Singapore, May 31, 2011 -- Moody's Investors Service has today placed the Government of Japan's Aa2 local and foreign currency bond ratings on review for possible downgrade.
The review has been prompted by heightened concern that faltering economic growth prospects and a weak policy response would make more challenging the government's ability to fashion and achieve a credible deficit reduction target. Without an effective strategy, government debt will rise inexorably from a level which already is well above that of other advanced economies.
Although a JGB funding crisis is unlikely in the near- to medium-term, pressures could build up over the longer term, and which should be taken into account in the rating, even at this high end of the scale. Moreover, at some point in the future, a tipping point could be reached, and at which the market would price in a risk premium to government debt.
More specifically, factors driving the decision are:
1. The much larger than initially expected economic and fiscal costs of the March 11 earthquake are magnifying the adverse effects imparted by the global financial crisis from which Japan's economy has not completely recovered.
2. Concern that the policy framework will continue to fall short of achieving deficit reduction on a timely basis.
3. The vulnerability of a long-term 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, or 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. The short-term rating is unaffected and remains unchanged at P-1.
RATIONALE FOR THE REVIEW
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 GDP growth of 4% in 2010 may prove to be the strongest among the major advanced economies, the apparent rebound was actually much weaker in nominal terms, and faltered in the fourth quarter of 2010. The March 11 earthquake contributed to a 3.7% annualized contraction in real GDP in the first quarter of 2011, sending the economy into its third recession in a decade.
In addition, the fiscal consequences of the earthquake are proving much greater than initially expected. Preliminary indications are that the direct costs to the government's budget may amount to around 2% of GDP, not including costs that may arise from Tokyo Electric Power's liabilities from the devastated Fukushima Daiichi Nuclear Power Station. This would be twice as great as those of the 1995 Kobe earthquake.
These developments further hamper the ability of the economy to achieve a growth rate that is strong enough to help achieve a steady reduction in the budget deficit. 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 effective and timely 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, Japan's 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 continue to threaten to bog down such efforts.
While we do not see the government encountering a funding crisis in the near- to medium-term, no country can continue to run large fiscal deficits forever.
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.
CREDIT SUPPORT FACTORS
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 and in the months after the March 11 earthquake, JGBs continued to demonstrate strong safe haven features because of a deep and dependable domestic funding base.
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 more than 50% was the largest of any industrialized advanced country — almost twice as large as Germany's, 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 the trade balance.
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 ACTION
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 a susceptibility to a credit market tipping point, which could lead to an abrupt fall in JGB prices and a rise in yields, which would in turn result in downward rating pressures.
The focus of the rating review is twofold: (a) an assessment of the scope, effectiveness, and timeliness of the administration's proposed comprehensive tax reform program, and (b) the near- and long-term fiscal costs and economic consequences of the March 11 earthquake.
While we do not see immediate pressures from other risk factors, potential adverse developments in a number of areas would add downward pressures on the rating trajectory. These include:
1. A reduction in 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.
2. 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.
A fiscal and economic reform program which holds promise for stabilizing government finances and eventually deflecting downward the rise in the government debt trajectory would be consistent with a rating in the Aa range.
On the other hand, a weak or delayed reform program coupled with continued weak economic growth prospects would put greater downside pressure on the rating and reduce the probability that it could remain in the Aa range.
PREVIOUS RATING ACTION & METHODOLOGY
The last rating action on the Government of Japan was on 22 February 2011, when Moody's changed the outlook on Japan's government bond ratings to negative from stable.
The principal methodology used in this rating was Sovereign Bond Ratings published in September 2008.
The Yen reacts accordingly: