Is Europe Making Japan Unsafe For US Investors?

Japan's first trade shortfall with the European Union, along with its rising government debt, could make the country an increasingly unsafe destination for U.S investors' money.

The decline in Japan's trade surpluses over the past four years is not the only aftershock of the debt morass in Europe. Rising fears of a contagion in the U.S are exposing Japanese government bonds to serious risks in the form of a significant rise in yields, analysts warn.

Investors who have burned their fingers in European sovereign bonds, such as those issued by Greece, could demand higher risk premiums from Japan. U.S. hedge funds, which have become skeptical about Japan, are resorting to an over-the-counter option called swaptions that they expect will be extremely profitable for them should Japanese bonds yields rise.

The world's third-largest economy recorded a trade gap of 11 billion yen ($139 million) with its European buyers in May -- its highest monthly shortfall with the EU since 1979. As the economic crunch continues to throttle demand in Europe, Japan's trade deficit with the EU could persist for the rest of the year, some economists say.

Japan's global trade deficit, recorded at 907 billion yen ($11.4 billion), grew 5.4 percent last month from the year before in the face of increased energy imports. At this time last year, the country was also reeling from the repercussions of the March 2011 earthquake-tsunami, the nuclear accident in Fukushima and the Thailand floods, which destroyed several factories belonging to Japanese automakers.

The trade deficit will add significantly to Japan's fiscal troubles, which are far worse than those of countries like Greece and Italy.

Tokyo is facing pressures to downsize Japan's burgeoning debt, which stands at roughly $14 trillion, a level close to the officially stated debt in the U.S., which is about twice the size of Japan. According to Fitch, which downgraded Japan's sovereign credit rating in May in its first such action since 2001, Japan's debt burden could escalate to 240 percent of its GDP by the end of this year -- a level that would be the highest in the world. Fitch's downgrade reflects growing risks for Japan's sovereign credit profile as a result of high and rising public debt ratios, Andrew Colquhoun, head of Asia-Pacific sovereign ratings at Fitch, said in a statement.

Despite Europe's sovereign debt crisis, the continent remains Japan's key trading partner. But if Japan's trade deficit with the EU persists for at least a few more years, as some economists are forecasting, its debt situation could worsen, jacking up yields on Tokyo's government bonds.

Another factor that is inviting skepticism from investors is the possibility of higher rollover risks on Japanese government bonds, which mature six years earlier than those issued by Ireland, Portugal, France, Spain, Italy and Greece. This means that payment obligations on these debts arise six years sooner than they do for European sovereign debt. Against such a backdrop, even a marginal spike in interest rates could spell disaster for investors.

Then there's the possibility of a rise in borrowing costs if a larger proportion of Japanese government bonds is rolled over. Such a situation could threaten Japan by increasing the load of interest payments, as in Greece and Portugal.

For now, the yen's rise against the dollar appears to be a silver lining in the cloud. The yen has hit historic highs against the U.S. currency on multiple occasions. The dollar, which was trading above 120 yen five years before, is now pegged at less than 78 yen. But economists predict that the yen will eventually weaken against the dollar if Japan continues to report trade shortfalls that eat into its fiscal resources.

Japanese policymakers are working to address the country's vulnerabilities to the European debt crisis. Some analysts expect Japan's subdued trade figures to drive the Bank of Japan to decide whether it should ease monetary policy for the third time since February this year.