DBRS, Inc. (DBRS Morningstar) confirmed Japan’s Long-Term Foreign and Local Currency – Issuer Ratings at A (high). At the same time, DBRS Morningstar confirmed Japan’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (middle). The trend on all ratings is Stable.
KEY RATING CONSIDERATIONS
The confirmation of Japan’s A (high) rating and Stable trend balances its strong credit fundamentals against the adverse consequences of the current health crisis on the country’s key macroeconomic indicators. Following the contraction in growth in Q4 2019, driven by typhoons and the consumption tax hike, the Japanese economy saw a sharp contraction in the first half of the year amid the coronavirus outbreak. Real GDP fell by 1.8% YoY in Q1 and 9.9% YoY in Q2. While the outlook is still highly uncertain and will likely depend on the evolution of the epidemic, the authorities expect GDP to decline by 4.5%- 5.6% in 2020, and recover to 3.0%-3.8% in 2021. The IMF in its latest WEO expects GDP to decline by 5.3% YoY in 2020 and expand by 2.3% YoY in 2021.
Japanese authorities have responded swiftly with a stimulus of JPY 234 trillion (about 40% of GDP) to protect households, businesses, and the health system. In addition to temporary income support to vulnerable workers, the government has provided solvency support through credit guarantees on loans made by private financial institutions to small and medium-sized firms while the Bank of Japan has provided liquidity on favorable terms in response to COVID-19. The magnitude of this shock does present challenges for Japan’s economy. The headline fiscal deficit is expected to surge to 14.2% in 2020, while Japan’s already high gross government debt ratio is likely to increase further to 266% of GDP, the highest ratio among advanced economies. An aging and shrinking working-age population and a slow pace of domestic investment both weigh on GDP growth potential and inflationary expectations.
Nonetheless, Japan’s A (high) ratings reflect its fundamental strengths, including its large and diverse economy, robust macroeconomic policy framework, and strong governing institutions. The country enjoys exceptionally low financing costs due to its large pool of private savings and its large domestic investor base. DBRS Morningstar 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. The BoJ’s holdings of Japanese government bonds (JGBs) and treasury bills now stand at 44.5% of total debt. Japan’s external position is another core credit strength. Its large current account surplus reflects high private sector savings that offset government dissaving, while its net creditor position – the highest among advanced economies – generates large income flows from abroad. The Japanese yen functions as a global reserve currency and supports the government’s capacity to finance its high debt burden. Governance indicators are among the strongest globally, reflecting the high degree of social and political stability.
Factors that could lead to an upgrade are the following: (1) continued structural reforms that improve growth potential or (2) Japan’s ability to sustain economic growth that results in a persistent downward trajectory of the debt-to-GDP ratio. Conversely, one or both of the following could lead to a downgrade: (1) the government persistently underperforms relative to deficit targets or if (2) the policy response fails to achieve a durable exit from the cycle of weak growth and entrenched low inflation.
Pandemic Deepens the Downturn Following the Consumption Tax; Continuation of Structural Reforms Could Aid Growth
The Japanese economy has stalled following seven years of above-potential growth which averaged 1.2% during 2013-2018. Despite measures taken to mitigate the negative impact, the October 2019 consumption tax hike and typhoons took its toll on consumption and the economy contracted 0.7% in Q4 2019. The spread of COVID-19 globally and the restrictive measures to limit contagion, which included postponing the Olympic games, led to a 5.8% GDP contraction in the first half of the year. The Bank of Japan expects GDP to decline by 5.3%-5.6% in 2020 and expand by 3.0%-3.8% in 2021. Cabinet Office is slightly more optimistic, expecting a 4.5% contraction in 2020 and 3.4% growth in 2021. Nonetheless, the growth projections are subject to considerable risk and remain linked to the evolution of the pandemic both domestically and abroad, to the scale of new containment measures, and to the broad availability of a vaccine.
The COVID-19 pandemic has also taken a toll on Japan’s labor markets. Japan’s aging and shrinking population, coupled with labor market rigidities, had resulted in the lowest unemployment rate since 1992 at 2.2% in December 2019. Unemployment rate has now risen to 3.0% in September 2020. The active job openings-to-applicant ratio which also touched 1.6 times last year – the highest since 1974 – has fallen to 1.0 times currently. That said, Japan’s low unemployment rates are a deceptive measure of labor market strength and illustrates shortcomings in Japan’s dual and rigid labor market.
