DBRS Assigns Negative Trend to Japan’s A (high) Ratings

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. DBRS has changed the trend on all ratings to Negative.

The Negative trend reflects DBRS’s concern that a stagnant economy, insufficient progress on raising potential GDP growth, and high and rising public sector debt could have a lasting impact on Japan’s credit fundamentals. Japan possesses a strong capacity to repay public obligations and the administration has initiated notable reforms. However, it appears the reform effort has not yet materially altered the outlook for weak economic growth and price trends. In the absence of new policies, DBRS expects longstanding structural constraints to persist and chronic fiscal deficits to contribute to the upward trajectory of government debt.

Over the next 12-24 months, DBRS could downgrade the ratings if the administration does not introduce additional fiscal measures to meet budget targets and stabilize public debt. Under current assumptions, DBRS believes the government is likely to underperform its deficit target. Backsliding on fiscal targets and slow progress on reforms that support prices and economic growth are the main channels that would likely result in deterioration of public debt dynamics and place downward pressure on the ratings. Conversely, the trend could return to Stable if authorities continue to introduce policy adjustments designed to improve growth prospects, and if fiscal management improves in line with stated targets that result in stabilization of public debt to GDP.

The rating confirmation reflects the country’s ample funding flexibility. Japan benefits from safe haven status, reflecting confidence in its capacity to service debt even during periods of investor risk aversion. Furthermore, Japan enjoys low financing costs due to its large pool of private sector savings and large domestic investor base. Bank of Japan (BOJ) annual purchases of ¥80 trillion in Japanese Government Bonds (JGBs) are likely to help maintain low borrowing costs, despite the very high public sector debt to GDP ratio. The average 10-year JGB yield has remained below 1% since January 2012 and around 0.4% over the last year. This debt structure minimizes risks to the government bond market from capital flight in a stressed scenario.

Japan’s external position is a core credit strength. A positive international investment position of 75.2% of GDP reflects high income flows from abroad and the current account position remains in surplus. Notwithstanding the 31% real trade-weighted depreciation of the Yen from 3Q10 to 3Q15, export growth has been muted. The reduced import bill – due to sharp falls in commodity and oil prices since 2014 – has been the main driver in reversing the negative trend in the trade balance. Maintaining its positive saving-investment balance is key for the country to finance its domestic investment needs and keep external vulnerabilities low. Japanese participation in the Trans-Pacific Partnership (TPP) agreement is also expected to lead to lower trade costs and positive spillovers over the medium term.

Institutional quality further supports the ratings. Japan is among the best performers on World Bank governance indicators within DBRS’s “A” rated peer group. Institutional strength reflects the capacity and willingness of the government to repay its debt. While Prime Minister Shinzō Abe’s growth revitalization strategy has yet to increase potential output, certain reform initiatives are credit positive. Business and financial sector reforms are designed to reduce private sector savings and increase risk capital. Some progress has also occurred in the energy and agricultural sectors, and by increasing female labor participation. However, the reform effort has not altered the outlook for the economy due to unresolved structural weaknesses, such as deteriorating demographics. DBRS agrees with the IMF’s growth estimates of 0.6% this year and its forecast for average 0.7% growth through 2020, well below the government’s “Economic Revitalization” projection of 1.8% growth on average from FY16-FY20.

Public finances remain Japan’s main credit weakness. A large public deficit of 7.3% of GDP in 2014 contributed to gross government debt of 246% of GDP, the highest ratio among advanced economies. The government’s 2013 medium-term fiscal plan aimed to halve the FY2010 central and local government fiscal deficit to 3.3% of GDP by FY2015 and achieve a primary surplus by FY2020. In order to do so, the consumption tax was increased from 5% to 8% in April 2014 and a second tax increase to 10% is planned for April 2017. DBRS believes the government’s growth assumptions might prove to be optimistic. Additional fiscal adjustments that slow the growth of established entitlement expenditures are likely required for the government to reach its primary deficit targets. DBRS’s baseline scenario reflects the IMF general government primary deficit, expected to narrow to 5.4% of GDP by end-2015 and remain above 4% through the end of the decade.

Debt to GDP is expected to continue its long-run upward trend. Indeed, the pace of public sector debt growth is likely to remain modest in the near-term, with net and gross debt increasing by 6% of GDP from 2015 to 2020, to 132% and 252%, respectively. This improves on the 36% increase of both ratios from 2010 to 2014. However, the rise in debt is likely to accelerate after 2020 from increasing age-related spending. The IMF projects gross debt to reach 290% of GDP by 2030. Furthermore, the outlook for public debt is sensitive to shock scenarios and shifts in market perceptions. Even a modest shock – from growth, fiscal, or interest rate channels – significantly increases the debt ratios and further weakens credit fundamentals.

Structural constraints to output growth and intermittent deflation exacerbate Japan’s debt burden. A shrinking working age population and retreating capital stock weigh on real GDP growth. The BOJ estimates output potential at around 0.5%. Annualized growth contracted in seven of the last fifteen quarters, including the -0.7% and -0.8% results for 2Q15 and 3Q15, placing Japan back in recession. Likewise, low inflation expectations remain entrenched among firms and households. The administration’s economic plan that attempts to break the low growth-deflationary cycle through expansionary policies and structural reforms showed some initial progress at lifting prices. However, price and output growth momentum stalled since the 2014 consumption tax increase. Growth in consumer prices has retreated to zero as of 3Q15. With a second tax approaching in 2017, it remains unclear whether authorities will manage to re-anchor inflation expectations, increase growth potential, and strengthen Japan’s ability to stabilize public debt.

Notes:
All figures are in Japanese Yen 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.

DBRS does not typically accept editorial changes other than to correct for factual, accuracy and/or to remove confidential, material non-public, or sensitive information that might otherwise be inadvertently disclosed.

Lead Analyst: Jason Graffam
Rating Committee Chair: Roger Lister
Initial Rating Date: 20 November 2013
Most Recent Rating Update: 20 November 2014

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