Fitch Ratings has downgraded Japan's Long-Term Foreign and Local Currency Issuer Default Ratings (IDRs) to 'A+' from 'AA' and 'AA-' respectively. The Outlooks on both IDRs are Negative. The Country Ceiling is downgraded to 'AA+' from 'AAA'. The Short-Term Foreign Currency IDR is affirmed at 'F1+'.
"The downgrades and Negative Outlooks reflect growing risks for Japan's sovereign credit profile as a result of high and rising public debt ratios," said Andrew Colquhoun, Head of Asia-Pacific Sovereigns at Fitch. "The country's fiscal consolidation plan looks leisurely relative even to other fiscally-challenged high-income countries, and implementation is subject to political risk."
Japan's gross general government debt is projected to hit 239% of GDP by end-2012, by far the highest for any Fitch-rated sovereign. This debt ratio would also have risen 61pp since the global financial crisis. This compares with a median of 39pp for OECD economies and 8pp for 'A' range sovereigns. Japan is less of an outlier when account is taken of its large pile of sovereign financial assets (worth about 80% of GDP on Fitch's calculations), but net indebtedness is still rising strongly.
Japan's Fiscal Management Strategy envisages declines in the government debt/GDP ratio only from FY21. Fitch regards this as a slow pace of consolidation given the scale of Japan's debt. Moreover, Japan's consolidation strategy is subject to political risk. The government's key revenue-raising plan is to hike the consumption tax to 10% by FY15 from 5% now. The measure is back-loaded (planned to start in FY14) and remains highly politically controversial.
Nonetheless, the Japanese sovereign retains exceptional financing flexibility and can fund itself at low nominal yields, a factor Fitch recognises as a support to the ratings. Funding flexibility is further reinforced by the role of the broader public sector in channelling savings to the sovereign: about half of government debt is held within the broader public sector. This funding strength is based on the deep pool of Japanese private sector savings, invested with strong "home bias". The Japanese yen is a global reserve currency and exhibits safe haven characteristics.
However, Fitch considers that this private sector savings behaviour may itself contribute to the economy's persistent deflationary equilibrium. The economy has experienced recurring deflation since 2001 and real GDP growth lags high-income peers. Nominal GDP of JPY468.6trn in 2011 was 0.2% lower than in 1991. Weak nominal GDP growth threatens to undermine fiscal solvency in the longer term.
Strong private savings contribute to the country's persistent current account surpluses, adding to an official foreign reserves stockpile worth USD1.3trn at end-2011. However, Fitch judges it is appropriate to equalise Japan's FC and LC IDRs on the view that pressure on the sovereign's funding position, if it emerges, would involve changes to Japanese savings and investment behaviour that would likely affect the FC credit profile too.
Japan's sovereign ratings are supported by fundamental structural strengths including one of the world's most advanced high-income economies and strong public institutions. However, its demographic profile is a structural weakness. Working-age population has been in decline since the mid-1990s. The authorities estimate ageing is adding about 0.2% of GDP per year to the social security bill, indicating that Japan needs to make progress fiscally just to offset pressure from population ageing.
The downgrade of the Country Ceiling is in line with Fitch's methodology and published criteria. Fitch recognises the strength of Japan's external finances both on a sovereign and whole-economy level, and Japan's integral role in the global economy. The conditions under which transfer and convertibility risk would be likely to arise for Japan remain remote in Fitch's view.
A lack of new fiscal policy measures aimed at stabilising public finances amid continued rises in government debt ratios could lead to a further downgrade. A shock to Japan's sovereign funding conditions such as a steep and sustained rise in yields would be strongly negative for the ratings, although Fitch does not consider this likely. Conversely, progress on fiscal stabilisation beyond Fitch's expectations could see the Outlooks revert to Stable. Markedly stronger economic growth than Fitch expects for a sustained period would be constructive for public debt sustainability and could see the Outlooks revert to Stable.