Following Abe's decision to delay the April 2017 increase in the consumption tax, warnings about Japan's rating (recall that Japan's consolidated debt/GDP ratio is the highest in the world at 400%) were inevitable, and moments ago Fitch was the first to come out and while "affirming" Japan's AA rating, it was the first major agency to cut its outlook from Stable to Negative. Expect the other two big agencies to do the same, followed inevitably by downgrades.
For now, however, the market does not care the tiniest bit about Japan's ruinous fundamentals, and instead just wants to frontrun the BOJ inevitable easing, as a result yields across the Japanese curve have dropped to fresh record lows.
Here is the full note:
Fitch Ratings-Hong Kong-13 June 2016: Fitch Ratings has affirmed Japan's Long-Term Foreign- and Local-Currency Issuer Default Ratings at 'A' and revised the Outlooks to Negative. The issue ratings on Japan's senior unsecured local-currency bonds are also affirmed at 'A'. The Country Ceiling is affirmed at 'AA' and the Short-Term Foreign-Currency IDR at 'F1'.
KEY RATING DRIVERS
The revision of the Outlooks on Japan's IDRs to Negative from Stable reflects the following key rating drivers:
- The Japanese government announced on 1 June that it had decided to delay a scheduled increase in the consumption tax from April 2017 until October 2019 (having already delayed the hike from the original date of October 2015), and did not identify any specific offsetting measures. The Outlook revision primarily reflects Fitch's decreased confidence in the Japanese authorities' commitment to fiscal consolidation.
- The consumption tax increase was an important element in the government's fiscal consolidation strategy, which aims to bring the primary deficit of the general account of the central and local governments into balance by the fiscal year from April 2020 to March 2021 (FY20), against a 3.3% deficit in FY15. Fitch had expected the increase in the consumption tax rate to 10% from 8% to yield about 0.8% of GDP for deficit reduction (netting out some enhanced social spending it would have funded; it is unclear whether these increases will still occur). When announcing the delay, the government said it remains committed to its target of primary balance by FY20, although it did not set out any further specific measures to achieve this goal.
- Fitch no longer expects the consumption tax to rise in its base case. Fitch's revised fiscal projections are for the ratio of gross general government debt to GDP to continue rising from 245% at end-2016 by 1-2pp per year over the projection period out to 2024, rather than peaking at 247% in 2020 as previously expected.
- The government indicated that its primary reason for delaying the tax increase was to shore up growth and boost the prospects of escaping deflation. With the delay in the tax increase, Fitch has revised its 2017 growth forecast up to 0.7% from 0.5% at the time of the April 2016 review. Fitch has also revised its 2016 forecast up to 0.8% from 0.7%. The 2016 revision balances a negative effect from the absence of consumption brought forward into 2016 to beat the tax hike against the impact from the higher-than-expected quarter-on-quarter growth in 1Q of 1.9%, seasonally adjusted annual rate.
Japan's 'A' IDRs also reflect the following rating factors:
- Japan's structural fundamentals sit comfortably alongside those of the most highly-rated sovereigns. Japan is one of the world's most advanced, productive and wealthy economies. Japan's standards of governance and the quality of its public institutions are among the strongest globally. The role of the Bank of Japan (BoJ) as issuer of an international reserve currency supports policy flexibility and debt tolerance. The country has a very high degree of social and political stability.
- Japan's credit profile benefits from the sovereign's exceptionally strong debt tolerance and funding capacity, although these do not entirely offset weaknesses elsewhere in the public finances. The sovereign's strong funding position partly reflects the deep pool of private-sector Japanese savings and the strong demand of the financial system for government debt. The Japanese domestic nonfinancial sector had gross financial assets of about 707% of GDP at end-2015, about the same as end-2014 and up from about 559% at end-2008.
- Japan's macroeconomic performance is a credit weakness. Nominal GDP growth has been much weaker than in most other advanced economies since the bursting of Japan's financial bubble in the early 1990s. Aggressive "Abenomics" policies since early 2013 have not yet convincingly broken the economy out of deflation or demonstrably raised potential growth. The evidence on the effectiveness of the BoJ's adoption of a negative interest rate in January 2016 is mixed so far. The BoJ is already expanding Japan's monetary base by about 16% of GDP annually and may face technical constraints in expanding qualitative and quantitative easing further. These factors may force the central bank either to accept a decrease in its policy flexibility or to consider less orthodox means of easing policy with less well understood transmission channels and uncertain effects on business, household and investor confidence.
- Japan's external finances are a rating strength both in terms of solvency and liquidity. Fitch estimates the country's net external position in debt-like assets will reach 70% of GDP by end-2016. Official foreign reserves reached USD1,254bn at end-May 2016, up from USD1,233bn at end-2015.Fitch estimates Japan's reserves will be worth about 18 months of current external payments by 2016, which is strong on any comparison.
SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Japan a score equivalent to a rating of 'A+' on the Long-Term Foreign-Currency IDR scale.
Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final Long-Term Foreign-Currency IDR by applying its QO, relative to rated peers, as follows:
- Macroeconomic Performance and Policy Management: -1 notch, to reflect relatively weak potential growth (most estimates range between 0.5% and 1% a year); rising uncertainty over fiscal strategy; and risk of constraints emerging on BoJ's policy flexibility
- Public Finances: -1 notch, to reflect fragile debt dynamics, more than offsetting the support from strong funding flexibility.
- External Finances: +1 notch, to reflect strengths in Japan's external finances not captured in the SRM, including the large net external creditor positions (both sovereign and whole-economy) and the structural current account surplus.
Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a Long-Term Foreign-Currency IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
The main factors that could, individually or collectively, lead to a negative rating action are:
- Lack of measures to compensate for the fiscal impact of the delay in the consumption tax increase, or other policy measures that further undermine Fitch's confidence in political commitment to fiscal consolidation
- Weaker macroeconomic performance than Fitch expects for a sustained period, intensifying the challenge of stabilising the public finances
- A sharp and sustained rise in real interest rates on government debt to a level that undermined debt sustainability
The Rating Outlook is Negative. Consequently, Fitch's sensitivity analysis does not currently anticipate developments with a high likelihood of leading to a positive rating change. Future developments that could individually, or collectively, result in the Outlook being revised to Stable include:
- Policy adjustments leading to increased confidence that the Japanese authorities are committed to achieving fiscal consolidation
- A stronger macroeconomic outlook than Fitch currently expects, making fiscal consolidation easier to achieve
- The ratings assume that the confidence of the Japanese public in the country's basic economic and financial stability is maintained, such that the Japanese sovereign's exceptional funding flexibility remains intact.
- Fitch assumes that there is no significant escalation in global or regional geopolitical tensions, for example, Japan's maritime territorial disputes with China, to a level that could disrupt economic activity.