Japan’s sovereign credit rating downgrade to Aa2 is not surprising: DBS

Moody’s downgrade of Japan’s sovereign credit rating to Aa3 from Aa2 came as no surprise yesterday. Moody’s has placed Japan on review for a possible downgrade ever since three months ago, and S&P has moved earlier this year to cut Japan’s rating to AA-. Japan’s outstanding public debt equivalent to 200% of GDP is already the world’s highest, and the upward trend in the public debt-to-GDP ratio is unlikely to stabilize anytime soon, because: 

1) the primary fiscal deficit is large at about 5% of GDP; 2) nominal GDP growth averaged in the past decade is near zero; 3) despite the short-term interest rates are close to zero too, the long term bond yields and the effective interest rates on debt repayment are staying in the positive territory.

Stabilizing the public debt ratio will require fiscal consolidation and/or structural economic reforms to boost the long term growth potential. Effective policy implementation is not in sight however, in the lack of strong political leadership. The natural disasters occurred in March have also increased public spending and cast doubts on the country’s longer-term economic prospects.

The market reaction of yesterday’s rating downgrade is muted. The JGB yields and the yen/dollar rate were little changed, and the 5-year CDS rose slightly by 2.5bps. Different from the twin deficit situation in the US and peripheral European economies, Japan still has excessive savings in the private sector to help finance its public debt, and its current account remains in the surplus zone.

There is low probability of JGB default in the shortto-medium term, and the yen is still seen as a safe haven currency. Ironically, despite the sovereign rating downgrade, the Japanese authorities still have to focus on stemming the appreciation of the yen amid the weak dollar environment. Yesterday the finance ministry announced to provide a USD 100bn credit line to increase Japanese companies’ overseas investment, and to monitor financial institutions’ FX positions.

The effectiveness of these measures are doubtful – the former will not have immediate effects, while the requirement of reporting FX positions is not associated with any penalty action.