Tur­bu­lence in the Ja­pan­ese fin­an­cial mar­kets

Following Sanae Takaichi’s clear election victory, fiscal concerns remain a major source of uncertainty

We see the recent turbulence in the Japanese financial market as a watershed moment — one that may have repercussions that extend far beyond the short‑term market reaction. The volatility was triggered by a potent combination of political timing, fiscal rhetoric and structural shifts in the market for Japanese government bonds (JGBs). Since Prime Minister Sanae Takaichi took office in October 2025, investors have gradually begun to price in a (significantly) more expansionary fiscal policy. This reassessment accelerated abruptly when Takaichi unexpectedly called a snap election for February 8, 2026 in mid‑January, while simultaneously signaling tax relief — in particular a two‑year suspension of the 8% Value-added tax on food. After Takaichi’s clear election victory, which secured a two‑thirds majority for her Liberal Democratic Party in parliament ^[1] the implementation of the plans has become significantly more likely — although the associated uncertainty remains. In a country with the highest public‑debt ratio among developed economies, this combination was enough to sharply heighten markets’ sensitivity to fiscal risks. In our view, however, while the recent events should certainly be taken seriously, they are unlikely to constitute an acute systemic threat, fiscally or for the Japanese banking system.

1 / Ambitious fiscal plans raise concerns

At the center of the current fiscal debate in Japan stands Prime Minister Sanae Takaichi’s proposal to fully suspend the 8% consumption tax on food for a period of two years. This measure was announced alongside the decision to call early elections for February 8, 2026. ^[2]Following Takaichi’s decisive election win, the implementation of the plans is now considerably more likely. According to the government, the tax suspension is intended to ease the burden on households facing higher living costs. It would apply to all food items currently subject to the reduced value added tax rate and would cost the government around 5  trillion Japanese yen (JPY) (which is approximately 32.5 billion U.S. dollars) in revenue per year, creating a substantial funding gap.  

In parallel to the planned tax suspension, the government had already adopted a large stimulus package worth approximately JPY 21.3 trillion in November 2025,^[3] which includes energy subsidies and household relief measures. Taken together, the combination of foregone tax revenue and additional fiscal expansion would place considerable strain on public finances — and Japan’s public debt ratio already exceeds 230 percent of gross domestic product (GDP). The market disruption, with Japanese ultralong government bond yields spiking, reflected the fact that the question of how the measures would be financed was left entirely unresolved. But Takaichi repeatedly stressed that the proposed tax suspension would not result in additional government borrowing. The prime minister further indicated that existing subsidies and budget items would be reviewed and that structural savings would be made to offset the revenue loss. Again, however, no specific funding sources were identified, and there is no detailed fiscal projection so far showing how the forecast budget shortfalls would be covered.

It is noteworthy that Japan’s opposition parties are largely moving in the same direction as the prime minister, calling for a reduction of the tax on food.^[4] A newly formed opposition bloc is even advocating for a permanent abolition of the food tax and has proposed the creation of a new sovereign investment fund that could generate ongoing income to finance future tax relief.^[5] However, since the opposition parties failed to make gains in last weekend’s election, the issue of a permanent tax suspension appears to be off the table for now. Nevertheless, the tax question is no longer merely part of the government’s agenda — it has effectively become a cross‑party issue. Takaichi announced that she would raise the matter with the opposition parties as soon as possible.

Despite the expected fiscal strain, government officials emphasize that Japan — due to its large domestic savings pool, stable current‑account surpluses and the continued dominance of domestic holders of JGBs — should be able to absorb the financial challenges, at least in the short term. But these structural factors, though they might prevent an immediate liquidity crisis from developing, were not sufficient to prevent a substantial repricing along the JGB curve.

2 / Japanese government bonds: Repricing at the ultra-long end of the JGB curve

3 / Yen: Stabilization or trend reversal?

4 / The question of debt sustainability: Market stress versus economic reality

The central question arising from the recent turbulence concerns Japan’s debt sustainability. At first glance, yields of around 3.5% for 30‑year and just under 4% for 40‑year government bonds appear alarming, particularly with a debt‑to‑GDP ratio of around 237%. However, what matters is not only the current market level of individual maturities, but the interplay between nominal growth and the effective average interest rate on the entire stock of government debt.

Japan’s government interest burden adjusts only slowly to rising market yields, as a large share of outstanding bonds were issued with extremely low coupons and long maturities. Even a sharp increase in long‑term yields therefore feeds into interest expenses only gradually. At the same time, the end to deflation and return of moderate inflation has boosted nominal growth, causing the debt ratio to move onto a slightly declining trajectory recently.

Japan’s debt remains broadly sustainable despite its already elevated level

Debt‑to‑GDP in 2050 under different interest‑rate and primary‑balance scenarios

Debt ratio as a function of the primary balance and interest rates

^{Sources: International Monetary Fund (IMF), Haver Analytics, DWS Investment GmbH as of January 2026, The color coding refers to the development of the debt‑to‑GDP ratio: red = rising exponentially; yellow = stabilizing at elevated levels; green = stabilizing at sustainable levels / red circle: scenario that appears most likely, based on our assumptions}

With regard to headline debt levels, Japan remains a special case. Despite the extraordinarily high debt ratio of around 237% of GDP, the burden appears surprisingly manageable at very low (2025: 0.54%). As long as average funding costs remain close to zero — or at most between 1 and 1.5% — Japan’s debt ratio should stabilize or even begin to decline gradually. The situation could become critical only if the government’s funding cost rose permanently toward 2% or above; in that case, even moderate fiscal deficits could trigger a rapid escalation of public debt. Japan’s debt sustainability is therefore underpinned less by fiscal strength than by monetary conditions. Over the long term, however, sustainability depends heavily on the assumption that inflation remains at around 2% and a return to deflation is avoided. Should the recent return of wage and price increases prove temporary and inflation fall significantly below the 2% level over time, the prospective debt dynamics would become considerably more challenging.

