Scope Ratings has today affirmed Japan’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at A+. The agency has also affirmed the short-term issuer rating at S-1+. All Outlooks are Stable.

Rating drivers

Japan’s A+ rating is supported by its very wealthy, large and diversified economy, its strong funding flexibility and safe-haven status, as well as its very sound external position as the world’s leading creditor nation with the second-highest foreign exchange reserves. However, known but unresolved demographically-induced growth and public finance weaknesses are important credit constraints. The Stable Outlook reflects the Japanese government’s efforts to revive the economy and enhance the labour supply by increasing the participation rates of women, the elderly and foreign workers as well as the Bank of Japan’s credibility and resolve to maintain an ultra-accommodative monetary policy stance which mitigates debt sustainability concerns at this stage.

First, Japan’s A+ rating is supported by its very wealthy, large and diversified economy. Japan has the world’s third-largest economy (only recently overtaken by China’s), which accounts for about 6% of global economic output, almost twice that of the UK or France. Japan’s high nominal GDP reflects its large population (second only to that of the US among rich democracies), strong institutions and competitive economy, driven by high spending on research and development. Based on OECD data, Japan has the world’s third-largest absolute investment in R&D at about USD 155bn in 2017, behind only China (USD 443bn) and the US (USD 484bn). R&D spending has been consistently above 3% of GDP since 2002, above the US (2.8%) and China (2.1%). Similarly, the World Economic Forum’s global competitiveness report consistently places Japan in the top 10, reflecting its excellent physical and digital infrastructure, healthy, well-educated workforce, highly competitive local markets, large domestic market and rapid absorption of technology given sophisticated consumers and businesses.

Second, Japan enjoys strong funding flexibility based on its safe-haven status and favourable debt profile. This reflects a large domestic investor base, with around 90% of Japanese government bonds held by resident investors, supported by a sizeable pool of private-sector savings. The importance of the yen as a reserve currency, combined with the Bank of Japan’s quantitative and qualitative easing, which is accompanied by yield curve control keeping the 10-year government bond yield around 0%, and negative short-term policy interest rates since 2016, results in extremely low and stable long-term government bond yields. In addition, possible refinancing risks due to Japan’s significant gross financing needs, estimated at around 40% of GDP for 2019 by the IMF, are mitigated by an average debt maturity of around nine years (excl. T-bills) and the absence of any foreign-currency debt.

Third, Japan’s A+ rating is bolstered by its very strong external position as the world’s leading creditor nation with the second-highest foreign exchange reserves. Significant primary income from the country’s high stock of foreign assets has resulted in consistent current account surpluses, which averaged 2.6% of GDP over the last decade, far above the averages for the UK (-3.9%) and the US (-2.4%). However, in Scope’s opinion, rising global trade tensions and a slowing Chinese economy could weigh on Japan’s current account. Scope notes that the share of goods exports to China and the US amounted to 38.5% in 2018 with China’s share rising substantially from 6.3% in 2000 to 19.5% in 2018. As a result, Scope expects the current account to moderate from its recent peak of 4.0% in 2017 to around 3-3.5% of GDP over the forecast horizon to 2024. Still, given sustained current account surpluses, Japan’s net international investment position exceeds USD 3.1trn (62.4% of GDP) at year-end 2018, far above the levels of peers, while its low external debt (79.4% of GDP) together with the Japanese yen’s reserve currency status significantly reduce the country’s vulnerability to shocks and risks linked to external debt sustainability.

Fourth, financial stability risks in Japan are broadly balanced, owing to the robust supervisory and regulatory oversight framework of the Bank of Japan and the Financial Services Agency. However, the persistent low-interest-rate environment, demographic headwinds and high levels of domestic competition have weighed on banking profitability. While net income has remained relatively high – underpinned by gains realised on stockholdings and the fall in borrowing costs – net interest income has trended down with the return on assets for Japanese banks being the second lowest in the OECD at 0.22% in 2018. This challenge has encouraged risk-taking by financial institutions, including increases in loans to higher credit risk, real estate and overseas borrowers (which also raises the sector’s foreign-currency exposure). Despite these concerns, the Japanese banking sector remains well capitalised, with the Tier 1 ratio reaching 14.8% of risk-weighted assets, and has strong asset quality, with the non-performing loan ratio decreasing to 1.1% in Q3 2018. This view is supported by the Bank of Japan’s latest macro stress testing results that found that Japanese banks have strong resilience. Furthermore, Scope views positively the move towards more forward-looking risk assessments by the Financial Services Agency and measures announced in April to expand the oversight of regional banks.

Still, an overly expansionary monetary policy – since 2012, the Bank of Japan tripled the size of its balance sheet, which reached 100% of GDP in 2018 – can lead to excessive risk-taking, which fuels asset price booms and may, in turn, result in financial instability. The biggest increase in asset prices is in government bonds as interest rates have fallen across the yield curve. In addition, as highlighted by the OECD, the Bank of Japan now owns more than three quarters of the exchange-traded fund market, making it among the top ten shareholders, indirectly, in 40% of Japanese listed companies. This may lead to the overvaluation of stocks and erode market discipline as companies are rewarded simply for being in major market indices rather than for having successful business strategies. In Scope’s opinion, this may also adversely affect corporate governance standards and thus the country’s growth outlook.

