DBRS Morningstar Confirms Japan at A (high), Stable Trend

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 reflects DBRS Morningstar’s view that the economy continues to demonstrate its resilience despite the uncertainty caused by tightening of global financial conditions, the Russian invasion of Ukraine and COVID-19 infections. The Japanese economy recovered from the pandemic shock with growth coming at 1.6% in 2021 versus the 4.5% contraction due to Covid in 2020. The Bank of Japan expects the economy to grow by 2.0% in 2022 and 1.9% in 2023. Japan’s public finances remain a key constraint to its rating. Japan’s fiscal policy response to the pandemic has resulted in the deficit coming in at 8.9% in 2020 and 6.7% in 2021. The deficit is likely to remain high at 7.8% of GDP in 2022 due to the developments in Ukraine and the consequent rise in energy prices. Japan’s public debt ratio also rose from 236% of GDP prior to the pandemic to 263% in 2021 and is likely to remain at these levels for the forecast horizon. An additional impediment to growth is its ageing and shrinking working-age population.

Despite Japan’s structural weaknesses, Japan’s A (high) ratings reflect its fundamental strengths, including its large and diverse economy and robust macroeconomic policy framework. 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 44.3% 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.

RATING DRIVERS

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) a sustained improvement in the fiscal stance, resulting in a downward trajectory of the debt-to-GDP ratio. Conversely, the following could lead to a downgrade: (1) persistent fiscal underperformance, or if (2) the policy response fails to achieve a durable exit from the cycle of weak growth and entrenched low inflation.

RATING RATIONALE

Japan’s Economic Recovery Continues Despite External Headwinds
Japan’s post-pandemic recovery continues to be led by manufacturing, business investment and consumption. Following the 4.5% contraction in 2020, the Japanese economy recovered to 1.6% in 2021 amid strong policy support, and is expected to grow by 2.0% in 2022 and 1.9% in 2023 (BoJ estimates). Despite external headwinds arising from Russia’s invasion of Ukraine and global monetary tightening, waning concerns of COVID-19 continue to support the resumption of economic activity. The recovery in manufacturing is led by exports, and domestic industry is benefiting from order backlogs and easing supply side constraints. The uptick in business investment is supported by high levels of corporate profits and by implementation of projects that have been postponed due to the pandemic and supply-side constraints as well as investments to address medium- to long-term issues, such as digitalization and decarbonization. While pent-up demand and savings continue to support consumption, tourism demand is also expected to recover in the coming months as the government relaxes entry restrictions.

While Japan’s economic recovery is continuing, its medium-term outlook remains clouded by demographic-related structural weaknesses, leading to a negative adjustment in the Economic Structure and Performance building block. The IMF expects real GDP growth to converge to its potential of 0.5%. Japan’s ageing and shrinking population have resulted in the highest old age dependency ratio among OECD countries at 50% and the figure is projected to rise to 79% in 2050. That said, the implementation 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 alleviating 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. The pandemic has resulted in this coming down to 66.6 million in 2021. That said, the increase in labor supply coupled with the increase in working-age female and elderly participation in the workforce have resulted in Japan’s labor force participation rate rising from 59.1% in 2012 to 63.0% 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.

BoJ’s Continued Expansionary Policies Take Its Toll on the Yen

The Bank of Japan (BoJ) remains an outlier relative to most other central banks, which are hiking rates to counter inflation. Global inflation has spilled over to Japan as well, with headline CPI rising to 3% YoY in September. However, core inflation (ex-food & energy) remains subdued at 1.8%, and overall inflationary trends remain much lower than in Europe and the United States. The BoJ expects headline inflation to rise further, mainly as a result of higher commodity prices rather than from an increase in domestic demand. The BoJ projects headline CPI to decline below 2% from 2023 onwards as the contribution of rising commodity prices to inflation peaks in 2023. Thus, while the BoJ has dialed back on all its policies to ease financial conditions and support households and firms during COVID-19, policy officials have reiterated that the BoJ will continue with its Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control (YCC), aiming to achieve the price stability target of 2 percent in a sustainable and stable manner.

In its latest policy statement in October 2022, the BOJ stated that it would continue with monetary easing to support domestic demand. While the BoJ continues to defend its yield target, 10-year JGB's have moved to the upper limit of the BoJ's YCC (0.25%), with the BoJ now holding over 50% of the JGB's issued. Meanwhile, the divergence in global rates is driving the yen weaker. The Japanese yen has been under pressure ever since the Fed changed its stance on monetary policy in October 2021. From trading at USD/JPY 110 in October 2021, the yen is currently trading at a historic 25 year low of USD/JPY 148. The BoJ has historically maintained that a weak yen is positive for the export sector, though it now notes the need to pay attention to the impact of foreign exchange markets on Japan’s economic activity. The rise of import costs due to yen depreciation are compressing corporate margins, while rising domestic inflation could dampen consumption growth. Consequently, with the Fed delivering its third 75bps increase in rates in September and signaling more hikes, Japanese authorities intervened in the currency markets for the first time since 1998.