Prior to the pandemic, the government had been implementing a series of reform measures to reduce the bottlenecks in labor supply and to improve wage-price dynamics. The passage of the Work Style Reforms in June 2018 (relating to cap on overtime and equal pay for equal work), the Immigration Control Act in December 2018 (allowing more foreign workers into the country), and incentives to increase female participation in the workforce all bode well for addressing Japan’s labor market challenges. The reform measures have resulted in Japan’s labor supply increasing from 62.7 million in 2012 to 67.2 million, with 25% of the increase due to foreign workers. Working-age female and elderly participation in the workforce also reached all-time highs of 72.6% and 25.3% respectively, though both figures have fallen slightly due to COVID-19. This increase partially mitigates current demographic pressures and could have positive implications for increasing Japan’s long-term output potential and stabilizing debt dynamics. Nonetheless, Japan’s medium-term outlook remains clouded by demographic-related structural weaknesses resulting in low potential growth of 0.5-1.0% of GDP and leading to a negative adjustment in the “Economic Structure and Performance” building block.
Unprecedented Fiscal Response Will Result in Record Fiscal Deficit
Japan’s fiscal deficit, which had stabilized at 3.3% of GDP during 2015-2019, is likely to surge to 14.2% in 2020. In response to the pandemic, the Japanese government implemented a series of measures with a projected size of JPY 234 trillion (about 40% of GDP), aimed at supporting the economy and mitigating the economic impact of the pandemic. The support packages include (1) financial support to households, (2) liquidity support to businesses through loan guarantees and deferred payments of taxes and social contributions, (3) concessional loans from public and private financial institutions, and (4) provision of subordinated loans by the public financial institutions to affected firms and subsidies to affected firms for their rent payments.
While the IMF is estimating a headline fiscal deficit this year of 14.2% of GDP in 2020, as most of the measures are temporary, the deficit is expected to decline to 6.4% in 2021 and 3.2% in 2022. Despite a likely medium-term stabilization of public finances, Japan’s long-term public finances are challenged by its high gross debt and its aging population. This is reflected in established spending pressures with debt service at 23% and social security expenditures at 35% of total expenditure. Japan thus needs a sustained increase in tax revenue not only to stabilize its public debt to GDP ratio but also to support long-term demographic changes.
Public Finances Remain a Key Challenge, But Financial Flexibility is High
Japan’s large public debt burden, which has risen from 64.3% of GDP in 1990 to 238.0% in 2019, is set to rise further to 266.2% in 2020 driven by a fall in economic activity. Following the rise in the debt ratio in 2020, due to a positive growth-interest differentials, the IMF in its latest WEO expects Japan’s gross and net public debt ratios to remain relatively stable over the projected horizon at 264% and 180% of GDP by 2025.
While the high stock of debt makes Japan vulnerable to various shock scenarios, DBRS Morningstar believes Japan’s financial flexibility is high and that BoJ’s extraordinary easing measures mitigate risks to the government’s ability to service debt. Most of the debt is held domestically, financed by a high rate of national savings (which stands at 27.9% of GDP), and denominated in yen. Thanks to the BoJ’s expansionary policies and the home bias of Japanese investors, liquidity and refinancing risks are low. Since the introduction of the Quantitative and Qualitative Monetary Easing by the BoJ in 2013, the BoJ’s holding of Japanese government bonds (JGBs) and treasury bills increased significantly from 13.1% of total debt in 2013 to 44.5% currently. In the same period, the weighted average maturity of debt has risen from 7.6 years in FY 2013 to 9.2 years in FY 2019.
Bank of Japan Further Expands Its Unconventional Monetary Policy
Reflecting the unprecedented large-scale economic measures conducted by the Japanese government to address COVID-19, the Bank of Japan expanded its ongoing expansionary monetary policies further through its ‘three pillars’. Measures include: (1) a new program aimed at supporting the cash flow of companies; (2) unlimited expansion of its Quantitative and Qualitative Monetary Easing, ensuring abundant supply of yen and foreign currencies in the bond market; and (3) doubling its annual purchases of ETFs and REITs to reduce the risk premium of the asset market. In addition, the BoJ said that it would conduct additional purchases of CP and corporate bonds up to JPY 7.5 trillion for each asset until the end of March 2021.
