S&P Revises Japan Outlook To Negative On "Diminishing Economic Policy Flexibility," Still Rated AA

More rumblings of an actual (gasp) downgrade down the line? S&P's report on Japan:


  • Japan's economic policy flexibility has diminished as a result of increased fiscal deficits and government debt, persistent deflation and a prospect of continued sluggish economic growth.
  • We revised the outlook on the long-term rating to negative from stable.
  • We affirmed our 'AA' long-term and 'A-1+' short-term sovereign credit ratings on Japan.

Rating Action

On Jan. 26, 2010, Standard & Poor's Ratings Services revised to negative from stable its outlook on the 'AA' long-term rating on Japan. At the same time, we affirmed our 'AA' long-term and 'A-1+' short-term local and foreign currency sovereign credit ratings on Japan.


The outlook change reflects our view that the Japanese government's diminishing economic policy flexibility may lead to a downgrade unless measures can be taken to stem fiscal and deflationary pressures. At a forecasted 100% of GDP at fiscal yearend March 31, 2010, Japan's net general government debt burden is among the highest for rated sovereigns. Moreover, the policies of the new Democratic Party of Japan (DPJ) government point to a slower pace of fiscal consolidation than we had previously expected. Combined with other social policies that are not likely to raise medium-term trend growth and with persistent deflationary pressures, we forecast that Japan's net general government debt to GDP will peak at 115% of GDP over the next several years.  

The affirmation of the 'AA' sovereign ratings on Japan rests on the country's strong net external asset position, the yen's status as a reserve currency, the financial system's resiliency throughout the recent global recession, and the economy's diversification. We believe that these strengths will keep the government's rating in the 'AA' category, even if further fiscal deterioration leads to a one notch downgrade.  

A strong net external asset position and the yen's key international currency position provide ample external liquidity and good access to global capital markets. Japan is the world's largest net external creditor in absolute terms with projected net assets of an estimated 309% of current account receipts at the end of 2009. The country's current gold and foreign exchange reserves of over US$1 trillion are second only to China's. Standard & Poor's expects Japan's net external assets to rise further in the coming years due to continued current account surpluses.

The global financial crisis affected Japan's financial system less than its counterparts in the U.S. and Europe. Compared with its equity base, Japan's financial system had relatively little exposure to troubled asset classes of structured finance and Japan's private sector is nearing the end of a decade-long process of deleveraging. The liquidity support policies of the Bank of Japan have assisted the country's financial system in facing the instabilities in global capital and financial markets.

However, the following factors suggest mounting pressure on Japan's credit quality:

  • Large fiscal deficits and outstanding debt. Stimulus measures to deal with the sharp decline in external and domestic demand will lift fiscal deficits to 10% of GDP in fiscal 2010 (ending March 31, 2011), and the government may extend the target of attaining a primary surplus well beyond a decade. Our forecast that net general government debt to GDP will peak at around 115% of GDP over the next several years assumes that Japan's recession is not protracted.  
  • Policy shifts by the new government, elected in August 2009, appear to place greater emphasis on redistribution of wealth, in part reflecting coalition dynamics. As a result, although there is still a commitment by the government to public sector reform, we do not see a comprehensive plan to boost growth potential and hence government revenues in the medium term. That said, we do not believe that the broad thrust of macroeconomic management that has characterized Japan for half a century will change.     
  • More than a decade of deflation. This has slowed economic activity by hurting the business environment and domestic consumption.
  • Aging population. Japan's fast-aging population challenges the government's inter-temporal fiscal position and depresses its economy's growth prospects. The nation's total social security related expenses now make up 30% of the fiscal 2010 budget. Although the country successfully reduced some of its long-term liabilities from its defined-benefit pension fund system in 2004 (by extending the period before benefits are paid, increasing members' contributions, and reducing the amount of payouts), more comprehensive reforms are necessary to ensure the system's long-term sustainability.


The ratings on Japan could fall by one notch if economic data remain weak and measures to boost medium-term growth are not forthcoming, given the country's high government debt burden and its weak demographic profile. Standard & Poor's will be looking for signs of government policy toward fiscal consolidation in the update of its medium-term fiscal plan, due to be released in the first half of 2010.  Additional policy initiatives may also be revealed after the upper house elections in July. If on the other hand we conclude that government policies, either on the fiscal side or structural reform side, will moderate the government's debt trajectory, the ratings could stabilize at the current levels.
Ratings List

Outlook Revised

                                   To                      From
Foreign currency         AA/Negative/A-1+   AA/Stable/A-1+
Local currency            AA/Negative/A-1+   AA/Stable/A-1+

Ratings Affirmed

Foreign Currency       AA/A-1+
Local currency           AA/A-1+