As long as nominal growth outpaces the effective interest rate and the primary fiscal balance — the budget balance before interest payments — does not deteriorate sharply, the debt trajectory should remain broadly stable. The main risk therefore lies less in current market movements than in a scenario in which inflation falls well below target while interest rates remain elevated. In such a case, debt sustainability would come under pressure. This is not our baseline scenario at present.

Suspension of the consumption tax with negative implications for debt dynamics

However, it should be noted that the suspension of the value‑added tax on food, proposed by Prime Minister Sanae Takaichi and now highly likely following her decisive election victory, would have a negative impact on debt dynamics. The tax break will cost roughly JPY 5 trillion per year, or about 0.8% of GDP. Of this amount, JPY 3 trillion would fall on the central government budget — increasing the primary deficit by that amount if no alternative financing source is identified. For 2027, the International Monetary Fund projects a primary deficit of JPY 10.3 trillion; the measure would therefore represent an increase of roughly 29%.

The impact that suspending the tax would have on nominal growth must also be considered. Estimates suggest that the tax suspension (in the first year) would reduce inflation by around 1.5 percentage points and raise real GDP by approximately 0.2 to 0.6 percentage points. Given that demand for food is typically inelastic, the growth effect is likely to be toward the lower end of that range. Multipliers used by the Cabinet Office indicate that the drop in the GDP deflator (driven by lower prices) would outweigh the rise in real GDP, resulting in a decline in nominal GDP. This, in turn, would have an additional negative indirect effect on Japan’s debt dynamics: the debt‑to‑GDP ratio would rise, and the budget deficit — measured as a share of GDP — would also increase.

Summary and critical assessment

5.1 Burden on the banking system: limited and manageable

Despite the sharp rise in long‑term yields in the JGB market, our calculations indicate that, as things stand today, no unmanageable strains are emerging for the Japanese banking system. While corporate financing in Japan is traditionally highly bank‑based — around 70 to 72% of all corporate debt is financed through banks, with regional banks playing a particularly important role — the structure of JGB portfolios significantly mitigates the impact. Major banks hold predominantly short‑dated government bonds with one‑ to three‑year maturities, and regional banks are likewise primarily invested in securities with remaining maturities of under three years. This pronounced short‑duration focus means that the recent rise in long‑term yields feeds into valuations of bank holdings only to a limited extent.

Only the regional Shinkin banks are more exposed, as they hold comparatively longer‑dated bonds in their portfolios and are thus more sensitive to mark‑to‑market losses. Nevertheless, the Bank of Japan’s latest stress test, which assumes a parallel 100 basis point increase in interest rates, paints an overall robust picture. Capital ratios across all banking groups — including Shinkin banks — remain clearly above the regulatory minimum requirements even under more severe assumptions. Valuation losses remain manageable, and the impact of potentially rising credit costs is also moderate. Overall, this points to a resilient banking system whose portfolio structure provides solid cushioning against recent market moves, even if specific segments such as the Shinkin banks warrant continued monitoring.

5.2 Financial stability and market implications: risks present, but no acute stress scenario

From a macro‑financial-stability perspective, the rise in yields does not currently imply an acute risk scenario. A credit crunch is not expected under current conditions, as such a development would only become realistic if regional banks were to face significant distress. Given their short JGB maturities, this appears unlikely. The only institutions that could come under more noticeable pressure from recent yield movements are again the Shinkin banks. However, their contribution to aggregate credit provision is limited, meaning that elevated stress in this segment would not automatically translate into a system‑wide tightening of credit.

International contagion risks also appear limited. Less than 7% of all JGBs are held by foreign investors, which sharply restricts direct global transmission channels. Although the share of hedge funds in trading volume has increased significantly — raising the likelihood of heightened volatility through rapid deleveraging during periods of market stress — global spillovers would likely remain moderate unless the Japanese banking system itself were to enter a crisis. Only in such a scenario would the risk of international spillovers rise markedly, due to Japanese banks’ growing exposures to foreign non‑bank financial institutions.

5.3 JGBs and the yen: between necessary adjustment and stabilizing anchors

Against this backdrop, the outlook for Japanese government bonds and the yen remains two‑sided. On the one hand, the market has undergone an important correction: the era of artificially suppressed term premiums has ended, and political risks — particularly in connection with the Takaichi administration’s ambitious fiscal plans — are once again being priced more visibly. On the other hand, several key stabilizing anchors remain in place, making an uncontrolled market dislocation unlikely. These include the still‑dominant role of domestic investors, the Bank of Japan’s substantial JGB holdings, and the potential for further supply‑side adjustments by the Ministry of Finance.

In the near term, however, we think volatility is likely to remain high — not least against the backdrop of questions surrounding how the suspension of the value‑added tax on food will be financed, but also in light of the Bank of Japan’s further monetary policy communication. A sustained easing of tensions at the long end of the curve would be most likely if expectations of fiscal stimulus were to be dampened, or if the central bank were to signal more clearly that it is prepared to address inflation risks more forcefully. Until then, investors should expect that Japan does not face an acute stability problem — but is also no longer the predictable anchor it was for many years. In our assessment, Japan is likely on a path toward normalization in both inflation and interest rates. However, the main risk remains that a “deflationary mindset” could once again gain the upper hand.