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

DBRS, Inc. (Morningstar DBRS) confirmed Japan's Long-Term Foreign and Local Currency - Issuer Ratings at A (high). At the same time, Morningstar DBRS confirmed Japan's Short-Term Foreign and Local Currency - Issuer Ratings at R-1 (middle). The trend on all ratings is Stable.

KEY CREDIT RATING CONSIDERATIONS

The confirmation of Japan's A (high) rating and Stable trend reflects Morningstar DBRS's view that the country's credit fundamentals offset the uncertainty generated from rising geopolitical tensions and the gradual normalization of domestic monetary policy. While economic growth remains above potential, the softness in growth seen since 2H 2023 is likely to reverse due to higher real wages following the Shunto wage negotiations. The BoJ expects its 2% inflation target to be met in a sustainable and stable manner on the back of a virtuous cycle between wages and prices and has reverted to using short-term interest rates as a primary tool for monetary policy. The BoJ expects headline growth to recover to 1.0% in fiscal 2025 and 2026 respectively. On the other hand, Japan's public finances remain a key constraint to its rating. Following the pandemic related fiscal measures, Japan's deficit rose to 9.1% of GDP in 2020 and remained high averaging 5.7% of GDP during 2021-24 due to government measures to address price increases including energy price subsidies following the conflict in Ukraine. The IMF expects the deficit to fall to 3.2% of GDP and 2.9% of GDP respectively in 2025 and 2026. Japan's public debt ratio which rose from 236.4% of GDP prior to the pandemic to 257.2% in 2022 is likely to trend marginally lower to 251.7% by the end of its forecast horizon in 2029. An additional impediment to economic 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 its 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. Morningstar DBRS expects Japan's safe-haven status and the Bank of Japan's (BoJ) bond purchases, 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) in June 2024 now stand at 46.9% of total debt. That said, on the back of a virtuous cycle between wages and prices, the BoJ will face a delicate balancing act: to normalize monetary policy while maintaining financial stability. 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.

CREDIT RATING DRIVERS

Japan's credit ratings could be upgraded if there is a material improvement in nominal growth and sustained reduction in the fiscal deficit. Conversely, the following could lead to a downgrade: (1) fiscal results persistently underperform, or (2) the policy response fails to achieve a durable exit from the cycle of weak growth and entrenched low inflation.

CREDIT RATING RATIONALE

Increase in Real Wages Likely to Support Japan's Economic Recovery
Following a robust post-pandemic recovery that was led by manufacturing, business investment and consumption which resulted in above potential growth of 1.9 % in 2021-23, the Japanese economy began slowing in 3Q 2023 with 1H 2024 growth contracting 1.0%. This is largely attributed to the suspension of shipments by a large automaker and negative real wage growth. Growth has picked up marginally with the rebound expected to continue in the coming quarters due to a multitude of factors including the resumption of auto production providing a boost to manufacturing and export, higher consumption and investment. Income tax rebates and higher real wages on the back of the wage increases reflected in the over 5% overall increase agreed in the Shunto wage negotiations, are likely to support consumption while the uptick in business investment is likely to continue due to high corporate profitability - a result of the pass-through of high import prices. In addition to digitalization and decarbonization, areas seeing a pickup in investment are those related to the strengthening of supply chains and measures to address labor shortages. The BoJ expects the Japanese economy to continue to grow above potential as the virtuous cycle from income to spending continues against the backdrop of relatively accommodative financial conditions. Taking into account the weak first quarter the BoJ expects headline growth to slow to 0.6% in fiscal 2024 before recovering to 1.0% in fiscal 2025 and 2026 respectively.

