As it begins rebuilding from the worst natural disaster in history, Japan's economy faces a bigger threat than the destruction of a relatively small portion of its industrial output: debt.
To pay for the rebuilding, the Japanese government will have to pile billions of dollars of fresh borrowing on top of a debt load that is already one of the biggest in the world.
Last week's devastating 9.0 earthquake and resulting 30-foot tsunami was just the latest blow to an economy that has been struggling to get back on its feet two decades after the collapse of a major financial bubble.
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"Japan has just got a horrific set of problems that it's been grappling with now for over 20 years," said Steven Roach, non-executive chairman of Morgan Stanley Asia. "They've had to rebuild the financial system. And they have the most powerful demographic headwinds of any economy in the world: Their population is not just aging, it's declining."
Those two "lost decades" have brought four recessions and left growth virtually flat-lined, with GDP rising, on average, less than 1 percent a year. Long before the quake struck, forecasters had expected the Japanese economy to continue contracting in the next few quarters.Story: Businesses wrestle with evacuation decisions
To try to revive growth, the Japanese government has been spending heavily, but with little lasting impact, except to build a mountain of bonds that will have to be repaid. At roughly twice its annual GDP, Japan has one of the world's highest public debt burdens, second only to Zimbabwe, according to the CIA Factbook. In contrast, the United States is ranked 36th, with a public debt of about 60 percent of GDP.
Now, as it faces huge relief and rebuilding efforts, Japan will have to issue more bonds to cover the cost, which preliminary estimates place at roughly $200 billion. The risk is that, as it piles on more debt, the Japanese government will have to pay higher interest rates to investors to maintain demand for all those new bonds.
"They're printing all this money to get out of this mess and eventually interest rates will go up with all that printing," said Lawrence McDonald, president of McDonald Advisory Group, an investment management firm. "A one percent increase in interest rates will equal 25 percent of their tax revenues."
Higher rates will also make it costlier for businesses and consumers to borrow, putting a damper on spending and investment and creating yet another headwind for the Japanese economy.
It's unclear just how much money the government will have to borrow. Private insurance is expected to cover only a relatively small portion of the rebuilding cost. That's because Japan has a comprehensive, government-backed earthquake insurance program that covers some individual property owners and backstops insurance companies in the event of huge losses. Initial estimates put total losses covered by private insurance at no more than $35 billion, or about 6 percent of the estimated total loss.
That means companies and consumers will have to pay some of the cost of rebuilding out of pocket, again cutting into business profits and consumer spending.
Japan's economy will also take a hit from the industrial production shut down by quake damage to factories. There have been isolated reports of shortages looming for parts and components, mainly for the electronics and auto industries.
But Japan is a large diversified economy and the disaster area contributes a relatively small portion of the country’s GDP. Economists also note that the devastating loss of any major natural disaster, especially in a developed country such as Japan, is typically followed by heavy spending and investment in reconstruction, all of which helps stimulate growth.
"I'm not trying to say there are no problems," said Steven Wieting, Citigroup's director of economic and market analysis. "But even radiological disasters, Chernobyl, Three Mile Island, what happened with the Deepwater Horizon last year, there's a great amount of emotion and concern. But none of the events, including the Kobe earthquake, all of these natural disasters don't have long-lasting, enduring economic impact."
As for the global economy, despite isolated parts shortages from Japanese suppliers, the Japan quake is “not likely to be significant to global trade” and the impact on the Japanese economy will probably be "localized,” according to FedEx CEO Fed Smith.
"Put it this way: if unfortunately we had a terrific tragedy in Arizona or Oregon sort of on the periphery of the country, it would be horrible," he said. “But the rest of the United States in all probability would continue operating."
Japan faces a potentially bigger problem from the recent rise in the value of the yen. The quake-induced surge is the result of several forces, according to currency market watchers. Japanese insurance companies and other businesses and investors are believed to have been selling overseas assets denominated in other currencies to raise cash back home. The scramble to buy yen has forced up its value.
Currency traders have amplified the move by betting on the rise. That prompted the central banks of the seven largest industrialized countries to agree Thursday to a coordinated effort, the first since 2000, to keep the value of the yen in check.
A rising yen could present the Japanese government with a bigger problem than what may be relatively small damage to its industrial base. A higher yen makes Japan's products more expensive to anyone in the rest of the world paying for them with another currency. That makes Japan's exports less competitive in the global marketplace and gives international companies one more reason to look for other suppliers.
The latest round of government borrowing presents a conundrum for Japan's central bankers, who have been struggling for years to keep interest rates low economy with a policy (also recently adopted by the U.S. Federal Reserve) called "quantitative easing." By dramatically expanding the supply of money, the policy aims to keep interest rates low, stimulate borrowing and revive growth.
It hasn't worked in Japan. Now, as the Japanese government floods the market with new debt, the central bank will have to continue buying those bonds if private investors don't step up to the plate and help finance the country's rebuilding effort.
Japan's plight could feel eerily familiar to some U.S. officials. The Fed is about to end its second, $600 billion round of bond buying in June, a response to the collapse of the much more recent American financial bubble. As Japan now grapples with its huge debt burden, U.S. policy makers could learn a lot from Japan's experience, according to Roach.
"Twenty years later, the post-bubble experience of Japan must give all of us pause for thought, especially those of us in the United States who feel that it could never happen to us," he said. "These are very devastating events and there are lessons in Japan that I think a lot of us have failed to learn."
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