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Risk of Bond Market Revolt in Japan: Expert

Doug Armand | Photographer's Choice RF | Getty Images

The Bank of Japan's recent radical shift in monetary policy that targets an inflation rate of 2 percent in the next two years could back fire and spark a crisis in the country's bond market, according to one expert.

"If Japan succeeds with its 2 percent inflation target, interest rates will rise at some point and they just need to reach 2.8 percent for the interest on government debt to equal government revenues," James Gruber, author of "Asia Confidential" said, noting that interest on government debt takes up 25 percent of government revenues currently.

"The bond market will revolt well before it reaches that point though," Gruber, who was formerly a fund manager, added.

The BOJ, which has traditionally adopted a cautious approach, shocked markets at its last meeting on April 4 when it said it would pump $1.4 trillion in to the economy to meet a 2 percent inflation target in around two years.

(Read More: After 'Shock and Awe,' What Next From the BOJ?)

The Japanese government has enjoyed paying a low rate of interest on its debt for many years because sovereign bond yields have remained compressed in the face of deflation, which has plagued the economy for the past two decades. However, rising prices could significantly increase the interest payment burden for the government as bond holders demand higher yields.

Even if the government is not successful in driving up inflation, Gruber said risks still remain as debt will continue to balloon as the central bank pursues its asset purchase program. Japan's government debt is estimated to reach 245 percent of gross domestic product this year - the highest in the world.

"Bondholders aren't going to sit there earning less than 0.6 percent on Japanese government bonds while debt increases and the yen tanks," he said.

In addition, Gruber said investors that assume the Japanese government bond market can never blow up as domestic Japanese own over 90 percent of the debt "are looking through the rear-view mirror."

"Aging Japanese need to fund their retirements and won't be able to support the government bond market as they've done in the past. Foreign investor holdings of government bonds are 9 percent and rising. These investors are going to want better returns for the risks that they're taking on," he said.

Concerns over the implications of "Abenomics" - Prime Minister Shinzo Abe's push to revive the economy through aggressive monetary easing and fiscal stimulus - for the country's bond market have been on the rise in recent weeks.

(Read More: Sentiment Turning for Japan Stocks? Foreign Buyers Bail)

Ratings agency Standard and Poor's on Tuesday said it saw more than a one in three chance of a sovereign credit rating downgrade from risks associated with recent government initiatives and uncertainty of their success. S&P has an AA- long-term rating on Japan's sovereign debt.

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