For the rating action annex, click here.

Rating action

Scope Ratings GmbH (Scope) has today downgraded Japan’s long-term local and foreign currency issuer and senior unsecured ratings to A from A+ and has revised the Outlooks to Stable, from Negative. Japan’s short-term issuer ratings were downgraded to S-1 from S-1+ in local and foreign currencies, with Outlooks Stable.

Rating drivers

The downgrade of Japan’s sovereign credit ratings to A from A+ reflects:

1. The lasting impact the Covid-19 crisis has had on fiscal fundamentals, further exacerbating risks posed by an already very elevated public debt stock in entering the crisis. The government response in this crisis, while appropriate, has led to historically wide budget deficits and a rapid increase in public debt ratios, pushing, moreover, the prospect for meaningful budget consolidation further in the future.
    
2. The country’s low and declining growth potential, which is structurally constrained by a rapidly ageing and declining population.

The revision of the Outlook to Stable represents Scope’s view that risks to the ratings over the next 12 to 18 months are balanced. The ratings could be downgraded, or the Outlooks revised to Negative, if, individually or collectively: i) unexpected erosion were to be observed in yen’s reserve-currency status and/or questions around the Bank of Japan’s balance-sheet policies were to damage central-bank credibility, reducing monetary policy space available to support the sovereign’s funding flexibility; ii) growth prospects were to deteriorate significantly, damaging fiscal dynamics; and/or iii) financial system risks increase significantly, weighing on macro-economic stability.

Conversely, the ratings/Outlooks could be upgraded if, individually or collectively: i) an appropriate and credible long-term fiscal consolidation plan stabilises the debt ratio and places it on a declining path longer-term, and/or ii) structural reforms accelerate and raise the country’s growth potential.

Rating rationale

The first driver of the ratings downgrade to A reflects a material and lasting impact of the Covid-19 crisis on Japan’s already comparatively weak public finances. The Japanese government responded to the Covid-19 crisis with large-scale budgetary support to contain transmission of the virus, enhance health-care capacities and provide much-needed financial support to distressed households and businesses. In the first half of 2020, the government adopted a series of economic support packages worth JPY 234trn (44% of GDP), which included JPY 67trn (12% of GDP) in direct fiscal expenditure. In December 2020, the government adopted the Comprehensive Economic Measures to Secure People's Lives and Livelihoods toward Relief and Hope, a JPY 74trn (14% of GDP) economic recovery package that includes JPY 40trn (7% of GDP) in direct fiscal spending. While Scope views such policies as appropriate responses amid a severe global economic and public-health shock, they have also led to substantive deterioration in fiscal fundamentals. The budget deficit widened to 12.6% of GDP, while public debt rose sharply to 256% of GDP in 2020.

The rating downgrade reflects Scope’s opinion that recent deterioration of public finances will not be reversed by the government, and that public debt will instead continue increasing within the forecast horizon. This is in part driven by structural budgetary pressures linked to adverse demographics. Population ageing and the shrinking of the Japanese workforce by a sizeable 26% by 2060 will weigh on budget performance via rising social security expenditure and a narrowing tax base. The share of Japan’s budget that is spent on social-security-related expense has increased substantively over recent decades, rising from 17.5% of total spending in 1990 to 33.6% according to the 2021 Budget¹. The IMF estimates the net present value of changes in health-care costs at 56% of GDP, the second highest such costs among peer countries such as the United Kingdom (54% of GDP), Belgium (50%) and France (41%) but below that of the United States (152%). In addition, the government has consistently failed in reaching budget consolidation targets due to structural bottlenecks under the low growth environment and given rising expenditure pressures. The target for achieving a primary surplus by 2020 was, in 2018, delayed to by 2025. The latest government baseline projections demonstrate that, without further fiscal reforms, the primary balance remains in deficit over this next decade with a stabilisation around -1.6% of GDP by 2030², further pushing the prospect for meaningful medium-run fiscal consolidation into the future. Scope forecasts the budget balance to average -4.4% of GDP over 2021-26 and for the government debt ratio to rise to over 260% of GDP by 2026, the highest such ratio in Scope’s rated sovereign universe and over 25 percentage points above pre-crisis levels.

The sovereign credit risk associated with Japan’s high debt stock is actively mitigated by the Bank of Japan (BoJ)’s accommodative monetary policies, including quantitative and qualitative easing with yield curve control. According to IMF data, the BoJ has increased total government debt holdings to about 44%, from 10% of the total government debt stock, over the past ten years, displacing holdings of domestic private sector investors, which presently account for holdings of about 42% of total public sector debt, compared with 84% in 2010. Scope expects this trend to continue as inflation is projected to remain below the 2% target and the central bank has indicated intentions to continue expansion of monetary base until inflation stabilises for a period above the target³. This may at some stage increasingly raise questions about the limits and sustainability of Bank of Japan policies amid an ever-increasing size of the balance sheet, which already exceeds Japan’s annual economic output. Under an adverse scenario, such questions could reduce monetary space available to support the sovereign’s funding flexibility.

