Scope Ratings AG has today downgraded the State of Japan’s long-term local-currency rating to A+ from AA-, following the release of its revised sovereign rating methodology, and has converted its status from subscription to public. The agency has also assigned a long-term foreign-currency issuer rating of A+, along with a short-term issuer rating of S-1+ in both local and foreign currency. The sovereign’s senior unsecured debt in local and foreign currency was also rated at A+. All Outlooks are Stable.

Rating drivers

The rating downgrade is driven by weaknesses in the ‘public finance’ analysis category and reflects Scope’s view that Japan’s fundamentals are weakened by: i) high public debt burden and weak debt dynamics, and ii) weak growth outlook with growth potential that is under trend. However, the ratings are supported by a broadly diversified economy with a wealthy population, exceptional funding flexibility, the government’s commitment to reform, a strong external position, recent political stability, and a resilient financial system. Going forward, Scope’s ongoing assessment will concentrate on the extent to which a continued unfavourable public debt trajectory is redressed through the proactive initiatives of authorities.

Japan’s weak public finances and the high debt burden are key credit weaknesses. Headline deficits averaged 6.4% of GDP from 2010 to 2016, adding to gross debt as a percentage of GDP amounting to 239.4% in 2016, the highest of any country rated by Scope. Public debt is projected to gradually decrease due to improving primary balance and a negative interest-growth differential to 233.6% in 2022. The primary deficit is projected to decline in 2018 as the impact of the supplementary budgets fades. Nevertheless, the government projects a primary deficit of 2.4% of GDP in 2018, well above its 1% target. Consequently, it is Scope’s view that the long-term target of a primary surplus by 2020 will be difficult to achieve, even with robust GDP growth.

Under Scope’s debt-sustainability analysis, Japan’s public debt can only be moderately reduced if the government’s primary balance were to be in balance over an extended period of time. Debt dynamics are sensitive to shock scenarios and shifts in market sentiment. A modest shock scenario from weak growth, fiscal slippages, or increased financing costs would significantly increase the debt-to-GDP ratio to well over 250% in 2022 and further weaken credit fundamentals.

The rating downgrade is also driven by Japan’s weak potential growth averaging under 1% during the next 10 years, below the historical trend level of greater than 1%. The government’s growth strategy – the third 'arrow' of Abenomics – has not yet been able to raise potential output or reverse the economy’s deflationary cycle, despite some encouraging structural reform initiatives undertaken by the authorities. Unfavourable demographics and structural bottlenecks in the labour market remain major limiting factors to growth potential going forward. Between 2015 and 2025, Japan’s overall population will decline by 3.6%, but the nation’s working-age population is expected to decline by 7.2%. This, combined with the anticipated slow pace of domestic investment, will further undermine the growth potential of the economy.

Faster GDP growth will be essential for fiscal sustainability. Japan has benefited from six quarters of uninterrupted expansion, with real GDP expected to grow at 1.3% in 2017 thanks to a continued pickup in international trade and temporary fiscal support. Preparations for the 2020 Olympic Games and accompanying urban redevelopment are expected to generate a one-off increase of between 0.2 and 0.3 percentage points of growth to Japanese GDP to continue through 2018. Given the country’s deep structural constraints, Scope however expects real GDP to average below 1% over to 2020. Downside risks to the outlook include heightened geo-political tensions in Northeast Asia and trade protectionism.

Nevertheless, Japan’s A+ rating benefits from one of the most diversified economies in the world and continues to be world-class in key areas such as electronics and machinery. Structural shifts within the Japanese economy are also largely positive, with increased diversification within intermediate demand and increasing value-added in both manufacturing and exports. The unemployment rate fell to 2.8% in July 2017, the lowest rate since June 1994.

Japan also benefits from safe-haven status reflecting its large domestic investor base with 91% of Japanese government bonds held by resident investors supported by a sizeable pool of private-sector savings. The importance of the yen as global reserve currency further eases funding flexibility. Moreover, the composition of the public debt helps to maintain low borrowing costs. Average debt maturity is also relatively long at eight years and eight months as of the end of 2016, but short-term debt (under two years) remains substantial at 24.8% of the total debt stock at the end of 2016. Long-term debt (5 to 10 years) has decreased from 27.6% of debt in 2007 to 23.3% at the end of 2016, with very long-term debt (10+ years) increasing from 16.5% in 2007 to 29.3% at the end of 2016.