The BoJ also reiterated that it is maintaining its "Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control (setting the short-term reference interest rate at -0.1%, targeting the yield on the 10-year benchmark JGBs at “around zero percent”) aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner. Through this, BoJ aims to support the economy and fulfill its role of achieving price stability. However, despite ongoing expansionary monetary policies, six years of nominal growth exceeding 1%, and tightening labor markets, inflation remains below targets. The BoJ expects inflation to fall to -0.6% in 2020 and increase slightly to 0.4% in 2021.
Bank lending rates and corporate bond yields are near historic lows, which provide easy financing conditions for firms but lower margins for financial institutions. Due to attractive rates, banks’ lending overseas have seen an increased demand, and though conditions are currently stable, foreign currency funding remains an area of risk. Financial institutions, pension funds, and insurance investors have been rebalancing their portfolios towards riskier foreign bonds and equity and may face losses in a scenario with a renewed downturn overseas. While low interest rates have taken a toll on banks’ net interest margins, systemically important financial institutions remained resilient despite some profitability pressures due to COVID-19 and higher provisioning levels. The mega banks have strong capital buffers and high business diversification which should enable them face COVID-19’s challenging operating environment.
Expansionary monetary policy has helped improve financial conditions, but DBRS Morningstar acknowledges that there are structural limits to the negative interest rate policy (NIRP) and the JGB yield-targeting framework. The NIRP, in combination with JGB purchases, has pushed down not only short-term but also long-term interest rates substantially. Concerns about the side effects from prolonged monetary easing has complicated BoJ’s reflation efforts leading to a negative adjustment in the “Monetary Policy and Financial Stability” building block.
Japan’s Solid External Position Provides a Significant Buffer to Absorb External Shocks
Japan’s external accounts are characterized by a structural current account surplus and a positive net creditor position. Its strong current account balance and high level of net foreign assets insulate it from external financial market shocks and is a core credit strength. Japan has been running perennial current account surpluses averaging 4% of GDP since the 1980s primarily due to robust income from foreign assets and a positive trade balance. The country’s net international investment position (NIIP) remains relatively high at 62.4% of GDP in 2019 and generates large income flows from abroad. Japan’s income surplus is attributed due to high yields on foreign assets, low FDI and portfolio debt liabilities and low yields on portfolio debt liabilities. The high NIIP reflects Japan’s ample USD 1.3 trillion foreign reserves and net portfolio assets and is a direct reflection of Japan’s high domestic savings. In addition, Japan holds a degree of resilience with the shock-absorbing benefits of the yen being one of the world’s primary currencies.
Strong Institutional Quality And Relatively Stable Politics
Japan’s institutional quality is strong and is reflected in its status as one of the best performers on World Bank governance indicators, both within DBRS Morningstar’s “A” rated peer group and globally. Japan scores favorably on government effectiveness, control of corruption, and rule of law. This institutional strength reflects the capacity and willingness of the government to conduct sound economic policies and repay its debt. DBRS Morningstar finds no deterioration in the Political Environment, despite minor volatility in the Voice and Accountability score, and thus is maintaining the building block assessment at Very Strong.
The country also benefits from a high degree of social and political stability. The Liberal Democratic Party (LDP) has maintained a majority in Parliament for much of the post-war era and currently governs in a coalition with the Komeito Party as a supermajority. Following the resignation of Prime Minister Abe due to health reasons in September 2020, the LDP appointed Yoshihide Suga as the prime minister who is likely to remain in office until 2021. The next key political events are the national elections for the house of representatives (lower house of parliament) scheduled to be held before October 2021 and the LDP leadership contest, which is scheduled for September next year. The LDP's rules state that if a previous party leader resigns part way through his or her term, the next party leader takes over the remainder of the previous party leader’s term.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/369777.
All figures are in USD unless otherwise noted. Public finance statistics reported on a general government basis unless specified.
The principal methodology is the Global Methodology for Rating Sovereign Governments (July 27, 2020).
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.
Generally, the conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are monitored.
The primary sources of information used for this rating include Japanese Ministry of Finance, Cabinet Office of Japan, Bank of Japan, IMF, OECD, Bank of International Settlements, International Monetary Fund, World Bank, UN, and Haver Analytics. DBRS Morningstar 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 for this rating action. DBRS Morningstar did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.
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