Less than two weeks ago [19]we were delighted to remind S&P that about a year ago, the laughable rating agency which is now terrified of being sued any time it tells the truth, promised it would downgrade Japan the moment things for the insolvent nation turn up to be, well, just as they are with the Bank of Japan now monetizing every yen of Japanese debt issuance. And yet, so far S&P has been very quiet on the downgrade front, most likely because it still has its hands full on the litigation front with the DOJ (and Tim Geithner) for downgrading the US back in 2011. So overnight we were not exactly surprised when that "other" rating agency, Moody's, shocked the world and headline scanning algos when it downgraded Japan by 1 notch from Aa3 to A1.
Here are the reasons why Moody's just did what it did, just two weeks ahead of the all-important for Abenomics snap election, in which should support for Abe tumble, then all bets on Abenomics, and the global stock market reflation game, are off.
The key drivers for the downgrade are the following:
- Heightened uncertainty over the achievability of fiscal deficit reduction goals;
- Uncertainty over the timing and effectiveness of growth enhancing policy measures, against a background of deflationary pressures; and
- In consequence, increased risk of rising JGB yields and reduced debt affordability over the medium term.
The full Moody's report below (link [20])
The A1 rating reflects the government's significant credit strengths, including a large, diverse economy with a strong external position, very high institutional strength and a very strong domestic funding base.
The stable outlook reflects the broad balance between upside risks including significant fiscal consolidation and a resumption of economic growth, and downside risks including intensification of deflationary pressures and loss in economic momentum.
The rating action does not affect Japan's Aaa foreign currency, local currency country and bank deposit ceilings. Those ceilings act as a cap on ratings that can be assigned to the obligations of other entities domiciled in the country.
RATIONALE FOR DOWNGRADE
DRIVER 1: HEIGHTENED UNCERTAINTY OVER REACHING FISCAL TARGETS AND CONTAINING DEBT
The first driver for the downgrade of the Japan government's debt rating to A1 is the rising uncertainty over whether the government's medium-term deficit reduction goal is achievable, and whether policy makers can overcome the tensions inherent in promoting growth while simultaneously stabilizing and reversing the rising debt trajectory.
The Bank of Japan remains committed to monetary expansion, with some positive impact on core CPI inflation. However, while monetary expansion has boosted domestic aggregate demand to some extent, the consumption tax increase on April 1 2014 has exerted even more powerful downward pressure. At least in the short term, deficit reduction is undermining the growth revitalization objective of Prime Minister Shinzo Abe's economic policy strategy.
The government's response, to announce a delay in the second step in the consumption tax increase, appears to represent a shift in policy towards stemming re-emerging deflationary pressures on economic growth and away from near-term fiscal deficit reduction. This strategy could have merits. In our view, the government's target of halving the primary deficit balance, excluding budgetary interest payments, by fiscal 2015 from its fiscal 2010 level will be difficult to achieve without more robust nominal GDP growth and hence improved buoyancy in tax revenues. In their absence, reaching the long-term target of a primary balance surplus by 2020 will be even more challenging.
However, the strategy also poses risks to fiscal consolidation and, over the longer-term, to debt affordability and sustainability. Japan's deficits and debt remain very high, and fiscal consolidation will become increasingly difficult to achieve as time passes given rising government spending, particularly for social programs associated with a rapidly ageing population.
The government acknowledges that additional but as yet unidentified economic and fiscal reforms will be needed for Japan to achieve its primary balance target in the second half of this decade. But the postponement of the second stage of the increase in the consumption tax has resulted in the delay of the 2015 budget, and a concrete plan to meet fiscal targets is not likely to emerge until the second half of 2015. The trajectory of government debt, projected at 245% of GDP in 2014 according to the IMF, will only start to decline under the most favorable combination of economic and fiscal reforms, including tax and social security system reforms and total factor productivity improvements, an end to deflation and achievement of annual nominal GDP growth of more than 3.5%. Given current domestic circumstances and lackluster external demand for Japan's exports, achieving these conditions will be challenging.
DRIVER 2: ECONOMIC GROWTH POLICY UNCERTAINTIES AND CHALLENGES IN ENDING DEFLATION
The second driver for the downgrade is the rising uncertainty over the government's ability to enhance medium term growth through structural economic reform -- the third 'arrow' of Abenomics -- success in which will be crucial to achieve fiscal consolidation. While some indicators suggest a pick-up in economic activity over the past year, potential economic growth remains low.
GDP growth sharply contracted in the second quarter of this year following the introduction on 1 April of the first step of the consumption tax increase, to 8% from 5%. Output was also affected by adverse weather in the summer to some extent. And both real and nominal GDP contracted again in the third quarter of the year, putting Japan's economy in recession for the third time since global financial crisis.
