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Will 2% inflation be enough for Japan?

Ko Sasaki | Bloomberg | Getty Images

Even if Japanese policy makers manage to pull off 2 percent inflation within their two year target, it may not be enough to save the struggling economy, Capital Economics has warned.

According to the London-based research house, Japan's burgeoning debt pile poses a major risk to its finances, and the central bank's inflation target falls well short of what is required to substantially reduce it.

"Higher inflation is the only plausible answer to Japan's fiscal problems, but even achieving the current target of 2 percent may not be enough," Julian Jessop, chief global economist at Capital Economics said in a note.

(Read More: Is Japan finally defeating its deflation demons?)

Japanese policy makers have this year embarked on an ambitious plan to overhaul the economy, which for decades has been dogged by high levels of public debt and deflation. The three-pronged strategy has involved aggressive monetary easing, along with fiscal stimulus and structural reform.

So far, Prime Minister Shinzo Abe's plan does seem to be gaining traction. Gross domestic product rose an annualized 3.8 percent in the second quarter of 2013, following a 4.1 percent rise in the first quarter.

Meanwhile, Japan's core consumer price index (CPI) climbed 0.7 percent on year in September, the fourth consecutive monthly rise.

(Read More: The verdict on Abenomics, one year on)

However, while many 'Abenomics' supporters have viewed the data as a positive sign, analysts at Capital Economics painted a much bleaker picture, warning that Japan's burgeoning debt remained the key risk.

"Japan's government debt is not yet on a hopeless path, but the risks are increasing by the year...Only small variations in the profiles for nominal GDP, the primary budget deficit or the level of interest rates would be needed to push the debt/GDP ratio substantially higher. Vary two or three of these factors together and the debt/GDP ratio could soon explode," he added.

According to Jessop, the most realistic way that Japan can tackle its astronomical debt pile – which currently stands at 240 percent debt to GDP according to the International Monetary Fund (IMF) – would be by achieving at least 4 percent GDP growth every year for a decade. This level of growth would cut debt to GDP to below 100 percent, he said.

However, Jessop was not optimistic on how successful policy makers will be in achieving this goal. Capital Economics forecasts Japan's sustainable real growth rate at just 1 percent per year, meaning a further 3 percent of inflation would be required to meet this goal, well above the current 2 percent target.

(Watch This: Abenomics doubters are getting fewer)

"The public debt problem in Japan has of course been brewing for many years without boiling over into a full-blown crisis. However, adverse demographics could soon cause the government's finances to spiral out of control," he said.

"Japan's low potential growth rate, the lack of political will behind fiscal austerity, and the fact that most debt is held by domestic financial institutions, all limit the options available to policy-makers," added Jessop.

(Read More: Japan success shows why Apple badly needs China Mobile)

—By CNBC's Katie Holliday: Follow her on Twitter @hollidaykatie

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