This is an extended version of the article that appeared in the February 2013 issue of Investment Advisor.

Japan’s new leader, Shinzo Abe, will take the helm of a country in recession, with business confidence near three-month lows and the highest debt-to-GDP ratio in the OECD. The prime minister, who has openly pushed for more aggressive monetary stimulus, has made clear his economic targets for his second period in power: overcoming deflation, reversing the rise of the yen and achieving nominal GDP growth of at least 3%. But how realizable are these goals in light of Japan’s demographic realities?

Japan has one of the most challenging demographic profiles globally. It is the oldest country in the world, with a median age of 44.7: five years higher than the developed country average and over 15 years higher than the global average. Life expectancy is high at 83, while Japanese fertility has, since the 1950s, been undergoing a steep and long fertility decline – one of the most dramatic in modern history. Current childbearing is estimated to be nearly 35% behind the replacement level.

The combination of these factors puts severe pressure on dependency ratios: By 2050 it is estimated that the elderly dependency ratio will be almost 75%, meaning there will be almost three retirees for every four people of working age. What’s more, the U.N. estimates that Japan’s population will fall from 126 million today to 120 million by 2030 and 108 million by 2050. All else equal, its demographic profile will severely hamper future growth and consumption. Worse, it could contribute to a crippling debt crisis.

Put simply, Japan’s shrinking working age population will reduce output growth and limit increases in economic welfare over the coming decades. In a speech in 2011, the deputy governor of the Bank of Japan, Kiyohiko Nishimura, argued that balance sheet adjustments associated with an aging population result in an inflexible and immobile economy, a loss of entrepreneurship due to underemployment and deterioration in financial institutions’ efficient functioning as financial intermediaries.

Furthermore, Japan has the highest debt burden among western economies, with the IMF forecasting that net debt will exceed 130% of GDP in 2012. This is in part the result of the substitution of public debt for private debt in the process of balance sheet adjustments, as well as the substitution of public demand for private demand during Japan’s declining growth. If this is not addressed, it will only deteriorate. The IMF forecasts that a near-term decline in GDP and reconstruction efforts will push the net public debt ratio to 160% by 2015. Stabilizing the net debt ratio by the mid-2010s and reducing it to 135% of GDP by 2020 would require a reduction of the primary deficit by 10 percentage points of GDP over the next decade. Without such a substantial adjustment, the net debt-to-GDP ratio will surely reach unsustainable levels.

Yet Japanese government bond yields have remained low and stable even as debt has ballooned. This is in part because of the strong home bias (which is partly forced upon them by financial repression) of domestic investors and financial institutions, which hold 95% of JGBs. However, this may not hold indefinitely. As explained in a paper for the National Bureau of Economic Research by academics Takeo Hoshi, a professor at the University of California, San Diego and Takatoshi Ito, a professor at the University of Tokyo, debt held by domestic investors cannot exceed domestic private sector assets, so when we reach that point – or the market believes we are nearing it – the yield will have to rise. With old age causing a decline in savings rate, this could happen within the next decade unless there is substantial fiscal consolation. If not, this could lead to a euro-style financial crisis, as JGB-laden financial institutions suffer massive losses.

Since the 1980s, Japan has undergone a series of major reforms, especially in the health care and pension systems, to try to dampen the fiscal burden of aging. These have left the country better prepared for the consequences of its population aging than much of the western world.

But the new prime minister still has his work cut out, and with the past five prime ministers averaging under a year in power, he does not have much time. This summer, Japan raised its consumption tax rate from 5% to 10% by 2015, which will help the debt burden. Abe may in theory be receptive to tax hikes, but he has promised more aggressive fiscal stimulus. This may have lifted market sentiment in the short term, but once pension funds start running down their assets, who will pay for this? Also faster growth and inflation may mean higher interest rates, raising the cost of debt service.

Japan already has a high level of elderly labor participation, with 77% of 60- to 64-year-old men still in the work force. But another means of increasing the work force would be to promote immigration and higher female participation. Compared to economies like the United States and United Kingdom, Japan has not managed to retain skilled and educated women within its work force. Meanwhile, immigration has helped other western economies maintain a healthier demographic profile. This would, though, require political willingness and a shift in culture among the public.

Whatever Abe’s best efforts, demographic change will still present serious challenges for the country: economically, politically and socially. We do think there are excellent investment opportunities to be found in Japan – especially in companies that tap into the demand shift in favor of older consumers and exporters that should benefit from the weakening yen. However, investors need to bear in mind the imperative of finding growth opportunities that are sustainable over the long term, especially from a demographic point of view.