The second driver of the one-notch downgrade to A is tepid growth potential, which is the lowest among Scope’s rated sovereign universe. According to Bank of Japan estimates, Japan’s growth potential has averaged 0.4% over the past five years and has declined to around 0% by year-end 2020, from above 4% in 1990. As such, despite substantive budget and monetary support over recent years under the “three arrows” of Abenomics, Japan has continued to experience a mix of low growth and structurally low inflation. Real growth has averaged only 1% over 2015-19, well below that of the United States (2.5%), Belgium and the United Kingdom (both at 1.7%), as well as France (1.6%). The Covid-19 crisis has impacted the economy with a 5.2% contraction in GDP last year. However, Scope forecasts a growth rebound of 3% in 2021 and 2.1% in 2022. Nonetheless, the crisis could result in long-run economic scarring, although extensive government support has mitigated impact from economic restrictions on labour markets and the productive capacity of the real economy. The unemployment rate only marginally increased to 3.1% in 2020 and is forecast to gradually return to pre-crisis rates by 2022-23 while business insolvencies have been at record lows. Downside risk such as another wave of virus or a rapid increase in business insolvency could weigh on the economic outlook.

Japan will have to face increasing pressures stemming from comparatively weak demographics longer term. The shrinking of the workforce exacerbates labour shortages with 76% of employers reporting a high level of difficulty filling outstanding roles, as compared with a global average of 45%⁴. Against this, it is crucial that government efforts to increase the labour force participation of women and older workers, enhance productivity and attract foreign workers accelerate. Labour productivity has been negative in recent years and averaged -0.6% over 2016-20, labour force participation of women (62%) remains below that of men (71%) and foreign nationals represent only a modest 2% of the Japanese population. Scope notes that the government has taken significant strides in these areas, for instance via the Work-Style Reform, enhancing access to child-care and corporate governance reform, among other priority areas. In addition, the government’s recovery plans, which focus upon digitalisation and innovative technology solutions supporting green growth, could mitigate outstanding growth-negative demographic bottlenecks. Still, additional structural reform progress is needed to meet the historic challenge presented by adverse demographics. The McKinsey Global Institute estimates that even assuming a 2.5-fold increase in productivity and automation of 27 existing work tasks by 2030, Japan would face a residual shortfall of 1.5m workers⁵.

Japan’s low growth and low inflation make substantive budget consolidation increasingly difficult as any consolidation could simultaneously impede the authorities’ reflationary objectives. This was evidenced in implementation of the VAT increase in October 2019, which together with the Typhoon Hagibis, pushed the economic growth into negative territory in 2019Q4 before the Covid-19 crisis. This highlights the very difficult task authorities face in placing government debt on a sustainable trajectory longer term – informing the one-notch ratings downgrade.

Despite these credit weaknesses, Japan retains considerable credit strengths.

Firstly, Japan’s A ratings are supported by a wealthy, diversified and highly competitive economy. Japan’s economy accounts for around 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 also benefits from high levels of economic sophistication and the presence of many of the world’s most competitive and innovative enterprises, ranking first globally on the Economic Complexity Index⁶. Similarly, the government benefits from a strong governance framework with resilient institutional checks and balances, strong observation of the rule of law and a stable political environment over recent years. Accordingly, Japan ranked sixth of 141 countries on the World Economic Forum’s 2019 Global Competitiveness Report, reflecting large market size, competitive market dynamics, excellent physical and digital infrastructure, and a well-educated, technologically adept population⁷.

Second, Japan benefits from very strong funding flexibility and excellent market access due to yen’s safe-haven status plus a highly favourable government debt profile, limiting near- to medium-run debt refinancing risk. While gross government financing needs are very elevated, refinancing risks are significantly curtailed by a large, savings-rich domestic investor base, with 86% of general government debt held domestically, of which 44% is held by this stage by the Bank of Japan. Ongoing increases in the share of government bonds held by the BoJ imply that, increasingly, government debt is owed back to itself, with profits on holdings transferred from the central bank to the central government. Interventions from the BoJ in government bond markets thus remain a prime support for Japan’s sovereign credit ratings, minimising risk to debt sustainability over the foreseeable future. In addition, yen’s reserve currency status, coupled with the central bank’s accommodative monetary policy, ensures continuous demand for Japanese sovereign debt at very low rates. At time of writing, the 10-year Japanese government bond yield stood at around 0%, below that of the US (1.5%), the UK (0.75%), Belgium (0.1%) and France (0.1%), helping ease government debt-servicing costs. Strong market access is further bolstered by a long average maturity of government debt of 9 years.