The ratings are further underpinned by Japan’s strong external position. A positive net international investment position of 61.0% of GDP in 2016 reflects high income flows from abroad, which has helped keep the current account in surplus for more than two decades. The current account surplus accelerated since 2015 reaching 3.9% of GDP in 2016 after several years of low current account surpluses due to high energy prices and weak exports.

The Japanese banking system has proven to be resilient in the face of significant challenges. It is one of the largest and most complex banking systems in the world, with total financial assets of around 620% of GDP in September 2016. More than half of total financial assets are held by commercial banks. The three largest banks alone hold 18% of total financial assets. The insurance sector is highly concentrated and the second-largest in the world after that of the US, with total financial assets of around 75% of GDP. Japanese banks are largely healthy, with low and declining non-performing loan ratios and an average capitalisation of 13% of risk-weighted assets. Local-currency liquidity indicators are favourable due to the Bank of Japan’s large excess reserves.

The political environment in Japan is characterised by a recent political stability and a strong institutional framework. Prime Minister Shinzo Abe has called for snap elections in October 2017. Scope does not expect any major policy changes to emerge and believes that the likely re-election of Prime Minister Abe would provide continuity for reform efforts.

Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on relative rankings of key sovereign credit fundamentals, signals an indicative A (a) rating range for the State of Japan. This indicative rating range can be adjusted by up to three notches on the Qualitative Scorecard (QS) depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis. For the State of Japan, the following relative credit strengths have been identified: i) economic policy framework, ii) macroeconomic stability and imbalances, iii) market access and funding sources, iv) current account vulnerabilities, v) external debt sustainability, vi) recent events and policy decisions, vii) financial-sector oversight and governance, and viii) macro-financial vulnerabilities and fragility. The following relative credit weaknesses have been identified for the State of Japan: i) growth potential of the economy and ii) fiscal performance. The combined relative credit strengths and weaknesses indicate a sovereign rating of A+ for Japan. A rating committee has discussed and confirmed these results.

For further details, please see Appendix 2 of the Rating Report.

Outlook and rating-change drivers

The assignment of a Stable trend reflects Scope’s view that risks to the ratings are now broadly balanced.

The ratings could be downgraded following: i) a sharp deterioration in the economic outlook, ii) strong deterioration in fiscal results, and/or iii) a reversal of structural reforms. The rating could be upgraded if: i) growth were to accelerate sharply, ii) there is a greater-than-anticipated reduction in debt, and/or iii) reforms significantly increase growth potential.

For the detailed research report, please click HERE.

Rating committee 

The main points discussed by the rating committee were: i) Japan’s demographic trends impact on economic growth potential, ii) fiscal performance and debt sustainability, iii) external position and yen reserve currency status, iv) structural reforms, v) banking and financial sector performance, vi) recent political and geopolitical developments, vii) peer considerations. 

Methodology

The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available at www.scoperatings.com.

Historical default rates from Scope Ratings can be viewed in Scope’s rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA) at http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default and definitions of rating notations can be found in Scope’s public credit rating methodologies at www.scoperatings.com.

The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months. A rating change is not automatically ensured, however.

Regulatory disclosures

This credit rating and/or rating outlook is issued by Scope Ratings AG.
Rating prepared by John F. Opie, Lead Analyst
Person responsible for approval of the rating Dr Stefan Bund, Chief Analytical Officer
The ratings/outlook were first assigned by Scope as a subscription rating in January 2002. The subscription ratings/outlooks were last updated on 05.05.2017.
The senior unsecured debt ratings as well as the short-term issuer ratings were assigned by Scope for the first time.

As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on the State of Japan are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Sovereign Ratings Calendar of 2017" published on 21.07.2017 on www.scoperatings.com). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case the deviation was due to the recent revision of Scope’s Sovereign Rating Methodology and the subsequent placement of the ratings under review, in order to conclude the review and disclose these ratings in a timely manner, as required by Article 10(1) of the CRA Regulation.

Solicitation, key sources and quality of information
The rating was initiated by Scope and was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the ratings process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.
The following material sources of information were used to prepare the credit rating: the Ministry of Finance of the State of Japan; Bank of Japan; the Japanese Research Institute; Mizuho Research Institute; Cabinet Office; Financial Services Agency; Ministry of Economy, Trade and Industry; Ministry of Internal Affairs and Communications; National Institute for Defense Studies; Nomura Global Markets Research; IMF; OECD; and Haver Analytics.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
Prior to publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Conditions of use / exclusion of liability
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