Moody's Investors Service has today changed the outlook on the Government of Japan's Aa2 rating to negative from stable.
The rating action was prompted by heightened concern that economic and fiscal policies may not prove strong enough to achieve the government's deficit reduction target and contain the inexorable rise in debt, which already is well above levels in other advanced economies. Although a JGB funding crisis is unlikely in the near- to medium-term, pressures could build up over the longer term which should be taken into account in the rating, even at this high end of the scale.
More specifically, factors driving the decision are:
1. The severity and persistence of the shock that the global financial crisis imparted on Japan's government finances and on aggravating pre-existing deflationary pressures,
2. As a result, the current policy framework will not be capable of overcoming hurdles blocking a return to a path of fiscal deficit reduction,
3. Increasing uncertainty over the ability of the ruling and opposition parties to fashion an effective policy reform response to the debt and growth challenges, and
4. Vulnerability inherent in the long-time horizon of Japan's gradual fiscal consolidation strategy to worsening domestic demographic pressures, as well as to possible, renewed shocks in a fragile and uncertain, post-crisis global economic environment.
The rating action does not affect the Aaa foreign currency bond and bank deposit ceilings, the outlooks for which remain stable. Nor does the rating action affect the Aaa local currency bond and bank deposit ceilings. The ceilings act as a cap on ratings that can be assigned to the domestic or foreign currency obligations of other entities domiciled in the country.
RATIONALE FOR THE CHANGE IN OUTLOOK
The global financial crisis has had a deep effect on Japan's economy. It has significantly raised the hurdles which policy efforts must overcome to reach the government's 2020 balanced primary budget target (excluding interest expenditure). While Japan's real GDP growth of 3.9% in 2010 may prove to be the strongest among the major advanced economies, the apparent rebound was actually weaker in nominal terms.
Nominal GDP growth was a modest 1.8% on account of chronic deflationary pressures, which were aggravated by the global financial crisis. Over the long term through to 2020, the government does not envisage growth breaking out of the 1-2% real and nominal range in its baseline, "Prudent" scenario.
Moreover, even under the government's more optimistic "Growth Strategy" scenario, the envisaged rise in nominal GDP to 3.8% by 2020 will by itself not be strong enough to eliminate the primary budget deficit—thus the importance of policy reform. While a more buoyant global economy and a higher domestic labor force participation rate would boost growth under this scenario, new fiscal measures are unavoidably necessary to close the primary deficit.
To that end, the government intends to introduce a comprehensive tax reform program in June. However, the divided Diet -- in which the opposition Liberal Democratic Party controls the Upper House -- and the intensifying level of political challenges to Prime Minister Kan together threaten to bog down such efforts.
By contrast, we note that under that stable government of Prime Minister Koizumi from 2001-2006, confidence in the economy improved and policies gained traction. Were it not for the global financial crisis, the Koizumi target for a primary budget balance may have already been achieved.
While we do not see the government encountering a funding crisis in the near- to medium-term, we agree with Bank of Japan Governor Masaaki Shirakawa's view that "as history shows, no country can continue to run (large) fiscal deficits forever" (7 Feb 2011 speech, "Toward a Revitalization of Japan's Economy").
Large deficits and the collapse of growth since the early 1990s have led to an overhang of government debt that is by far the largest among the major advanced economies -- whether projected at 226% of GDP by the IMF, or at 174% of GDP by the Cabinet Office for 2010 (accounting practices explain the difference). Moreover, both sources project an inexorable rise in debt over the long term under current policy and growth assumptions.
RATING OUTLOOK DYNAMICS AND CREDIT SUPPORT FACTORS
Should the government of Japan put into place a comprehensive package of fiscal and supply-side economic reforms in June, we would monitor developments to assess their efficacy in stabilizing the government's credit fundamentals.
Japan's credit strengths lie mainly in its deep financial markets from which spring an exceptional home bias. The government can fund itself at a lower nominal cost than any other advanced economy. Moreover, throughout the global financial crisis, JGBs demonstrated sounder and more stable safe haven features than even US Treasuries, as the government relies on a domestic funding base buttressed by an ample stock of household savings equal to three times GDP and relatively moderate indebtedness.
Related to Japan's home bias is its strong external payments position which insulates the country from external shocks. In addition to a seemingly structural current account surplus on the balance of payments, its net international investment position, at 58% of GDP in 2009, was the largest of any industrialized advanced country — larger than Germany's 28% of GDP, while Aa-rated Spain and Italy had net liability positions. In fact, net income receipts from overseas assets provide a bigger contribution to the current account surplus than net merchandise trade.
Lastly, the strong external payments position is a reflection of the continuing competitiveness of Japan's large, export-oriented companies. Despite the recent appreciation of the yen, we see this sector continuing to support growth and the external position over the long term.
CREDIT TRIGGERS FOR A FUTURE RATING ACTIONS
Japan's very large economy and very deep financial markets provide the wherewithal to absorb economic shocks. Nevertheless, the inexorable rise in government debt suggests that actions are urgently needed to regain a path of fiscal consolidation. Moreover, the government's large refinancing needs introduce susceptibility to financial tipping points, which could lead to abrupt, downward rating pressures. These may include:
1. An inability by the government to put into place its comprehensive tax reform program, or its adoption of weak measures that postpone action into the indefinite future.
2. A depletion of the domestic funding base to a level that is insufficient to meet government refinancing requirements. This could arise from a drop in the household savings rate into negative territory.
3. A shift in the current account on the external balance of payments into deficit. This would reflect a downshift in national savings and would raise government funding costs to a level on par with those in foreign government debt markets. It could also sharply raise the risk premium for JGBs.
On the upside, policies which help revitalize the economy and which lead to a clear and sustainable reduction in fiscal deficits would support the current Aa2 rating.
We expect the outlook horizon to extend over the next year or two, depending on developments.
PREVIOUS RATING ACTION & METHODOLOGY
The last rating action was on the Government of Japan on 18 May 2009, when Moody's unified Japan's public sector ratings at Aa2 with a stable outlook.
The principal methodology used in rating the government of Japan is "Moody's Sovereign Bond Methodology", which was published in September 2008.
Press releases of other ratings affected by this action will follow separately.