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Rating action

Scope Ratings has today affirmed Japan’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at A+ and revised the Outlook to Negative. The agency has also affirmed the short-term issuer rating at S-1+ in both local and foreign currency and revised the Outlook to Negative.

Summary and Outlook

The Outlook change to Negative reflects Scope’s view that the Covid-19 shock will have a lasting, material impact on the country’s already weak public finances and growth outlook, and will thus, in the context of low growth and inflation prospects, make any significant fiscal consolidation after the crisis unlikely. This reflects the significant structural challenges posed by a rapidly shrinking and ageing population, which i) exacerbates Japan’s fiscal vulnerabilities due to rising ageing-related costs and a declining tax base and ii) constrains the country’s already low growth potential. The affirmation of Japan’s ratings at A+ is supported by a wealthy, diversified and competitive economy, strong funding flexibility due to the yen’s reserve currency status and ongoing large-scale purchases of Japanese government bonds by the Bank of Japan, and a robust external position. The assignment of the Negative Outlook reflects changes in Scope’s assessments in the ‘domestic economic risk’ and ‘public finance risk’ categories of its sovereign methodology.

The Negative Outlook reflects Scope’s view that risks to the ratings are tilted to the downside over the next 12 to 18 months. The ratings could be downgraded if: i) post-crisis primary surpluses remain an elusive target, raising doubts about the government’s ability to achieve long-term fiscal consolidation and place the debt-to-GDP ratio on a firm downward trajectory, and/or ii) economic reforms fail to meaningfully raise the country’s growth potential. The Outlook could be reversed to Stable if: i) an appropriate and credible long-term fiscal consolidation plan stabilises the debt-to-GDP ratio and places it longer-term on a firm downward trajectory, and/or ii) structural reforms accelerate to raise the country’s growth potential.

Rating rationale

The first driver of the Outlook change to Negative is Japan’s weak public finances and high debt burden. Since 1993, when the public debt-to-GDP ratio stood at only 74%, Japan has posted persistent primary deficits. Since 2010, budget deficits have, however, increasingly been supported by large-scale government bond purchases from the Bank of Japan (BoJ), helping to keep rates low. Specifically, based on IMF figures, the BoJ has increased its total government debt holdings to about 40% from 10% of the total public debt stock over the past ten years, displacing the holdings of domestic private sector investors, which now account for about 46% of total public sector debt, down from 85% in 2010. This trend is likely to persist over coming years and may at some point raise questions about the limits and sustainability of Bank of Japan policies and the size of the balance sheet, which already exceeds Japan’s annual economic output, at around 110% of GDP.

Despite this forceful intervention, the government is still committed to placing public debt levels on a more sustainable path and has taken steps in this direction – including the October 2019 VAT tax hike. However, the primary deficit remains large and has averaged 2.8% of GDP over 2017-19, above that of France (1.3% of GDP) and the United Kingdom (0%) but below that of the United States (3.2%). Importantly, Scope notes that the government has a track record of pushing back its own targets for achieving a primary surplus: initially, the government planned to achieve such a primary surplus by 2020, which was delayed to 2025 in 2018. The Japanese Cabinet Office already projected in January 2020 that a primary surplus would only be achieved by2027¹. The recent deterioration in Japan’s fiscal outlook following the Covid-19 economic shock makes the achievement of a primary surplus by 2027 unlikely in Scope’s view, with the possibility that achieving a primary surplus will only become feasible by around 2030, a full decade after the original target.

This highlights the materiality of the Covid-19 shock on Japan’s fiscal fundamentals in 2020 and beyond. Prior to the shock, general government debt had already increased steadily from 201% of GDP in 2009 to 238% in 2019. Since December 2019, the government has announced successive fiscal stimulus packages that amount to JPY 118trn, of which JPY 33.9trn (around 6% of GDP) relates to direct government spending, to respond to a deteriorating economic outlook following the VAT tax hike and subsequent Covid-19 shock. According to the IMF, gross government financing needs are the highest among advanced economies at around 46% of GDP in 2020, and the budget deficit is set to widen to around 7% of GDP in 2020, which, on top of the contraction in nominal GDP, will lead to an increase in public debt to around 250-255% of GDP, with risks even on this figure depending on the duration of the health crisis.