Finally, Japan’s A credit ratings are supported by a very robust external position as the world’s leading external creditor – in reflection of large current account surpluses, high domestic savings and a sophisticated domestic banking system. Japan has posted current account surpluses since 1981. As a result, a large net international investment asset position of 69% of GDP as of March 2021 has been the outcome, far above that of France (-26%), the UK (-116%) and the US (-66%). Japan’s large net external creditor position supports current account dynamics via substantial primary income inflow, which has been increasing since the mid-1990s. This has helped ease impact of lowered exports in this crisis on the current account balance, the latter which posted a 3.2% of GDP surplus last year. Japan’s net international investment asset position, low external debt levels of 97% of GDP and reserve currency status significantly lower vulnerability to external shocks and risks associated with external debt sustainability.

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 a first indicative rating of ‘a+’ for Japan. Japan receives a one-notch uplift to this indicative rating via the reserve currency adjustment under the methodology. As such, the ‘aa-’ indicative rating can be adjusted under the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses against a peer group of countries.

For Japan, the following QS relative credit strength has been identified: i) Current account resilience. The following QS relative credit weaknesses have been identified: i) Growth potential of the economy; ii fiscal policy framework; iii) debt sustainability; iv) banking sector performance; v) financial imbalances; and vi) environmental risks.

The QS generates a two-notch downside adjustment and indicates A long-term credit ratings for Japan.

A rating committee has discussed and confirmed these results.

Factoring of Environment, Social and Governance (ESG)

Scope explicitly factors in ESG sustainability issues during the ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weighting under the quantitative model (CVS) as well as in the qualitative overlay (QS). Under governance-related factors in the CVS, Japan performs strongly – and in line with scores of highly-rated sovereign peers, such as France, Belgium, the United States and the United Kingdom, as evaluated under the World Bank’s Worldwide Governance Indicators. Japan benefits from high political stability although recent by-elections signal weakening polling support for the ruling Liberal Democratic Party.

Socially related credit factors are similarly captured under Scope’s CVS. High labour force participation rates and low-income inequality support the credit ratings while high and increasing old age dependency ratios are a credit weakness. The qualitative assessments of social factors are reflected in the ‘social risks’ evaluation category of the QS, under which Japan is assessed as ‘neutral’ compared with sovereign peers, balancing strong health-care and education systems with pressures on social care systems, gender inequalities and elevated rates of suicide.

In Scope’s assessment, environment-related credit risks of Japan are elevated. Japan faces environmental risks in the form of exposure to extreme weather events. Japan is particularly vulnerable to natural disasters due to its climate and topography, and experiences earthquakes, typhoons and other types of natural events that directly affect economic and fiscal performance. A highly carbon intensive economy exposes Japan to risks in the transition to a greener economy – priorities that have not been sufficiently addressed over past years. Japan remains highly reliant upon imported fossil fuels, which account for 88% of the total primary energy supply⁸. The government has accelerated efforts in reaching carbon neutrality, including an ambitious new target for cutting greenhouse gas emissions by 46% from 2013 levels, versus an earlier goal of 26%. In addition, the economic recovery plan includes a climate pillar and foresees reform to the energy sector, changes in the structure of the manufacturing industry and investments in the energy efficiency of buildings. Still, the government strategy for achieving carbon neutrality is in its initial stages and has yet to produce tangible outcomes.

Rating Committee
The main points discussed by the rating committee were: i) fiscal developments; ii) Japan’s growth potential; iii) the Bank of Japan’s monetary policies; and iv) financial stability risks.

Rating driver references
1. Ministry of Finance (2021), Japanese Public Finance Fact Sheet
2. Japanese Cabinet Office (2021), Economic and Fiscal Projections for Medium to Long Term Analysis 
3. Bank of Japan (2021), Outlook for Economic Activity and Prices: April 2021
4. Manpower (2021), The Talent Shortage Survey
5. McKinsey & Company (2020), The future of work in Japan: Accelerating automation after Covid-19
6. The Observatory of Economic Complexity (2019), Economic Complexity Index Rankings
7. World Economic Forum (2019), Global Competitiveness Report 2019 
8. IEA (2021), Japan 2021: Energy Policy Review

Methodology
The methodology used for these Credit Ratings and/or Outlooks, ‘Rating Methodology: Sovereign Ratings’ 9 October 2020, is available on https://www.scoperatings.com/#!methodology/list.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other 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 Credit Rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 Ratings’ definitions of default and Credit 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 factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit 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 Ratings: public domain.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst Thibault Vasse, Senior Analyst
Person responsible for approval of the Credit Ratings: Dr. Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on January 2003. The Credit Ratings/Outlooks were last updated on 24 April 2020.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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