DBRS Confirms A (high) Rating of Japan, Stable Trend

DBRS, Inc. has confirmed its issuer ratings of A (high) to Japan’s long-term foreign and local currency debt, and its issuer ratings of R-1 (middle) to the country’s short-term foreign and local currency debt. The trend on the ratings is Stable.

The rating confirmation and Stable trend reflects Japan’s strong credit fundamentals as one of the wealthiest and most diversified economies. Japan enjoys low financing costs due to its large pool of private sector savings and large domestic investor base. Bank of Japan (BOJ) purchases of Japanese Government Bonds (JGBs) are likely to help maintain low borrowing costs despite the very high public sector debt to GDP ratio. Despite the call for a snap election on December 14, 2014, we expect political conditions to remain favorable. Set against these strengths are the country’s high and rising public debt, chronic government deficits, and longstanding structural constraints that have resulted in low growth and deflationary pressures.

Public finances remain Japan’s main credit weakness. A large public deficit of 7.1% of GDP has contributed to government debt of 245% of GDP, the highest ratio among advanced economies. This high debt burden is susceptible to growth and interest rate shocks. Rising debt without a credible plan for stabilization will put downward pressure on Japan’s ratings. Conversely, the Stable trend could be changed to Positive if fiscal consolidation results in a lower deficit and structural reforms improve medium-term growth prospects.

Japan benefits from safe haven status, reflecting investor confidence in the country’s capacity to service debt even during periods of investor risk aversion. The predominance of the Yen as one of the world’s reserve currencies facilitates funding flexibility. Likewise, the composition of the public debt helps maintain low borrowing costs. Over 90% of JGB holders are domestic investors, external debt is low, and the average debt maturity has increased to 7 years and 7 months. Japan’s deep pool of private sector savings perpetuates high demand for JGBs. The 10-year JGB yield has averaged 1.1% since 2008, and averaged 0.6% through the first ten months of 2014.

Though progress on structural reforms has been incremental, the broad reform agenda is a rating strength. Business and financial sector reforms are designed to unleash private sector savings and increase capital directed towards higher yielding domestic assets. These include a shift in holdings by the state pension fund (GPIF) towards more equity purchases, a tax-free investment account for households, a new stock market index limited to high corporate governance performers, and new codes on stewardship and corporate governance. Furthermore, Prime Minister Shinzō Abe presented a revised growth strategy (the third arrow of Abenomics) in June 2014. Abenomics is based upon three principles, or arrows: (1) aggressive monetary easing, (2) flexible fiscal policy, and (3) structural reforms. The update included measures that reduce the corporate income tax rate, from 35% to below 30%, and removes disincentives for female and skilled foreign labor participation. By some estimates, implementation of these measures could increase real output potential to around 1%. More structural adjustments are likely necessary to raise trend growth above 2% by the end of the decade, as envisioned by the Cabinet Office in a revitalization scenario.

Despite a widening trade deficit, Japan’s external position remains strong. Firms have geared toward liquid low-risk instruments or investments in foreign assets. A positive international investment position of 68.1% of GDP reflects high income flows from abroad and supports the current account. Since late 2011, the trade balance has deteriorated due to higher energy imports and import costs. As a result, the current account balance fell to a small 4Q rolling deficit in the second quarter. Nevertheless, improvement in the trade balance is expected as exports respond to the weaker Yen. Furthermore, possible Japanese inclusion in the Trans-Pacific Partnership Agreement (TPP) could lead to lower trade costs and positive spillovers.

However, for the government to reach its goal of a primary surplus by FY2020, additional fiscal adjustments are likely required. The consumption tax was increased from 5% to 8% in April 2014 and was scheduled to increase again to 10% next year. Article 18 of the tax-increase law that passed in 2012 allows the government the latitude to reconsider the timing of the second tax increase. Given the weaker than expected macroeconomic results, the administration decided to dissolve parliament and call an early election in December 2014 as part of a mandate to delay the second tax increase until April 2017. As a result of the decision, Japan will likely miss its goal of halving its primary fiscal deficit to 3.3% of GDP by FY2015. The medium-term fiscal impact of a delay remains uncertain, as the deferral could be partially offset by stronger near-term growth. DBRS believes that a fiscal consolidation plan that slows the growth of established entitlement expenditures and places the debt to GDP trajectory on a declining path is of more importance than the timing of the tax increase.

Since the mid-1990s, Japan’s debt burden has been exacerbated by structural constraints to output growth and intermittent deflation. Prime Minister Abe’s economic revitalization plan aims to break the low growth-deflationary cycle that has contributed to economic stagnation and rising public debt. The BOJ estimates output potential at around 0.5%. A shrinking working age population and retreating capital stock from a risk-averse private sector weigh on real GDP growth, which has averaged 0.8% since 1993. Furthermore, low growth expectations have entrenched deflationary expectations among firms and households. The average annual consumer price index declined by 0.1% from 1995-2012.

Stimulus policies introduced by the current administration and the BOJ have produced encouraging results. The government directed ¥10.3 trillion in FY2012 and ¥5.5 trillion in FY2013 of fiscal stimulus towards public works. The BOJ introduced quantitative and qualitative monetary easing (QQE), designed to double the monetary base through purchases of JGBs and reach a 2% inflation target. The initial impact of these policies was evident by a marked depreciation of the Yen, higher corporate profits, stronger growth, and a return of inflation. However, in the wake of the April 2014 consumption tax increase, the economy contracted sharply and inflation growth stalled. This led the BOJ to announce in October 2014 that it will increase its annual asset purchases by ¥80 trillion, up from ¥60-70 trillion. It is uncertain whether the central bank will manage to end deflation and re-anchor inflation expectations.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

The sources of information used for this rating include the Ministry of Finance, Cabinet Office of Japan, Bank of Japan, IMF, OECD, BIS, World Bank, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Jason Graffam
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 20 November 2013

For additional information on this rating, please refer to the linking document under Related Research.