????What a downgrade of Japanese debt by S&P could mean for the country's future and for the rest of the world.

????The timing of the downgrade of Japan's sovereign bonds by Standard & Poor's on Thursday came as a bit of a surprise to some. After all, Japanese government bond yields have been relatively stable recently, the yen fairly strong, and, as Citigroup points out, the government has vowed to address its sky-high debt load this year.

????But S&P isn't convinced that's going to happen. "The downgrade reflects our appraisal that Japan's government debt ratios--already among the highest for rated sovereigns--will continue to rise further than we envisaged before the global economic recession hit the country and will peak only in the mid-2020s."

????The agency has been concerned about Japan for months, issuing reports last October and November that said the country's debt, the highest in the developed world, threatened to destroy its credit worthiness. As it did then, S&P says today that the country has no "coherent strategy" to tackle problems that have been decades in the making.

????When Japan's economy collapsed in the late 1980s, the government chose not to write down bad loans or take the pain of massive restructurings. Instead it launched a massive borrowing program in the hope of stimulating the economy enough to outgrow its rough patch. Government debt grew from 66% of gross domestic product in 1989 to 226% in 2009 -- by far the largest percentage of any industrialized nation. (The U.S. figure is 93%.) Despite the spending, Japan's economy never strengthened, and the country fell into a cycle of increased deficit spending.

????Certainly Japan's woes are no secret. But perhaps paradoxically, because the country has stagnated for so long, many assumed the economy had bottomed out. Sure, a recovery may not be likely -- but a collapse? Hard to imagine, or so one might think.

????The debt problem could push Japan's rating into the BBB category after 2015, S&P said in November, "and by 2025, the country's fiscal indicators might weaken to the extent that they would be more typical of the performance we currently associate with speculative-grade sovereigns (those rated 'BB+' or lower)." Today's downgrade pushed its long-term rating from AA to AA-minus.

????While the move came as a surprise to some, a handful of investors and economists saw the downgrade as an acknowledgment of what they have believed for years: Japan is en route to a national debt crisis and a massive devaluation of the yen.

????Kyle Bass, who runs the Dallas-based hedge fund Hayman Advisors, has been the most vocal prophet of Japan's doom, taking his message to conferences and the media for over a year. The genial southerner, who darkens at the mention of the country's finances, is wagering his investors' money (and his own) that, sometime in the next five years, the Japanese government will have to pay such high interest rates to sell its bonds that the government will effectively go bankrupt. "The Japanese have created the circumstances for the greatest financial failure in world history," he says. The worldwide impact will be "awful."

????Money manager Vitaliy Katsenelson and Devin Stewart, a senior director at the Japan Society in New York and a Carnegie Council Senior Fellow, agree with Bass. The way they see it, Japan has never meaningfully flirted with a loan default because it has always been able to borrow money from its own life insurance companies, pension funds, and banks.

????Indeed, these institutions own more than 90% of all of Japan's outstanding debt. Moreover, they loaned the government ever-larger sums and demanded almost no yield in return. That left the Japanese government much like a man who carries a huge balance on an ultralow-interest-rate credit card: His salary may never be large enough to pay the bill in full, but he can always cover the minimum payment.

Disastrous demographics

????Bass, Katsenelson and Stewart say that this balancing act is being upended because of a simple shift in demographics. Seniors now make up about 23% of the country, according to estimates from the Organization for Economic Development and Cooperation. That's nearly twice the percentage of retired citizens in the U. S. and three times that of the rest of the world.

????The graying of the population is playing out in two ways that could have disastrous consequences for Japan. First, entities like life insurance companies and the Government Pension Investment Fund will be net sellers of Japanese government bonds going forward so that they can gather cash to support the new pensioners.

????Meanwhile the population is in long-term decline -- the working-age group peaked in 2009 -- so there are fewer workers and a smaller pool of tax receipts to support the retirees. Japanese tax revenues have collapsed to levels not seen since 1985, both because of the demographic shift and the global recession.

????That means Japan has to sell more bonds even as its traditional customers begin selling more than they buy. The rub: "The available pool of capital to buy bonds is no longer greater than the debt needs," says Bass.

????Japan will someday have to entice new investors, mostly from other countries -- and it doesn't have an appealing story to tell. The government currently runs a deficit of about $500 billion a year and growing. And it has the highest corporate taxes and among the highest income taxes in the world. Attempts to raise the nation's value-added tax have been rejected by the people. Efforts to raise capital by liquidating the country's $2.8 trillion in financial assets (many of which are U.S. Treasuries) would send the sort of desperate signal that would hurt the price of Japanese bonds.

????In short, if Japan wants to sell bonds to the rest of the world, it's going to have to offer higher interest rates. But if Japan paid what the rest of the G-7 pays, its interest costs would immediately exceed its revenues. Current debt payments are about $244 billion a year. Bass has calculated that every percentage point in higher yields adds another $125 billion in annual interest expenses. So if investors demand just an extra two percentage points above current yields -- bringing Japan in line with what Canada would pay to issue debt -- that adds $250 billion in annual interest payments to the country's debt figure. That eats up the nation's entire $489 billion in revenue.

????Aaron Costello, a global investment strategist at Cambridge Associates says that the need to borrow from the outside would probably trigger a debt crisis, but it could be a long time before this happens. In some ways, Japan's fate is tied to the speed with which investor sentiment can change.

????"Like all government debt, Japan faces a confidence game," Costello says. "Right now there's plenty of confidence, but the markets inside and outside of Japan may move in anticipation of stress. It could price in the need for incremental foreign purchases and you could see yields easily double to 3%."

The Japan of the future

????Vice Finance Minister Fumihiko Igarashi said this week that his country must fix its budget problems or face a debt crisis that could trigger a global depression.

????Bass says the scenario would mean the political chess game between debtor and indebted nations is on. "Central banks should be positioning themselves for this and playing out the endgame," Bass says. "How many times do you think the U.S. military has game-theoried a conflict between Iran and Israel? I'd be willing to bet countless times. But how many times do you think our Treasury has played out a Japanese bond crisis? I'm willing to say never."

????Most importantly, the difference between Japan, which seems relatively sanguine, and the struggling EU nations, which seem to flirt with disaster everyday, is that no one has enough money to bail out Japan.

????"If Lehman Brothers was too big to fail, then Japan would be too big to save," agrees Costello. "In some respects Japan is ahead of the curve, because Europe and the United States are eventually going to have to deal with this, and it will be interesting to see how this plays out."