Japan's medium-term outlook remains clouded by demographic-related structural weaknesses. Japan's potential growth stands at a mere 0.6%, leading to a negative adjustment in our Economic Structure and Performance building block assessment. Japan's ageing and shrinking population have resulted in the highest old age dependency ratio among OECD countries exceeding 50% and the figure is projected to rise to 80.7% 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 partially alleviated Japan's labor market challenges in the recent years. The reform measures resulted in Japan's labor supply increasing from 65.7 million workers in 2012 to 69.3 million in 2023.,. Furthermore, the increase in labor supply coupled with the increase in working-age female and elderly participation in the workforce resulted in Japan's labor force participation rate rising from 59.1% in 2012 to 62.9% in 2023. However, due to the successful implementation of the Work Style Reforms which have resulted in a cap on overtime coupled with a peaking of women and elderly work force participation, Japan is beginning to witness labor shortages in key sectors. This in turn is pushing wages and inflation higher.

BoJ Begins To Normalize Policy: Ends An Era of Negative Interest Rates and Explicit Yield Curve Control
Earlier this year in its March policy, on the back of an improving inflation outlook, the BoJ discontinued its ultra-easy monetary policy) which had been in place since 2013. While continuing its commitment to buy Japanese Government Bonds (JGBs), the BOJ has discontinued purchases of ETFs and REITs. The BoJ also reinstated the uncollateralized overnight call rate (within the range of 0-0.1%) as the primary monetary policy tool, thus ending the era of negative rates that had been in place since 2016. The BoJ moved again in July raising the overnight call rate from 0.1% to 0.25% while simultaneously announcing a reduction of JGB purchases from JPY 6 trillion a month to JPY 3 trillion by March 2026, with a quarterly reduction of JPY 400 billion.

Headline inflation in Japan which had been above 2% since April 2022 rose to a three decade high of 4.3% YoY in January 2023, driven largely by the lagged impact of higher commodity prices and yen depreciation. Since then, lower energy prices and government measures have driven down prices, but inflation remains above the BoJ's medium term 2% target with headline inflation at 3.0% in August 2024 and core inflation (ex-fresh food) at 2.8%. However, Japan is now seeing signs of demand-pull negotiations, with the Shunto wage negotiations exceeding 5% in 2024, higher than 3.6% last year and the highest in three decades, wage increase are being seen across firms of all sizes and spread across all regions and industries. Consequently, the BoJ expects prices to remain in line with its price stability target of 2% rise due to an improvement in the output gap and higher inflation expectations due to potential changes in firm-level wage and price-setting behavior. The BoJ's baseline scenario for prices is for core inflation at around 2.5% in fiscal 2024 and 2.1% in fiscal 2025.

Despite moves towards normalizing monetary policy, the divergence in global rates continues to put downward pressure on the yen which has weakened considerably since the US Federal Reserve began raising rates in March 2022. From trading at USD/JPY 110 in October 2021, the yen depreciated to a low of USD/JPY 160 in July 2024 resulting in Japanese authorities intervening in currency markets in 2022 and 2024. The last intervention done by the BoJ was during the 1997-98 Asian Financial Crisis. Since then, concerns on a greater than anticipated slowdown of the US economy coupled with a tighter monetary policy stance by the BoJ in its July meeting have seen interest rate differentials narrowing and the yen recovering to a range of USD/JPY 140-150.

Looking ahead, the BoJ's key challenge entails a delicate balancing act: to normalize monetary policy while maintaining financial stability. In its latest Financial Stability Report the BoJ said that major banks have avoided accumulating larger holdings of yen-denominated bonds, deployed interest rate hedging strategies, and reduced the average maturity of their JGB portfolio holdings, thereby mitigating potential negative impacts. Including unrealized gains or losses on securities, CET1 ratios have been consistently above regulatory requirements. In addition, stress tests suggest major banks have the necessary capital buffers to absorb large shocks. Regional banks have also adopted a conservative risk management stance toward their investments. We note that an increase in the BoJ's base rate will have a positive net impact on major banks' interest income over time, and that the overall financial sector's fundamentals are strong. Including unrealized gains or losses on securities, CET1 ratios have been consistently above regulatory requirements. We also note that while the recent sell-off could decrease the banks' unrealized gains and associated capital cushion, banks have been progressively reducing their Japanese equity holdings over the past years. That said, while the financial sector fundamentals are strong, contingent risks stemming from the regional banking sector may increase if rates rise by more and faster than expected.

