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 COVID-19 on the economy. Following the 4.6% economic contraction due to the pandemic in 2020, the Japanese economy is recovering, albeit at a slow pace due to the successive waves of the virus in 2021. The Bank of Japan (BoJ) projects GDP growth at 3.4% in FY2021 and 2.9% in FY2022. Japanese authorities have responded with a package of measures worth JPY 316 trillion (about 53% of GDP) to protect households, businesses, and the health care system. As a result, Japan’s fiscal deficit, surged from 3.1% of GDP to 10.2% in 2020 and is expected to remain high at 9.0% in 2021. The public debt ratio also rose from 235% of GDP in 2019 to 254.1% in 2020 and is likely to increase further to 256.9% 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.
Despite Japan’s structural weaknesses, 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 Discount Bills (T-Bills) now stand at 44.1% 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.
Japan’s ratings could be upgraded if one or a combination of the following occur: (1) continued structural reforms that improve growth potential, or (2) sustained economic growth combined with a prudent fiscal stance, resulting in a downward trajectory of the debt-to-GDP ratio. Conversely, the following could lead to a downgrade: (1) if the government persistently underperforms relative to deficit targets, and if (2) the policy response fails to achieve a durable exit from the cycle of weak growth and entrenched low inflation.
Japan Sees A Slow Cyclical Recovery, While Structural Challenges Weigh on Medium Term Outlook
Following the -4.6% Covid-related contraction in 2020, the Japanese economy is recovering, albeit at a slow pace. This is largely due to the successive waves of the virus in 2021 which resulted in Japan being in a state of emergency for eight of the first nine months of the year and a relatively slow start to the vaccination process. However, since H2 2021, the pace of vaccinations has picked up speed with 72.8% of the population vaccinated as of November 1. The Bank of Japan forecasts real GDP growth of 3.4% in FY2021, 2.9% in FY2022, and 1.3% in FY2023. The lagged economic recovery has also resulted in a lagged pick up in labor markets. The unemployment rate which rose from 2.2% prior to the pandemic to 3.1% in October in 2020 remains at 2.8%. Given Japan’s ageing and shrinking population, coupled with labor market rigidities, Japan’s unemployment rate is relatively low, but somewhat overstates the degree of labor market strength. The active job openings-to-applicant ratio, dropped from 1.6 pre-pandemic to 1.1 currently, underscoring the still relatively limited demand for new hires.
Japan’s medium-term outlook remains clouded by demographic-related structural weaknesses leading to a negative adjustment in the Economic Structure and Performance building block. Japan’s ageing and shrinking population have resulted in the highest old age dependency ratio among OECD countries at 50% and is projected to rise to 79% in 2050. That said, since 2018, the government has 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 a 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 in 2019, with 25% of the increase due to foreign workers. This coupled with the increase in working-age female and elderly participation in the workforce have resulted in Japan’ labor force participation rate rising from 59.1% in 2012 to 62.3% currently. This increase partially mitigates current demographic pressures and could have positive implications for increasing Japan’s long-term output potential and stabilizing debt dynamics.
Japan’s Fiscal and Debt Metrics Deteriorate Further During the Pandemic, But Its Financial Flexibility Remains High
Japan’s fiscal and debt metrics are a key constraint to its ratings. Japan’s fiscal deficit, which had stabilized at 3.3% of GDP during 2015-2019, surged to 10.2% following the pandemic in 2020. As per the IMF policy tracker, Japanese authorities responded with a stimulus of JPY 316 trillion (about 53% of GDP) to protect households, businesses, and the health system. While the direct fiscal stimulus across three supplementary budgets was 16.7% of GDP, the government provided solvency support through credit guarantees on loans made by private financial institutions to small and medium-sized firms. The stimulus and contraction in growth have resulted in Japan's headline fiscal deficit rising from 3.1% of GDP in 2019 to 10.3% in 2020. The deficit is estimated to remain high at 9.0% in 2021 before coming down to its long term average of around 3.9% in 2022.