Similarly, historically low interest rates and moderate economic growth rates have supported Japan’s non-financial private sector debt to date, at 202% of GDP in 2018, which is relatively high compared to that of peers such as the UK (184%), the US and China (both 148%) exposing the business sector (non-financial corporate debt stood at 142% of GDP at year-end 2018), to sudden shifts in interest rates. Overall, while Scope sees potential side effects from the Bank of Japan’s expansionary monetary policy, at the moment there are no signs that financial and economic activities are overheating as highlighted by the Bank of Japan’s Financial System Report.

Despite these credit strengths, Japan is exposed to two inter-dependent fundamental weaknesses:
First, Japan’s demographically-constrained low-growth potential and weakening economic outlook. The government’s ‘Abenomics’ reflation initiative, together with the sustained and synchronised global recovery, increased annual growth from around 0.5% over the 1997-2012 period to 1.3% since the end of 2012, and replaced persistent deflation with positive, albeit low, inflation. However, the Japanese economy has grown much more slowly than its peers since the financial crisis. Real GDP is now only 7% above its pre-crisis level, compared to the US (22%) and France (11%).

As the economic cycle turns, the output gap closes, and global trade tensions rise (especially between the US and China, which together account for almost 40% of Japan’s exports), Scope expects Japan’s economy – at full employment, with an unemployment rate near or below 3% since Q2 2015 but with core inflation of only 0.9% as of April 2019, and thus well below the Bank of Japan’s price stability target of 2% – to post growth rates that converge downwards towards its medium-term potential, and thus again below 1%. Estimates of the country’s growth potential range between 0.5% (IMF, OECD), 0.7% (Bank of Japan) and 1.1% (government). Consequently, despite the government’s ambitious monetary, fiscal and structural growth reform efforts since 2012, the country’s growth outlook remains very low among advanced economies.

Japan’s low-growth potential is mainly driven by its declining growth contribution from total hours worked. This also reflects the country’s adverse demographics, in particular, the four linked issues of: i) women’s underemployment, with only 76% of women aged 24-44 in employment, compared with 93% of men, depriving the country of a significant portion of its human capital; ii) a low and declining birth rate of around 7 births per year per 1,000 people, compared to around 11 in the US and France, which, given the absence of meaningful immigration (foreigners constitute only around 2% of the workforce) results in; iii) a declining population, already down by about 1.7m people since 2008 to around 126.4m, and, according to the estimates of the National Institute of Population and Social Security Research, projected to decline further to around 123m by 2025 and around 102m by 2050; and iv) its ageing population with elderly people, defined as those above 65 years of age, already constituting about 28% of the total population. These factors have resulted in Japan having the world’s highest old-age dependency ratio, estimated, according to the UN, at around 43 for 2015 (up from 25 in 2000), and projected to increase to above 50 by 2025, well above France (37) and the US (30).

Japan’s total employment has increased over the past few years despite a decline in its working-age population due to the recent economic expansion reaching its highest level ever in 2018. However, the OECD estimates that the population will decline by one fifth and the workforce by one quarter by 2050, assuming constant labour force entry and exit rates. This will increase labour shortages and compound the challenge of fewer tax-paying workers to fund the pensions and health-care expenses of more pensioners. This is a known but unresolved policy challenge despite the government’s efforts and partial success in increasing the labour supply: from 2012 to 2018, 2.9m women joined the workforce (although around half were non-regular workers), the employment rate of people over the age of 65 increased by 4.8%, and the number of foreign workers doubled from 0.7m to around 1.5m.

Further reforms are needed, as highlighted by the OECD, to remove barriers to women (the gender wage gap is the third highest in the OECD at around 25%, compared to the OECD average of around 14%), break down labour market dualism, shift to more flexible employment and wage systems based on performance rather than age, and substantially increase the role of foreign workers (beyond the 345,000 to be accepted between 2019-24 under the Immigration Control Act enacted in December 2018). In addition, to compensate for the declining workforce, Japan also needs to strengthen its reform efforts to raise the country’s productivity, which grew at around 1% per year over the 2012-17 period, half that of the government’s goal of 2% by 2020 and around a quarter below the top half of OECD countries.

The second key credit constraint is Japan’s weak public finances and high debt burden. Since 1993, when the debt-to-GDP ratio stood at 74%, Japan has had persistent primary deficits. While primary deficits have declined significantly from a five-year average of 8.2% in the 2009-13 period to 3.3% during 2014-18, the IMF estimates average primary deficits of 2.1% for 2019-24, slightly better than the US (2.3%) but below that of France (1.0%). As a result, general government debt has increased steadily to around 237% in 2018, up from 201% in 2009.