Moreover the relapse of the GDP deflator, the broadest measure of price movements, into negative territory in the third quarter of this year highlights the difficult nature of ending more than a decade of deflation. Although the ratcheting up by the Bank of Japan of its quantitative easing policies in October may once again move the deflator back onto positive ground in the fourth quarter of 2014, the task ahead for economic revitalization and price reflation is looking more challenging than envisaged by Prime Minister Abe when he introduced his three-arrow economic policy package in March 2013.
Looking further ahead, the most notable structural reform measure to be implemented to date is a reduction in corporate taxation beginning in fiscal 2015. The details have yet to be announced, and the implications for business investment are therefore still unclear. It is not yet clear what further measures the government will choose, or be able, to take to address the deep-rooted structural problems of Japan's economy, including broadening labor force participation, enhancing corporate governance and dealing with the challenges posed by demographic trends.
DRIVER 3: EROSION OF POLICY EFFECTIVENESS AND CREDIBILITY COULD UNDERMINE DEBT AFFORDABILITY
The third driver for the downgrade is the potential implications of the first two drivers for the affordability and sustainability of Japan's huge debt load. Debt sustainability will rest on the continued willingness of domestic investors to provide funding at affordable rates for the government. This looks likely to remain the case as long as investor confidence is not undermined. The JGB market has been characterized by low and stable interest rates despite the exceptional rise in debt since the 1990s. And JGB interest rates have remained low and stable through a number of crisis episodes, including Japan's 1997-1998 financial crisis, the 2008 global financial crisis and the 2011 tsunami and Fukushima nuclear power plant disaster.
Nonetheless, the Bank of Japan's efforts to raise inflation to 2% may eventually put pressure on government bond yields and thereby raise government borrowing costs. Rising interest rates would increase expenditure and offset gains from revenue buoyancy. Rising uncertainty regarding the government's capacity to deliver on its policy objectives could raise yields without any commensurate rise in revenues. Either outcome would further undermine the government's ability to meet its fiscal deficit targets and reduce its debt burden over the medium term, and eventually start to undermine debt sustainability.
RATIONALE FOR A1 RATING AND STABLE OUTLOOK
JAPAN'S CREDIT STRENGTHS SUPPORTED BY A DEEP DOMESTIC BOND MARKET, STRONG INSTITUTIONS, LOW VULNERABILITY TO EXTERNAL SHOCKS
Whatever the challenges facing the government, Japan retains very significant credit strengths. Its A1 rating and stable outlook are supported by its large, diverse economy, which we characterize as having 'High' economic strength. And even with the very significant debt burden, we believe that Japan exhibits only 'Low' susceptibility to event risk. A marked home bias on the part of resident investors provides a strong funding base —domestic investors retain a marked preference for government bonds, which has allowed fiscal deficits to be funded at the lowest nominal rates globally over the past two decades. Private sector fiscal surpluses remain more than adequate to fund government deficits, without the government resorting to external funding. We believe that very high institutional and structural strengths, including a decisive and powerful central bank, currently sustain this funding advantage and are very unlikely to diminish over the rating horizon.
Although Japan's government gross financing requirements are far larger than other advanced country governments', contingent risks which could elevate further such financing needs are low and remote. Japan's banking and corporate sectors have restored their health in recent years in terms of capitalization and deleveraging. Household debt is at a moderate level and has remained stable over the past decade. And despite low economic growth, Japan's labor market is relatively sound in regard to key features, such as low unemployment level, the recent pick-up in employment and nominal wages and a labor force participation rate broadly comparable with other advanced economies.
Related to Japan's home bias is its strong external payments position, which reflects the accumulated system-wide savings. At more than 60% of GDP in 2013, Japan's net international investment position is much larger than any advanced industrial G-20 economy, insulating its economy and capital market from global shocks. Income earned from Japan's sizable external assets has helped to sustain the current account surpluses, although this has diminished owing to a shift into a trade deficit which is in large part driven by the demand for energy imports following the shutdown in the nuclear power industry after the 2011 tsunami and Fukushima nuclear power plant disaster.
WHAT COULD MOVE THE RATING DOWN / UP
While the stable outlook indicates that we believe the rating is well positioned for the next twelve to eighteen months, factors that could prompt a negative rating action include significant divergence from the path toward achieving fiscal targets; an intensification of deflationary pressures; a severe loss in economic momentum; or a shift in the external current account surplus into persistent deficit.
Moody's would consider a positive rating action if Japan were to implement policies that we concluded were likely to restore economic momentum and improve prospects for significant fiscal consolidation and debt reduction.