As such, the Covid-19 crisis exacerbates pre-existing structural budgetary pressures Japan faces due to its ageing population, the world’s oldest: the median age is estimated at 48 years, 29% of the population is aged 65 years and above, and Japan’s old age dependency ratio will rise from 49% to 74% over the next forty years². This will magnify fiscal challenges as the tax base shrinks and ageing-related spending, in particular, healthcare costs, rises. From 2000 to 2019, social security spending rose from around one fifth to one third of total expenditures and is set to continue increasing. The IMF projects the net present value of changes in healthcare costs over 2019-50 to represent 61% of GDP, well above that of France (44%), and the UK (49%)³. These structural pressures, coupled with low growth and low inflation, will prevent any meaningful decrease in the debt-to-GDP ratio at least through 2024, implying that the public debt ratio is set to remain permanently at least 15-20pp higher than prior to the Covid-19 shock. A credible and detailed medium-term fiscal consolidation strategy, anchored in realistic growth and budget projections, is needed to strengthen public finances.

The second rating driver underpinning the Negative Outlook on the A+ rating is Japan’s demographically constrained low growth potential. Despite the government’s highly ambitious ‘Abenomics’ reflation initiatives, Japan’s economy has grown significantly slower than peers’ with real growth averaging just 1.0% over 2015-19, below the US (2.4%), the UK (1.8%) and France (1.5%). According to estimates from the Bank of Japan, Japan’s potential growth is low and has declined significantly from a peak of around 4% in the 1990s to 0.4% at year-end 2019. This is mainly driven by an increasingly negative contribution from total hours worked, which contributed -0.6% to potential growth in 2019. Low productivity growth also weighs upon economic performance as firms direct more investments abroad and employment shifts from sectors with high productivity, such as manufacturing, to less productive services sectors. Labour productivity growth in Japan averaged 0.6% over 2014-18 versus 1.2% in France and 0.8% in the US⁴.

Scope expects demographic headwinds to aggravate this trend given the projected shrinking in the working age population by 26% by 2060. While government efforts to enhance labour supply by promoting the participation of women and the elderly as well as foreign workers are appropriate, more progress is needed to face upcoming labour shortages and raise productivity levels. Female labour force participation rates have been increasing in recent years but remain low at 73% compared with 86% for men, foreign workers only represent 2% of the total workforce and the share of firms reporting labour shortages reached 88%, the highest among surveyed countries⁵.

Scope notes that Japan has experienced a combination of low growth and structurally low inflation despite the forceful actions of the Bank of Japan including negative interest rates as well as large scale purchases of government and corporate bonds and bills, exchange traded funds as well as real estate investment trusts. As highlighted by the IMF, lower potential growth and adverse demographics have substantial deflationary effects and likely constrain the Bank of Japan’s ability to provide effective monetary stimulus^6,7. Since 2012, the Bank of Japan increased its balance sheet from 32% of GDP to around 110% of GDP, significantly above that of the ECB (39% of euro area GDP) or the Federal Reserve (27%). Yet, headline inflation stood at just 0.4% in February 2020, well below the Bank of Japan’s target of 2% despite the economy being at full employment with unemployment rates under 3% since May 2017.

The deterioration in Japan’s near-term growth outlook due to the knock-on effects of the October 2019 VAT tax hike and recent crisis will exacerbate macroeconomic challenges. While forecasts are subject to downside risks, the IMF expects the Japanese economy to shrink by around 5% in 2020 after posting -7.1% annualised growth in Q4 2019, followed by a recovery of 3% in 2021 with gradual convergence towards potential growth rates of 0.3%. In this context, Japan should strengthen structural reform efforts to increase the country’s productivity and growth potential as well as support reflation. If no meaningful gains are made in these areas, demographic challenges will accentuate a low growth, low inflation environment thus further weighing on the country’s weak public finances.

