) would also be affected.

No matter if 2012 spells doomsday for Japan, our analysts put together a free report: "The Motley Fool's Top Stock for 2012". It's completely free!

At the time this article was published Fool contributorDan Newmandoes not own any shares of the companies mentioned above, and prefers pineapple in his sushi.Motley Fool newsletter serviceshave recommended buying shares of Salesforce.com.Motley Fool newsletter serviceshave recommended shorting Salesforce.com. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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