From a financial markets point of view, Japanese households have stuck to their risk-averse investment style with a strong home bias despite a long period of low interest rates in domestic markets. This has helped Japan fund its deficits at low interest rates. Rising international yield differentials may reduce the attractiveness of yen investments, though at present 10-year yield differentials remain within historical ranges. While we expect Japan to retain its considerable financial flexibility, we will be monitoring the risks of a change in the historical home bias of Japanese households. A material shift in expectations toward further tightening by the Fed, ECB, and other major central banks could pose additional challenges for the BoJ. For more details please see DBRS Morningstar Commentary (BoJ Remains Accommodative As Growth and Inflation Remain Subpar).

While expansionary monetary policy has helped improve financial conditions with bank lending rates and corporate bond yields remaining low, margins for financial institutions have also trended lower. Moreover, despite pension and insurance investors rebalancing their portfolios towards riskier foreign bonds and equity, financial institutions have maintained abundant liquidity. Loan demand has increased, in part driven by real-estate related loans and foreign loans. Non-performing loan ratios remain at relatively low levels. Overall, bank fundamentals are strong and contingent liabilities for the government stemming from the banking sector are limited. In addition, stress tests suggest major banks have the necessary capital buffers to absorb large shocks.

Japan’s Public Finances Remain A Challenge, But Its Financial Flexibility Remains High

Japan’s fiscal and debt metrics remain a key constraint to its ratings. Japan’s deficit, which averaged 3.9% of GDP during 2004-2008, was derailed by the shocks in 2009 (global financial crisis) and 2011 (earthquake), with the deficit averaging nearly 9% during 2009-2013. Japan’s fiscal policy response to the pandemic resulted in the deficit rising from an average of 3.3% during 2015-2019 to 8.9% in 2020 and 6.7% in 2021. The deficit is expected to remain high at 7.8% of GDP in 2022 as a result of the government’s expansion of the fuel subsidy to combat rising energy prices. The IMF projects Japan’s fiscal deficit to average 2.7% during 2023 to 2027.

Japan’s high deficit and drop in output during the pandemic resulted in its public debt-GDP ratio rising from 236% of GDP in 2019 to 263% of GDP in 2021. Due to the elevated global uncertainty owing to the war in Ukraine and the pandemic, despite positive growth-interest differential, the IMF in its latest World Economic Report (October 2022) projects Japan’s gross and net public debt ratios to remain relatively stable over projected horizon to 263% and 175.1% of GDP by 2027. That said, despite Japan’s high debt ratios, DBRS Morningstar believes that Japan’s financial flexibility is high. Government debt is all yen denominated, and is financed by a high rate of national savings (which stand at 29% of GDP). The Bank of Japan’s extraordinary easing measures mitigate risks to the government’s ability to service debt. The central bank’s holdings of Japanese government bonds (JGBs) and Treasury Discount Bills (T-Bills) has increased significantly from 13.1% of total debt in 2013 to 44.3% of total currently. Nonetheless, Japan’s capacity to refinance its debt could be sensitive to shifts in market sentiment. If domestic bond investors begin to demand a risk premium and the government’s real cost of borrowing increases, debt dynamics could deteriorate and potentially jeopardize financial stability.

Japan’s External Position Remains A Key Credit Strength

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 3% of GDP over the last few decades primarily due to robust income from foreign assets and a positive trade balance. The current account surplus narrowed marginally to 2.9% in 2020 and 2.8% in 2021 due to a decline in travel restrictions which impacted the services balance. Japan’s current account surplus is likely to narrow further in 2022 due to high energy prices resulting in a deterioration in its trade account. However, Japan’s income balance remains the main contributor to the current account surplus. The country’s net international investment position (NIIP) remains relatively high at 76.0% of GDP in 2021 and generates large income flows from abroad. The high NIIP reflects Japan’s ample USD 1.4 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 Support Japan’s “A” Ratings

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 political stability. The Liberal Democratic Party (LDP) has maintained a majority in Parliament for much of the post-war era, with Fumio Kishida being elected as the 100th prime minister of Japan in October 2021.

The Kishida government’s policy agenda is centered on sustainable and inclusive growth and bodes well for sustaining Japan’s economic recovery. The PM’s policy on "New Capitalism," aims to address inequality through policies to promote economic growth, such as raising the share of labor income by promoting wage hikes, narrowing the wage gaps between genders and regular and non-regular workers, and facilitating support for business restructuring and productivity improvements by small and medium enterprises. The administration aims to solidify Japan’s status as a scientific and technological powerhouse, and has introduced policies focusing on R&D investments into areas such as green technology, artificial intelligence, quantum computing and biotechnology. Lastly following the Russian invasion of Ukraine, in an effort to diversify energy sources and enhance energy security, Prime Minister Kishida announced in August 2022 that Japan would restart idle nuclear plants and build new reactors with regulation ensuring higher safety standards. This move aligns with the government's energy transition and decarbonization plans and is supportive of Japan’s ratings. For more details pls see DBRS Morningstar Commentary (Japan’s Proposed Pivot Back to Nuclear Energy is Positive for Energy Security and Decarbonization).

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings. (May 17, 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/404883.

Notes:
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/401817/global-methodology-for-rating-sovereign-governments (August 29, 2022). In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings. (May 17, 2022) in its consideration of ESG factors.

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.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com.

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