In “My Top Ten Surprises for 2011” (January 10, 2011) article I said: “The yen begins to reach its ‘Keynesian end-game’. International investors realise they need a risk premium to invest in a country whose public sector debt could reach 300 percent of GDP by 2019.”On Thursday, last week, S&P downgraded Japan’s sovereign credit rating one notch to AA-. Although this announcement may not be a big deal in itself, it tends to support my worries that 2011 will be the year when Japan’s dire fiscal position finally impacts markets both at home and abroad.While many investors remain fixated on the problems in Europe, the downgrade offers a subtle warning to not ignore the huge economic and financial challenges facing the Japanese government.Japan continues to suffer from an excessive debt burden that is exacerbated by persistent deflation and demographic pressures.Gross debt is currently around 196 percent of GDP in Japan but is projected to grow to 250 percent by 2015 and maybe 300 percent by 2019.This compares to current debt-to-GDP levels of 144 percent for Greece and 98.5 percent for Ireland. Zimbabwe is the only country with a higher debt-to-GDP ratio at 241 percent.Furthermore, Japan’s budget deficit (the amount its government spends in excess of what it earns in tax revenues) has ballooned from about 9 trillion yen in 1990 to nearly 55 trillion yen in 2010. At this level Japan’s budget deficit as a percent of GDP in 2010 is forecasted to be 7.8 percent versus Greece’s 8.3 percent and Portugal’s at 7.3 percent. In fact, today’s interest expense for Japan is about 26 percent of tax revenues (using 2010 estimates).So why has Japan so far escaped the sort of debt crisis that has engulfed the periphery of the euro-zone?First of all Japan’s external position is very healthy with ample overseas assets that have been accumulated from their years of current account surpluses. Basically, because Japan exports more than it imports it doesn’t need to rely on foreign capital to finance its deficits.Secondly, Japan has had the luxury of being able to draw almost exclusively on domestic investors to finance its government borrowing, so it’s not vulnerable to the whims of the global markets.Domestic buyers hold about 95 percent of the nation’s debt, according to the Japanese Ministry of Finance. This compares to the roughly 50 percent in the US, 78 percent in Greece, 47 percent in Ireland, and 60 percent in Portugal.These factors, however, have encouraged complacency and perpetuated what I believe to be a false axiom that Japan will always be able to issue cheap debt. In fact, I would argue that we are now approaching a limit to this, as Japan approaches an imminent demographic shift.Japan has the oldest population in the world. Not only will the retiring baby boomers in Japan want to run down their savings to fund their retirement (reducing demand for government bonds), but increasing social costs associated with health and welfare programmes will lead to surge in the budget deficit and supply of bonds.This has slowly been the case and is evident in the rapidly declining saving rate in Japan which has fallen from 10 percent in 1999 to 5.5 percent, according to the latest data.Domestic holders of Japanese debt may soon become net sellers. If so, Japan will need to fund itself more and more by external means and will need to compete by offering higher interest rates in a world of better sovereign credit profiles.This would lead to a higher cost of debt. Currently Japanese government bond yields are the lowest of any developing nation the benchmark 10-year note yields about 1.2 percent compares to the 3.4 percent of a US Treasury and the 3.2 percent of a German bund.If foreign buyers demanded more competitive yields, Japanese government bond yields may rise substantially, increasing the overall interest expense for the government.This would put immense pressure on government finances. For example, the current interest expense for Japan is about 9.8 trillion yen compared to the roughly 5 trillion yen spent on Education & Science, Public Works and National Defence.If rates were to double (hitting 2.4 percent) the government would be unable to fund these departments without issuing even more debt. Thus a vicious cycle develops.In the end, the Japanese government will not be able to afford this massive increase in its debt servicing cost so it will need to monetise its own debt the Bank of Japan will essentially perform the “Mother of all Quantitative Easings” by buying a great deal of its own debt to ensure interest rates do not soar.Consequently, there is the risk that the yen may depreciate substantially.The investing implications are many but here are a few.A weakening yen actually greatly assists Japanese exporters. Their goods become increasingly more competitive as they are priced in a weaker currency.As a result, Japanese exporters may see a strong surge in profitability and the Japanese stock market may rally in yen terms. More leveraged Japanese companies; however, will likely face higher interest costs.Also, if the Bank of Japan is forced to buy more Japanese bonds it will obviously sell foreign bonds such as US Treasuries, of which it is the largest holder. This would further pressure the US dollar and lift US Treasury rates and help, to some extent, mitigate the yen depreciation versus the dollar. Most importantly investors need to be aware that there are sovereign debt issues both to the west and to the east.Full disclosure: The author is short the Japanese yen.Nathan Kowalski is the chief financial officer at Anchor Investment Management. He holds a Chartered Financial Analyst (CFA) designation and Chartered Accountant (CA) designation.