Chronic fiscal deficits since 1991 have resulted in Japan’s gross debt rising from 64.3% of GDP in 1990 to 238% of GDP in 2019 and further to 254.1% in 2020 due to the pandemic. Following the rise in the gross and net debt ratios to 256.8% and 171.5%, respectively, in 2021, the IMF in its latest World Economic Outlook expects Japan’s gross and net public debt ratios to decline modestly over the projected horizon to 251.1% and 168.7% of GDP by 2025, respectively, due to a positive growth-interest differential. Despite Japan’s high debt ratios, DBRS Morningstar believes that Japan’s financial flexibility is high. The Bank of Japan’s extraordinary easing measures mitigate risks to the government’s ability to service debt. The central bank’s holding of Japanese government bonds (JGBs) and Treasury Discount Bills (T-Bills) has increased significantly from 13.1% of total debt in 2013 to 44.1% of total currently. Further, the debt is all yen denominated, mostly held domestically, and is financed by a high rate of national savings (which stands at 29% of GDP).
Bank of Japan Continues with Expanded Unconventional Monetary Policies
The Bank of Japan (BoJ) has since the late 1990s used unconventional monetary policies to fight deflation. The central bank has been conducting its monetary policy under the framework of Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control (10 year target of zero percent) aiming to achieve the 2 percent price stability target. The BoJ expanded its ongoing expansionary monetary policies in response to the pandemic, introducing a special program to support financing in response to COVID-19, the unlimited expansion of its QQE ensuring abundant supply of domestic and foreign currency liquidity in the bond market and increased its upper limit of annual purchases of ETFs and REITs to reduce the risk premium of the asset market and has extended these measures until March 2022. Further, given the government’s declaration on achieving carbon neutrality by 2050, the BoJ in its June 2021 policy announced the introduction of a new fund-provisioning measure to support private financial institutions' various efforts in fields related to climate change.
Despite an aggressive monetary policy response following the pandemic, spending growth in Japan remains weak and inflation remains negative. The latest CPI reading stood at 0.2%YoY for headline, 0.1% (less food) and -0.5% for Core CPI (less food and energy). In addition to one-off factors, such as price cuts in mobile charges, and Japan’s lagged cyclical recovery, structural factors continue to play a big role in keeping inflationary expectations low in Japan. Consequently, despite the rise in input costs, Japanese businesses are reluctant to increase prices. BoJ forecasts CPI (less food) to remain at 0.0% in fiscal 2021, 0.9% in fiscal 2022 and 1% for fiscal 2023.
While expansionary monetary policy has helped improve financial conditions with bank lending rates and corporate bond yields remaining at historic lows, margins for financial institutions have also trended lower. Moreover, despite pension and insurance investors rebalancing their portfolios towards riskier foreign bonds and equity, reserves of financial institutions continue to rise as loan demand remains muted due to structural factors. Although low interest rates have taken a toll on banks’ net interest margins, overall bank fundamentals are strong and contingent liabilities for the government stemming from the banking sector appear limited. 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.
Japan’s Solid External Position Provides a Significant Buffer to Absorb Shocks
Japan’s external position is a core credit strength. Its external accounts are characterized by a structural current account surplus and a sizeable net creditor position. 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 68.3% of GDP in 2020 and generates large income flows from abroad. 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. Institutional strength reflects the capacity and willingness of the government to conduct sound economic policies and repay its debt. The country also benefits from a high degree of social stability. The Liberal Democratic Party (LDP) has maintained a majority in Parliament for much of the post-war era, recently winning the elections with an absolute majority (261 out of 465 seats) on October 31, 2021. Following the resignation of Prime Minister Shinzo Abe in September 2020, the LDP appointed Yoshihide Suga in his place. With Mr. Suga not standing for the LDP leadership contest, Fumio Kishida was elected as the 100th prime minister of Japan.
Key priorities of the new administration include controlling and containing the pandemic. With over 70% of the population already vaccinated, the administration aims to vaccinate all those who wish to be vaccinated by the end of November. Plans are also underway for a stimulus package to support households and workers most severely affected by COVID-19 disruptions. In addition, Prime Minister Kishida aims to pursue a program, referred to as "New Capitalism," which will continue to promote economic growth but not at the expense of equity. The administration aims to solidify Japan’s status as a scientific and technological powerhouse, and is thus likely to focus on R&D investments into areas such as green technology, artificial intelligence, quantum computing and biotechnology.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/387509.
All figures are in JPY 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 https://www.dbrsmorningstar.com/research/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). Other applicable methodologies include DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).
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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