Importantly, the FY 2018 target of a primary deficit of around 1% was missed by almost 2 pp due to lower-than-expected growth, repeated supplementary budgets and delays in raising the consumption tax from 8% to 10% (originally planned for 2015). This slippage, together with the decision to use some of the additional revenue from the 2019 tax hike for new social spending, put the FY 2020 target of a primary balance out of reach. The government’s January 2019 projection estimates that a primary surplus can be achieved by 2026, assuming annual nominal growth of around 3% for the 2019-25 period, which is well above the average of less than 2% since 2012. Even the more realistic assumption of annual nominal growth of around 1.8% – based on average annual real growth of 1.1%, almost double the IMF’s growth outlook – results in a primary deficit of 1.0% by 2026 according to the government.

As a result, the government’s interim targets for FY 2021 of reducing the primary deficit to 1.5% of GDP (from 2.9% in 2018) and lowering government debt to 180%-185% of GDP (by the government’s measure it was 188% in FY 2017) appear too optimistic. In this context, persistent primary deficits combined with a low growth outlook prevent a downward trajectory in the public-debt-to-GDP ratio, despite negligible interest expenses of around 0% of GDP over the projected horizon. While the IMF’s baseline scenario estimates that the debt-to-GDP ratio will remain stable at around 238% by 2024, a slight deterioration in any of the debt-relevant variables would quickly bring the ratio close to 250% (or 150% excluding the government’s assets of around 100% of GDP).

Scope notes that refinancing risks are significantly reduced by the fact that most of the debt is held domestically, specifically by Japanese individuals, businesses and pension funds (many of them owned by the government itself), and the Bank of Japan which holds around 40% of total Japanese Government Bonds or 85% of GDP. Still, in Scope’s opinion, a credible, detailed medium-term growth-friendly fiscal consolidation strategy, as highlighted by the IMF and the OECD, based on realistic economic assumptions and budget projections, specific measures to limit spending, especially on pensions, public health care and long-term care, and increases in government revenue, is needed to bring the debt-to-GDP ratio onto a declining trend. While Japan’s growth and public finance challenges are acknowledged, they remain unresolved, and, compared to other advanced economies that face similar challenges from their ageing populations, are much more difficult to redress.

Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative ‘a’ (‘a’) rating range for the State of Japan. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.

The following relative credit strengths have been identified for the State of Japan: i) the economic policy framework; ii) market access and funding sources; iii) the current account; iv) external debt sustainability; v) vulnerability to short-term shocks; vi) recent events and policy decisions; and vii) financial sector oversight and governance. Relative credit weaknesses are: i) the growth potential of the economy; ii) the fiscal policy framework; and iii) debt sustainability. The combined relative credit strengths and weaknesses generate a one-notch adjustment and indicate a sovereign rating of A+ for the State of Japan. A rating committee has discussed and confirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope considers sustainability issues during the rating process as reflected in its sovereign methodology. Governance factors are explicitly captured in Scope’s assessment of ‘institutional and political risk’ under its methodology, in which Japan has high scores on a composite index of six World Bank Worldwide Governance Indicators. Social factors are reflected in Japan’s comparatively high GDP per capita, very low rates of unemployment, and the world’s highest old-age dependency ratio. Finally, environmental factors are considered during the rating process, but did not play a direct role in this rating action.

Outlook and rating-change drivers

The Stable Outlook reflects the Japanese government’s efforts to revive the economy and enhance the labour supply by increasing the participation rates of women, the elderly and foreign workers as well as the Bank of Japan’s credibility and resolve to maintain an ultra-accommodative monetary policy stance, which mitigates debt sustainability concerns at this stage.

The ratings/outlook could be downgraded if: i) economic reforms fail to meaningfully raise the country’s growth potential; ii) primary surpluses remain an elusive target, raising doubts about the government’s long-term fiscal consolidation plan to place the debt-to-GDP ratio on a firm downward trajectory; and/or iii) interest rates rise, challenging public debt sustainability efforts and heightening financial stability risks.

The ratings/outlook could be upgraded if: i) economic reforms accelerate to raise the country’s growth potential; and/or ii) a credible, long-term fiscal consolidation plan places the debt-to-GDP ratio on a firm downward trajectory.

Rating committee
The main points discussed by the rating committee were: i) the growth potential of the economy; ii) recent fiscal developments; iii) public debt sustainability; iv) monetary policies adopted by the Bank of Japan and inflation prospects; v) demographic challenges; vi) external position; and vii) macro-financial vulnerabilities.

Methodology
The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on http://www.scoperatings.com. The historical default rates used by Scope Ratings can be viewed in the rating performance report on 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): 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 on www.scoperatings.com. The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months. A rating change is, however, not automatically a certainty.

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: public domain and third parties. Key sources of information for the rating include: Ministry of Finance of the State of Japan, Bank of Japan, the BIS, the IMF, the 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.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Alvise Lennkh, Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director
The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The ratings/outlooks were last updated on 16.03.2018.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
© 2019 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis GmbH, Scope Investor Services GmbH and Scope Risk Solutions GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions 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. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided ‘as is’ without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or other damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party as, opinions on relative credit risk and not a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstrasse 5, D-10785 Berlin.

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