Toward a World with Interest Rates

On October 6, the interest rate on 10-year government bonds became a bit of news. The coupon rate for new 10-year government bonds issued by the Ministry of Finance reached 3.1% per annum. This was a sharp increase from the previous 2.7%, marking the highest level in about 30 years since 1996. In the actual auction, the average accepted yield was 3.101%. A Kyodo News article also wrote that “the rise in interest rates leads to an increase in interest payment costs for government bonds, further straining public finances.”

So, if government bond interest rates reach 3%, is Japanese public finance in danger? This requires a bit of explanation.

First, it is easy to understand if you think of the Japanese government’s debt like a household mortgage. However, the Japanese government’s debt was not borrowed all at once. As a result of continuing to issue government bonds for many years and decades, a huge mountain of debt has been created. A large amount of government bonds issued in the past with low interest rates in the 0% or 1% range remain. Therefore, just because the interest rate on 10-year government bonds reached 3.1% today does not mean that 3.1% interest will be applied to all of the government’s debt from the next day.

The problem arises if that continues for many years.

Government bonds have maturity dates. For example, suppose a government bond borrowed at 0.5% in the past matures, and the government issues a new government bond to prepare funds for repayment. If the interest rate at that time is 3%, the 0.5% debt is replaced by 3% debt. This happens little by little every year. Therefore, the impact of rising interest rates on public finance is felt gradually over several years rather than hitting suddenly.

The Ministry of Finance itself already anticipates this. In the fiscal year 2026 budget, it estimates interest payments on government bonds at 13 trillion yen. This is an increase of 2.5 trillion yen from the 10.5 trillion yen in the initial budget for fiscal year 2025. The Ministry of Finance cites as the reason for this, in addition to the impact of raising the assumed interest rate for newly issued government bonds from 2% to 3%, the impact of low-interest old government bonds being refinanced into high-interest government bonds.

This brings up the question of “which is higher, the economic growth rate or the government bond interest rate?”

For this fiscal year, the government expects real GDP to grow by about 1.3%, and nominal GDP, which includes price increases, to grow by about 3.4%. Nominal GDP is, roughly speaking, “the size of the Japanese economy measured in yen.” Even if prices rise or corporate sales and wages increase, nominal GDP grows.

When considering government debt, this nominal GDP becomes important. Even if there is 1,000 trillion yen in debt, if the Japanese economy itself continues to grow, the weight of the debt relative to the size of the economy becomes relatively smaller.

For example, having 10 million yen in debt for a person with an annual income of 5 million yen has a different weight than having 10 million yen in debt for a person with an annual income of 10 million yen, even though the 10 million yen is the same. Similar to that, when looking at the Japanese government’s debt, we look not only at the absolute amount but also at how much it is relative to GDP.

What is important here is the competition between the speed at which the economy grows and the speed at which debt expands due to interest.

If the Japanese economy is growing at about 3% in nominal terms every year, while the average interest rate actually paid on government debt is about 1%, the economy grows faster than the debt. In that state, at least for existing debt, the weight relative to GDP tends to gradually become lighter.

This is the intuitive meaning of the “Domar condition” that often appears in fiscal theory. There is no need to memorize difficult mathematical formulas. You can just think, “If the speed at which the country’s nominal income increases is faster than the speed at which the country’s debt expands due to interest, the debt tends to become relatively lighter.”

That is why the argument arises that “this year’s nominal growth rate is in the 3% range, and the 10-year government bond interest rate is also in the 3% range. Isn’t this dangerous?”

However, there is one big pitfall here. What should be compared is not the 3.1% of the 10-year government bond issued today and this year’s nominal growth rate of 3.4%.

The 10-year government bond rate of 3.1% is, so to speak, the “interest rate when the government borrows new money today.” On the other hand, the government also holds a huge amount of low-interest government bonds issued in the past. Therefore, the average interest rate that the government is actually paying on its entire debt is much lower than the current 10-year government bond interest rate.

Therefore, the understanding that “the nominal growth rate is 3.4% and the 10-year government bond rate is 3.1%, so there is only 0.3% room left” is wrong. It is not a story that public finance has reached its limit immediately.

However, that does not mean you can be at ease.

In the 10-year government bond auction in January this year, the accepted yield was 2.095%. That rose to 2.350% in April, 2.649% in June, 2.840% in August, 2.995% in September, and 3.101% on October 6. In just about nine months, it has generally risen from 2.1% to 3.1%.

If this interest rate of around 3% ends up being temporary, the impact will be limited. However, if the level of around 3% takes hold for several years, the story changes. This is because low-interest government bonds that reach maturity every year will be gradually replaced by government bonds of around 3%. As a result, the average interest rate that the government pays on its entire debt will also rise over time.

Moreover, there is no guarantee that a nominal growth rate of 3.4% will continue indefinitely. Even in the government’s medium- to long-term projections, while the nominal growth rate is expected to remain in the 3% range in a scenario of strong continued growth, the ‘status quo projection case,’ which assumes the current economic structure remains unchanged, shows that it will stay at around 2% in the medium to long term.

This is where the real problem lies.

Suppose that in the future, Japan’s nominal economic growth rate falls to around 2%, while government bond yields settle at around 3%. In that case, the interest paid on government debt will become higher than the rate at which the economy itself is growing. The ‘power to make debt relatively smaller by growing the economy,’ which has supported Japanese public finance until now, will weaken.

If that happens, other methods will be needed to lower the debt-to-GDP ratio. Either tax revenue must be increased, expenditures must be curbed, or the economic growth rate itself must be raised. In other words, the degree of freedom in fiscal management will diminish.

This does not mean that ‘Japan will face a fiscal collapse tomorrow.’ On the contrary, the problem is difficult to see precisely because the rise in interest rates affects Japan’s public finances with a time lag.

Just because the 10-year government bond yield has reached 3.1% does not mean that interest at 3.1% will be applied to all of the government’s debt of over 1,000 trillion yen starting tomorrow. However, if a 3% world continues for five or ten years, the composition of the debt itself will be replaced by that 3% world.

In fact, the Ministry of Finance’s projections for subsequent fiscal years show a case where, even assuming a certain economic growth rate, interest payments on government bonds will increase from 13.0 trillion yen in fiscal 2026 to 15.5 trillion yen in fiscal 2027, 18.5 trillion yen in fiscal 2028, and 21.6 trillion yen in fiscal 2029. Of course, this is a mechanical calculation and not a prediction that it will happen exactly as stated. However, these are easy-to-understand figures for observing the structure where ‘interest rate hikes affect public finance with a time lag.’

Therefore, the significance of the 3.1% 10-year government bond yield is not that ‘Japanese public finance has immediately entered the danger zone.’ It means that ‘we have entered an era where we must seriously consider the interest burden on government bonds, which we hardly had to worry about until now due to ultra-low interest rates.’

For a long time, Japan has kept its interest payment burden low through extremely low interest rates while carrying a massive government debt. That environment is beginning to change.

What is important from here on is not the single-day figure of the 10-year government bond yield reaching 3.1%. It is how much Japan’s economy can grow in nominal terms, at what level government bond yields will settle, and at what speed government bonds issued during the low-interest-rate era will be replaced by high-interest-rate bonds.

‘As long as interest rates are lower than the growth rate, we can manage’ has been, to put it very crudely, a tailwind for Japanese public finance. That tailwind is weakening. The news of the 10-year government bond yield at 3.1% should be seen as an event that made that change visible in the form of a number.