Overall, the two drivers for the Negative Outlook highlight the difficulties Japan’s government faces in striking the balance between two policy objectives that, over time, are becoming alternatives, rather than complements: medium-term fiscal consolidation and near-term fiscal support to lift growth and reflate the economy. With reflation efforts falling short, the BoJ’s balance sheet already exceeding GDP, and the Covid-19 pandemic putting further pressure on the fiscal and growth outlooks, the channels to sustainably reduce the public debt burden – fiscal consolidation, higher growth and higher inflation – are becoming less available to policymakers, underlining the Negative Outlook.

Despite these structural weaknesses, Japan retains considerable credit strengths.

First, Japan’s A+ rating is supported by its wealthy, diversified and competitive economy. Japan’s economy accounts for about 6% of global economic output, as the third largest economy in the world and around twice the size of that of the UK or France. Japan’s economy is home to internationally competitive companies with high levels of export sophistication. Japan also has one of the highest levels of research & development (R&D) intensity in the world, with domestic R&D spending averaging 3.3% of GDP over 2014-18, well above levels in the UK (1.7%), France (2.2%), China (2.2%) and the US (2.8%). Similarly, the country benefits from a strong governance framework with resilient institutional checks and balances, strong observation of the rule of law and a stable political environment. Accordingly, Japan ranked sixth out of 141 countries in the World Economic Forum’s 2019 Global Competitiveness Report, reflecting its large market size, competitive market dynamics, excellent physical and digital infrastructure and well-educated, technology-savvy population⁸.

Second, Japan benefits from its very strong funding flexibility and excellent market access owing to the yen’s safe-haven status and a highly favourable debt profile, which limit refinancing risks. While gross government financing needs are very high, refinancing risks are significantly reduced by a large, savings-rich domestic investor base, with 86% of general government debt being held domestically, of which 40% is held by the Bank of Japan, according to IMF data⁹. Ongoing increases in the share of government bonds held by the Bank of Japan imply that, increasingly, government debt is owed back to itself, with profits on holdings transferred from the Bank of Japan to the central government. Interventions from the Bank of Japan in government bond markets thus remain a prime support for Japan’s sovereign ratings, minimising risks to near-term debt sustainability. In addition, the yen’s reserve currency status, coupled with the central bank’s very accommodative monetary policies, ensure continuous demand for Japanese sovereign debt at very low rates. At the time of writing, the 10-year Japanese government bond yield stood at around 0%, below that of the US (0.6%), the UK (0.3%) and France (0.1%), which reduces the government’s debt-servicing costs. Strong market access is further bolstered by a long average debt maturity of around 8 years and no foreign currency debt.

Third, Japan’s A+ rating is supported by its very robust external position as the world’s leading external creditor due to persistent current account surpluses and the yen’s reserve currency status. Japan has continuously posted current account surpluses since 1981, reflecting its open, market-based economy and competitive export sectors. As a result, it has accumulated a large net international investment asset position of USD 3.5trn (66% of GDP) as of 2019, far above that of France (-23%), the UK (-26%) and the US (-51%). In turn, Japan’s high stock of foreign assets, on top of high returns on foreign investments, provide substantial primary income flows, which have been increasing since the mid-1990s and will help mitigate downward pressures from the Covid-19 pandemic and a less supportive external environment on Japan’s current account. The US, China and the EU, hard hit regions by the pandemic, together accounted for 47% of Japan’s exports as of March 2020. Japan’s large net international investment assets, low external debt of 81% of GDP and reserve currency status significantly lower vulnerability to external shocks and external debt sustainability risks.

Finally, Scope notes that financial stability risks are broadly balanced although some downside risks are emerging. Scope notes positively that the Bank of Japan views financial institutions as broadly resilient to tail risk events such as a global financial crisis scenario¹⁰, which reflects a robust regulatory and supervisory framework, a well-capitalised banking system with strong asset quality (tier 1 ratio of 15.1% of risk-weighted assets and the non-performing loans ratio stood at 1.1% in 2019). In addition, Japanese companies benefit from large cash reserves compared to peers in advanced economies.

