By Tetsushi Kajimoto and Takaya Yamaguchi
TOKYO (Reuters) -Japan's finance minister on Friday said he would strive to contain the risk of runaway debt after unveiling an annual budget as speculation mounts the central bank will shift away from more than two decades of ultra-easy monetary policy.
The world's third-largest economy is under pressure to restore its fiscal health after prolonged stimulus and spending worsened a national debt that is the heaviest in the industrialised world.
In calculating borrowing costs, the government adopted a higher interest rates estimate - 1.9% from the current 1.1% - in the budget plan for the coming fiscal year, which would mark the first increase in 17 years.
"When we return to life with interest rates, and if interest rates continue to rise to push up interest payments, that could affect fiscal management, squeezing policy outlay," Shunichi Suzuki told reporters after the government crafted the fiscal 2024/25 budget.
"The government needs to minimise such risks. To achieve that, we must limit bond issuance and curb interest payments for the future through efforts such as securing stable funding sources and strike a balance in compiling budgets."
The budget for the fiscal year that starts in April is estimated at 112.07 trillion yen ($787 billion), down 2% from the current year's initial amount of 114.4 trillion yen.
The budget is still above 110 trillion yen for two straight years, inflated by the cost of military outlay to deal with threats from China and North Korea and welfare costs for Japan's ageing population.
The plan shows its debt dependence at 31.2%, meaning new bond sales account for one third of the budget.
More than two decades of super-low interest rates have loosened fiscal discipline in a country whose public debt is more than double the size of the economy as a result of rounds of fiscal stimulus.
"The bulk of spending cuts comes from reduction of COVID-led emergency reserves. Excluding such factors, spending reform made little headway," Takahide Kiuchi, economist at Nomura Research Institute, said.
"Policymakers must have a sense of crisis and guide responsible fiscal policy as the Bank of Japan normalises monetary policy. Unexpected rate rises would further aggravate public finances."
The higher assumed rates would push up debt-servicing costs to 27 trillion yen in fiscal 2024/25, up 7% from this year.
Analysts say it is unlikely Japan will meet its aim of getting the primary budget balance, excluding new bond sales and debt servicing costs, into the black by the fiscal year-end in March 2026.
"What's important is to present a credible plan to restore public finances even if it causes a delay in achieving the target," Takuya Hoshino, senior economist at Dai-ichi Life Research Institute, said.
"I think they are going to review the target sooner or later," Hoshino said. "They would likely delay the PB target."
($1 = 142.4400 yen)