DBRS Downgrades Japan to A, Stable trend

DBRS, Inc. has downgraded Japan’s long-term foreign and local currency issuer ratings to A, and the country’s short-term foreign and local currency issuer ratings to R-1 (low). The trend on all ratings is changed to Stable.

The downgrade reflects DBRS’s view that Japan’s credit fundamentals have weakened due to structurally low growth and high and rising public sector debt. Japan possesses a strong capacity to fund 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. Likewise, the government’s decision in 2016 to delay a scheduled increase in the consumption tax without identifying offsetting measures to resolve chronic fiscal deficits contributes to the upward trajectory of government debt.

The Stable trend reflects the view that Japan’s favorable funding conditions will remain low and stable for the foreseeable future. Japan enjoys low financing costs due to its large domestic investor base and its ample pool of private sector savings. DBRS expects Japan’s safe haven status and the Bank of Japan’s (BoJ) bond purchases as part of its yield targeting framework to help maintain low borrowing costs, despite the very high public sector debt to GDP ratio. Credit fundamentals are also supported by the country’s strong external position, its political and institutional stability, and sound financial system.

The administration’s growth revitalization strategy has yet to raise potential output above the BoJ’s 0.5% estimate or break the economy’s deflationary cycle, despite some encouraging reform initiatives. Key reforms include incremental improvements to the financial sector and corporate governance that have reallocated some savings into riskier assets, some liberalization around the power and agricultural sectors, and increased female labor participation. The economy expanded at a 1.3% annual pace in the third quarter and government expects improved domestic and external demand to increase growth to 1.5% in the current fiscal year ending March 2017. Due to unresolved structural weaknesses, DBRS expects real growth to average below 1% through 2020.

Public finances remain Japan’s main credit weakness. General government deficits averaged 8.0% of GDP from 2010-2015 and contributed to gross debt of 248% of GDP in 2015, the highest ratio among advanced economies. The decision this year to delay the second consumption tax increase until 2019 eliminated any likelihood of the government meeting its primary surplus target by the end of the decade. The Cabinet Office’s base case is for a central and local government primary deficit of 1.7% of GDP by FY2020. This appears ambitious given the 1.9% nominal GDP growth assumption from FY16-FY20. DBRS’s baseline scenario is for a general government primary deficit of 5.2% of GDP this year and to average above 4% through 2020.

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 through 2020, with net and gross debt increasing to 132% and 255% of GDP, respectively. However, the rise in debt is likely to accelerate in the medium term 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 a slow pace of domestic investment weigh on GDP growth potential. Furthermore, low inflation expectations remain entrenched among firms and households. Expansionary monetary policies meant to break the low growth-deflationary cycle introduced since 2013 showed some initial progress at lifting prices. However, price growth momentum stalled since the 2014 consumption tax increase. Headline inflation was -0.4% as of October 2016. Despite the BoJ’s expansionary measures this year, including the introduction of negative rates, the new yield targeting framework, and the commitment to overshoot the 2% target, it remains unclear whether authorities will manage to re-anchor inflation expectations at a higher level and sufficiently reanimate domestic consumption and investment to increase growth potential. Lower public deficits and higher nominal GDP growth are likely necessary in order for Japan to stabilize its public debt.

Nonetheless, Japan has exceptionally low funding costs and remains one of the world’s most advanced and wealthy economies. Governance indicators are among the strongest globally, as evident by the high degree of social and political stability. Institutional strength is reflected by the BoJ’s role as issuer of a global reserve currency and high confidence in the willingness and capacity of the government to fund its debt.

Japan’s external position is a core credit strength. The U.S. election result has raised questions around the future of the Trans-Pacific Partnership (TPP) agreement, which would likely have led to lower trade costs and positive spillovers for Japan over the medium term. Despite the setback, Japan’s external balance sheet is expected to remain strong. A positive international investment position of 75% of GDP in 2015 illustrates high income flows from abroad. The healthy 3.9% of GDP current account surplus as of the third quarter reflects strong private sector savings that offset government dissavings. Maintaining its positive saving-investment balance is key for the country to finance domestic investment and keep external vulnerabilities low.

Contingent liabilities for the government stemming from the banking sector appear limited. The Japanese banking system is large and has been managing shrinking margins associated with negative interest rates, but bank fundamentals are strong. The systemically important financial institutions appear able to take on higher levels of risk and stress tests suggest major banks have the necessary capital buffers to absorb large shocks.

RATING DRIVERS
DBRS anticipates a low likelihood of developments that would place upward pressure on the ratings. Yet, policy adjustments that materially improve growth potential, reduce deficits in line with stated targets, and stabilize public debt to GDP would be credit positive. Under current assumptions, DBRS believes Japan is likely to progress slowly on reforms that support prices and economic growth. Persistent underperformance of deficit targets and deterioration of public debt dynamics could place further downward pressure on the ratings.

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. These can be found at http://www.dbrs.com/about/methodologies.

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 was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities.

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 Roger Lister
Initial Rating Date: 20 November 2013
Most Recent Rating Update: 30 November 2015

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