S&P Downgrades Japan From AA To AA-, Outlook Stable
- Standard & Poor's expects Japan's fiscal deficits to remain high in the next few years, which will further reduce the government's already weak fiscal flexibility.
- We have lowered Japan's long-term sovereign credit ratings to 'AA-' from 'AA'. We affirmed the short-term ratings at 'A-1+'.
- The outlook on the long-term rating is stable, reflecting our view that Japan's strong external balance sheet and monetary flexibility partially offset the pressures stemming from the fiscal side.
On Jan. 27, 2011, Standard & Poor's Ratings Services lowered its long-term sovereign credit ratings on Japan to 'AA-' from 'AA'. At the same time, we affirmed the 'A-1+' short-term sovereign credit ratings. The outlook on the
long-term rating is stable. The transfer and convertibility (T&C) assessment remains 'AAA'.
The downgrade reflects our appraisal that Japan's government debt ratios--already among the highest for rated sovereigns--will continue to rise further than we envisaged before the global economic recession hit the country and will peak only in the mid-2020s. Specifically, we expect general government fiscal deficits to fall only modestly from an estimated 9.1% of GDP in fiscal 2010 (ending March 31, 2011) to 8.0% in fiscal 2013. In the medium term, we do not forecast the government achieving a primary balance before 2020 unless a significant fiscal consolidation program is implemented beforehand.
Japan's debt dynamics are further depressed by persistent deflation. Falling prices have matched Japan's growth in aggregate output since 1992, meaning the size of the economy is unchanged in nominal terms. In addition, Japan's
fast-aging population challenges both its fiscal and economic outlooks. The nation's total social security related expenses now make up 31% of the government's fiscal 2011 budget, and this ratio will rise absent reforms beyond those enacted in 2004. An aging and shrinking labor force contributes to our modest medium-term growth estimate of around 1%.
In our opinion, the Democratic Party of Japan-led government lacks a coherent strategy to address these negative aspects of the country's debt dynamics, in part due to the coalition having lost its majority in the upper house of
parliament last summer. We think there is a low chance that the government's announced 2011 reviews of the nation's social security and consumption tax systems will lead to material improvements to the intertemporal solvency of
the state. We even see a risk that the Diet might not approve budget-related bills for fiscal 2011, including government financing authorization. Thus, notwithstanding the still strong domestic demand for government debt and corresponding low real interest rates, we expect Japan's fiscal flexibility to diminish.
That said, the sovereign ratings on Japan are supported at the lower '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 254% 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 corporate plus 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 is sound, following several years of restructuring and private sector deleveraging. Standard & Poor's assigns the Japanese banking system a '2' on its Banking Industry Country Risk Assessment (BICRA) scale, which ranges from '1' for the strongest to '10' for the weakest.
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.
The stable outlook on our ratings on Japan balance weak public finances and anemic growth prospects with its strong external position and the flexibility afforded by the yen's international role. Should the government be able to consolidate its finances and to enact measures to improve its growth prospects--as it did in the early part of the last decade--upward pressure on the ratings would build. Conversely, if we again mark down our fiscal forecasts, downward pressure on the ratings could reemerge.