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. While we expect Japan to retain its considerable financial flexibility, we will be monitoring the risks of a change in the savings behavior of Japanese households. While pension and insurance investors rebalancing their portfolios towards riskier foreign bonds and equity, financial institutions have maintained abundant liquidity, which significantly reduces the risk of needing to sell JGBs at a loss. Nonetheless, normalizing policy in Japan, via either rate hikes or unwinding asset purchases, could put stress on financial markets.

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 deficits have averaged around 4% of GDP since the 1980s and edged higher during global and domestic shocks. Deficits touched 9% levels in 2009 (global financial crisis), 2011 (earthquake) and 2020 (global pandemic). Since then, the deficit has declined but remained high averaging 6.1% in 2023 and 2024, due to tax cuts and fuel subsidies to combat the impact of inflation on households and enable companies to hike wages. The IMF projects Japan's fiscal deficit to decline to 3.2% in 2025 and average 3.3% during 2026 to 2029.

The pandemic resulted in its public debt-GDP ratio rising from 236.4% in 2019 to 258.3% in 2020. Since then, the recovery in growth has resulted in Japan's debt-GDP ratio declining marginally to 252.4% in 2023 and 254.6% in 2024. Japan's near- and medium-term debt dynamics are favorable due to positive growth and negative real interest rates. The IMF projects Japan's gross and net public debt ratios to moderate to 252.1% and 154.8% of GDP over the projected horizon of 2024 to 2028. However, longer term risks remain due to Japan's demographics and social security spending, that account for nearly 35% of total expenditure. Moreover, a sharp reversal in Japan's ultra-loose monetary policy could also have implications for Japan's public finances reversing the downward trend in the debt-service ratio, which has been declining for over two decades.

That said, despite Japan's high debt ratios, Japan's financial flexibility is high. Government debt is all yen denominated with an average maturity of 9 years and 5 months as of the end of FY2023 and is financed by a high rate of national savings which stand at 29.7% of GDP currently. 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) have increased significantly from 11.5% of total debt in March 2013 to 53.2% of total in March 2024. Other holders of JGB's include insurance companies (18.2%), domestic banks (11.3%) and pension funds (3%). Foreign investors hold only 6.5% of total debt. 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. 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. Following the dip in the current account surplus to 2% in 2022, the surplus increased to 3.4% in 2023 reflecting lower commodity prices which helped the trade deficit narrow and surge in inbound tourism which boosted the services balance. With Japanese companies continuing to expand overseas, Japan's income balance that comprise direct investment income and securities investment incomes remains the main contributor to the current account surplus, with the weakness in the yen increasing the value of overseas investment income.

The country's net international investment position (NIIP) remains high rising from 75.0% of GDP in 2022 to 79.6% of GDP in 2023. This was primarily driven by an increase in both net FDI and portfolio outflows and the positive valuation effects of the yen depreciation. 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. Japan's strong current account balance and high level of net foreign assets insulate it from external financial market shocks and is a core credit strength. In addition, Japan holds a degree of resilience with the shock-absorbing benefits of the yen being one of the world's most widely used 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 Worldwide Governance Indicators, both within Morningstar DBRS's "A" rated peer group and globally. Japan scores favorably on government effectiveness, control of corruption, and rule of law with scores in the 90th percentile. 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. In the recently held LDP elections in September 2024, Mr Shigeru Ishiba was elected as the president of the LDP who will lead the party in the next general elections scheduled to be held later this month. He follows PM Fumio Kishida who decided not to run for re-elections and who took over from Yoshida Suga. While details are awaited, Ishiba has indicated that he would prioritize measures to support the economy.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

There were no Environmental/Social/Governance factor(s) that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/441403.

Notes:
All figures are in Japanese yen 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 (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS' outlooks and credit ratings are monitored.

The primary sources of information used for these credit ratings 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.
Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings was of satisfactory quality.

The credit rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

Morningstar DBRS did not have access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

The last credit rating action on this issuer took place on October 19, 2023.

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