Ratings tremor rocks Japan

Japan’s wounded, high-on-debt economy received the thumbs-down from ratings agency Standard & Poor’s on Tuesday, drawing attention to sovereign risks creeping around the world.

S&P cut its outlook on Japan’s long-term sovereign debt rating from ‘stable’ to ‘negative’, but maintained its long-term and short-term local and foreign currency sovereign credit ratings at AA and A-1+ respectively.

The agency said 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.”

It further said that the new Japanese government’s policies “point to a slower pace of fiscal consolidation than we had previously expected.” By some estimates, Japan’s public debt currently runs at over 200% of GDP.

The timing of S&P’s announcement “was somewhat abrupt”, given that Japan is in the middle of budget deliberations, notes Barclays Capital analyst Chotaro Morita.

The action was perhaps motivated by a widening in the credit default swaps — the premium on the risk of default — in countries with deteriorating public finances amidst troubles in Greece, he reasoned.

But Japan is something of an aberration in Asia-Pacific, given that most other countries in the region are “demonstrating resilience” in their sovereign ratings through the global crisis, according to another leading ratings agency, Moody’s Investor Service.

Except for Japan, “most countries in the region entered the crisis with sound fiscal positions,” Moody’s noted. And again, except for Japan, all countries in the region are moving at various speeds towards exit strategies, in line with the recovery in economic output in the latter half of 2009 and the return of risk appetite and associated capital inflows.

Japan is the one industrialised country that has experienced a series of downward ratings actions since the end of 1990s — even before the latest cycle of fiscal deterioration, points out Morita.

The lesson that many analysts took away from that was that a country with a current account surplus was unlikely to experience a full-blown capital flight and had limited currency depreciation risk, and so a surge in long-term yields due to inflation would not occur.

But this time around, Morita notes, “Japan is not alone: there are other industrialised countries with similar fiscal deficits, including the US and the UK.” Therefore, although past experiences “suggests yen bond yields are unlikely to surge amid ‘sell Japan’ dynamics, it would not be entirely impossible to see dramatic developments on a global scale surrounding a ‘fiscal crisis’ theme,” Morita adds.

Under such a scenario, yen bond markets too could be affected, “but even in that case, there is no obvious destination for the funds that simultaneously take flight from several massive government
bond markets,” he says.

“Even if there are fluctuations in exchange rates and long-term interest rates spreads over the short term, it is unclear whether such changes would last over the long term.”

While sounding its cautionary note, S&P also flagged some of Japan’s hidden strengths: a current account surplus, large gold and foreign exchange reserves (second only to China) and the yen’s importance as an international currency, which implied that Japan has good access to global capital markets.

Moody’s pointed out that Japan’s debt-to-GDP ration likely increased the most in the region during the crisis - by about 35% between 2007 and 2010.

“However, Japan’s debt currently remains affordable as it appears that the market will continue to absorb Japanese government bond (JGB) issuances at favourable yields.