First US, Now Japan: S&P Revises Japan Credit AA- Outlook To Negative

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S&P revises Japan's AA- credit rating outlook to negative. The culprit: the Japan earthquake that just as predicted, has become the scapegoat to excuse another quarter of "non-recurring" EPS misses. And while according to Wall Street the economic devastation is GDP positive, Japan may soon be a single A credit, which of course will send it 10 year bond trading with a 0 yield handle.

Overview

  • Standard & Poor's expects costs related to the March 11, 2011, earthquake, tsunami, and nuclear power plant disaster will increase Japan's fiscal deficits above prior estimates by a cumulative 3.7% of GDP through 2013.
  • We revised the outlook on the long-term rating on Japan to negative to reflect the potential for a downgrade if fiscal deterioration materially exceeds these estimates in the absence of greater fiscal consolidation.
  • We affirmed our long- and short-term sovereign credit ratings on Japan at 'AA-' and 'A-1+', respectively.

Rating Action

On April 27, 2011, Standard & Poor's Ratings Services revised to negative from  stable its outlook on the long-term ratings on Japan. At the same time,  Standard & Poor's affirmed its long- and short-term sovereign credit ratings  on Japan at 'AA-' and 'A-1+', respectively. The transfer and convertibility
(T&C) assessment remains 'AAA'.

Rationale

In our Jan. 27, 2011, announcement lowering the long-term rating on Japan to  'AA-', we noted that if we were to mark down our fiscal forecasts, downward pressure on the ratings could reemerge. The March 11, 2011, earthquake, tsunami, and attendant damage to Tokyo Electric Power Co. Inc.'s (TEPCO; BBB+/Watch Neg/A-2) Fukushima No. 1 nuclear power plant cause us to make such a markdown to our forecasts. As long as there are no revenue-enhancing measures such as tax increases, we currently project that reconstruction costs could range from ¥20 trillion to ¥50 trillion, with ¥30 trillion being our central forecast. If there are no revenue enhancing measures such as tax increases, we expect the central and local governments to bear most of this cost, adding 2% of GDP to our forecast for this year's general government deficit and 1% to our forecast for next year's, with deficits remaining above 8% of GDP through 2014, compared with 8.0% in 2013 in our previous forecast (see table below). Overall, we expect Japan's fiscal deficits to increase above our prior estimates by a cumulative 3.7% of GDP through 2013. Although we do not expect the disasters to materially hurt the country's medium-term growth potential--and we do not expect the government's real effective interest rate to rise significantly--we see net general government debt to GDP reaching 145% of GDP in fiscal 2013 (ending March 31, 2014), compared with our previous forecast of 137% of GDP.

In light of the evolving developments at the TEPCO nuclear power plant, in particular, we regard these projections as uncertain. Much will depend on Japan's political leadership and its ability to forge a political consensus on how to offset fiscal measures in the future. The extent of environmental contamination in northeastern Japan remains unknown.  Although we expect no lasting damage to Japan's supply chains, some manufacturers could decide to move a greater share of production offshore. Combined with the headwinds of intermittent deflation and a fast-aging population, Japan will be challenged to raise its real GDP growth potential much above 1% annually over the medium term, in our view.

That said, Japan's sovereign ratings are supported at the 'AA-' level by the country's ample net external asset position, relatively strong financial system, and diversified economy. In addition, the yen is a key international reserve currency.

Japan is the world's largest net external creditor in absolute terms, with projected net assets of an estimated 322% of current account receipts at yearend 2010. The country's current gold and foreign exchange reserves of over US$1 trillion are second only to China's. In addition, both the financial sector and the combined corporate and household sectors are external creditors. Standard & Poor's expects continued current account surpluses to further enhance Japan's net external asset position in the coming years.

In our judgment, Japan's financial system appears sound, following several years of restructuring and private sector deleveraging. Despite the damage by the tsunami, we do not expect a major rise in credit losses in the banking system on a whole, although there are some local financial institutions that
we expect may need government support.

The denomination of 2% of declared international reserves in yen as of the end of September 2010 illustrates the yen's reserve currency status. In addition, 17% of daily global foreign exchange transactions are denominated in yen as of April 2010, and Japan's deep domestic capital markets, combined with its open
capital account, permit the use of the yen as a global financing vehicle.

Outlook

The negative outlook signals that a downgrade is possible if Japan's public finances weaken further over the next two years in the absence of fiscal consolidation to offset them. We believe that uncertainty over the country's fiscal and economic outlook will lessen over the next six to 24 months.  If the government's debt trajectory remains on its current course or begins to erode the nation's external position, the long- and short-term ratings could be lowered. If reconstruction costs place less burden on public finances than we expect–either because of lower outlays or increased revenues to cover them–and the government makes progress in strengthening Japan's fiscal profile, we could revise the outlook back to stable.