However, the sustained accommodative monetary policy stance of the Bank of Japan has also increased financial vulnerabilities. Persistently low rates weigh on banks’ profitability and encourages risk taking behaviour while large-scale asset purchases by the Bank of Japan of government and corporate bonds as well as stocks through ETF purchases may fuel asset price booms and erode market discipline. Larger Japanese banks have increased their overseas exposures while regional banks have been actively taking risks in domestic lending and securities investment. Similarly, the Government Pension Investment Fund, for which assets amount to 30% of GDP and which has a track record of conservative investment strategies, is increasing exposures to foreign equities and bonds as well as alternative investments (the latter with a cap at 5% of total assets)¹¹. Non-financial private sector debt is elevated at 205% of GDP in Q4 2019, above that of the UK (177%), the US (148%) and China (151%). In Scope’s opinion, structural pressures relating to demographic headwinds, low potential growth and a sustained low yield environment risk intensifying macro-financial challenges.

Sovereign rating 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 upward 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, its highly skilled workforce and the world’s highest old-age dependency ratio. The country has made progress in increasing the labour force participation of women and the elderly, but more progress is needed to reduce obstacles to employment and make labour markets more inclusive. Women remain under-represented in leadership roles and account for two-thirds of non-regular workers. Improving work-life balance by strictly enforcing the 360-hour annual limit on overtime, increasing access to childcare and addressing workplace discrimination would eliminate a key source of inequality and poverty, as highlighted by the OECD¹¹, while also raising potential growth.

Finally, environmental factors were considered during the rating process. Japan is the fifth largest greenhouse gas emitter globally. In March 2020, Japan maintained its carbon emissions reduction target of -26% by 2030 and -80% by 2050 (versus zero net emissions in many European countries). Japan’s plan for achieving its 2050 target lacks a detailed strategy and does not commit to gradually phasing out coal-fired power generation, a major source of carbon emissions. While Japan has been successful in realising substantial energy efficiency gains, a more ambitious long-term climate strategy is needed to cut emissions, mitigate climate risks and work towards meeting the Paris Agreement’s goals. An incremental increase in carbon pricing, while keeping in mind its social and economic impact would also be warranted. Scope’s environmental assessments did not play a direct role in this rating action.

Rating committee
The main points discussed by the rating committee were: i) Japan’s economic growth potential and demographic pressures; ii) fiscal fundamentals and debt trajectory; iii) risks related to Covid-19 pandemic; iv) inflation and monetary policies of the Bank of Japan; and v) peers.

Rating driver references

1. Cabinet Office – Economic and Fiscal Projections for Medium to Long term Analysis

2. National Institute of Population and Social Security Research - Population projections

3. IMF – 2020 Fiscal Monitor

4. OECD – Productivity statistics database 

5. Manpower – Talent shortage survey 2019

6. IMF (2014) – Is Japan’s Population Aging Deflationary? 

7. IMF (2019) – Demographics and the Natural Rate of Interest in Japan.

8. World Economic Forum – The Global Competitiveness Report 2019 

9. IMF – Sovereign Debt Investor Base dataset

10. Bank of Japan – Financial System Report (October 2019) 

11. Government Pension Investment Fund – Annual Reports 2015-18

12. OECD (2019) – Economic Surveys: Japan 2019 

Methodology
The methodology used for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, published on 25 July 2019, is available on https://www.scoperatings.com/#!methodology/list.
Information on the meaning of each rating category, including definitions of default and recoveries can be viewed in the “Rating Definitions - Credit Ratings and Ancillary Services” published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated 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 definitions of default and rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how Environmental, Social or Governance factors (ESG factor) are incorporated into the rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.

Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the rating process. The rating process was conducted:
With Rated Entity or Related Third Party Participation   [NO]
With Access to Internal Documents                                [NO]
With Access to Management                                          [NO]
The following substantially material sources of information were used to prepare the credit rating: public domain.
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 the issuance of the rating or outlook action, 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, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0.
Rating prepared by Alvise Lennkh, Director, Public Finance
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Public Finance
The ratings/outlook were first assigned by Scope in January 2003. The ratings/outlooks were last updated on 21 June 2019.

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
© 2020 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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