Scope affirms Japan's A ratings; Outlook revised to Negative
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Scope Ratings GmbH (Scope) has today affirmed Japan’s long-term local and foreign currency issuer and senior unsecured ratings to A and has revised the Outlook to Negative, from Stable. Japan’s short-term issuer ratings were affirmed at S-1 in local and foreign currencies, with Stable Outlooks.
The revision of the Outlook to Negative on Japan’s A sovereign credit ratings reflects our expectation of a sustained deterioration in Japan’s fiscal fundamentals, given an uneven economic recovery and the associated announcement of additional fiscal stimulus. We expect structural fiscal pressures due to an ageing population to weigh substantially on medium-term fiscal performance with limited prospects of meaningful consolidation. The combined effects of weak growth and wide fiscal deficits will further push up Japan’s very elevated public debt ratio. In this context, Japan is increasingly dependent on the highly accommodative policy stance of the Bank of Japan (BoJ) and the yen’s reserve currency status to mitigate the refinancing risks and interest burden associated with its very high debt. While appropriate given domestic deflationary pressures, the central bank’s sustained ultraloose policy stance is facing challenges related to rising financial imbalances and pressures on the value of the yen amid a global tightening of monetary policies.
The Negative Outlook represents Scope’s view that risks to the ratings over the next 12 to 18 months are tilted to the downside. The ratings could be downgraded if, individually or collectively: i) the government fails to achieve meaningful consolidation and stabilise its debt-to-GDP ratio; ii) financial system risks increase significantly, weighing on macro-economic stability; and/or iii) an unexpected weakening in the yen’s reserve-currency status were to be observed.
Conversely, the ratings could be upgraded or Outlook revised to Stable if, individually or collectively: 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) the country’s growth potential increases tangibly, for instance thanks to effective structural reform.
The revision of the Outlook to Negative on Japan’s A rating reflects the material and lasting fiscal deterioration the country has suffered due to the Covid-19 pandemic. The Japanese government responded to the Covid-19 crisis by adopting two large stimulus packages in 2020 totalling JPY 191trn (34% of 2019 GDP), of which JPY 88trn (16% of GDP) in direct fiscal outlays. While these exceptionally forceful policies provided much needed support to the households and firms and prevented large-scale job losses and bankruptcies, it had a limited impact on private consumption and investment as transfers were largely saved. They have also led to a substantial deterioration in the country’s fiscal fundamentals. The budget deficit widened to 9% of GDP in 2020 while public debt rose sharply by 23pps of GDP to 259% of GDP, according to IMF figures.
The outlook revision is also underpinned by Scope’s view that the recent deterioration in Japan’s public finances will not be reversed by the government, despite its commitment to consolidate finances, and that public debt will pursue a firm upwards trajectory within the forecast horizon. The economic recovery from the sharp economic contraction of 4.5% in 2020 has been uneven and significantly weaker than that of other advanced economies. Japan posted negative annualised quarter-on-quarter growth of -2.2% and -2.8% in Q1 and Q3 of 2021 respectively. Real growth inched up by only 1.6% in 2021, well below expectations and the government’s June 2021 projections of 3.7% 1. To reinvigorate the economy, the government announced an additional fiscal stimulus package in November 2021 of JPY 79trn (15% of 2021 GDP). As such, we expect the budget deficit to reach 7.8% of GDP in 2022, up from 7.6% of GDP in 2021.
Beyond these adverse short-term developments, we expect Japan to continue to be challenged by its ageing and shrinking population which presents structural fiscal and economic pressures. According to United Nations estimates, the old age dependency ratio will rise from 52% in 2020 to 81% in 2050 while the working age population will decline by 28% over the same period 2. In terms of budgetary prospects, the country will have to contend with rising pension, healthcare and long-term care spending while simultaneously facing a shrinking tax base. The share of Japan’s budget which is spent on social security related expenses has increase substantially over the last decades, rising from 18% of total spending in 1990 to 34% according to the 2022 budget. Our baseline forecasts see the budget deficit averaging 3.9% of GDP over the 2022-27 period. In addition, the declining working age populating will exacerbate the labour shortages that the country already faces and weigh considerably on the growth and inflation outlooks.
Importantly, these unfavourable dynamics raise questions as to the credibility of the government’s consolidation strategy. The government has consistently failed to meet its own fiscal targets. The target for achieving a primary surplus by 2020 was delayed in 2018 to 2025 and recently reaffirmed by the government. The Cabinet Office’s latest baseline long-term forecasts show that the primary balance will remain negative over the next decade with a stabilisation at around -0.7% of GDP by 2031, despite what Scope views as optimistic growth assumptions 3. Fiscal consolidation is hampered by the underlying weaknesses in the economy. Any meaningful consolidation could have an adverse effect on Japan’s reflationary efforts, as was evidenced in previous episodes of budget consolidation through VAT rate hikes. We expect growth to peak at 2% in 2022 and then gradually converge to Japan’s low growth potential of around 0.4%. A combination of weak growth and wide fiscal deficit underpins a sustained increase in debt over the forecast horizon, reaching 266% of GDP in 2027, well above previous estimates. Scope notes that, should Japan’s financing rates increase materially, both its debt and gross financing needs would enter an explosive path, as highlighted by the IMF 4.
Japan’s debt sustainability is increasingly reliant on the BoJ’s ultra-accommodative monetary policies and the yen’s reserve currency status which are critical for supporting funding flexibility and low debt costs. However, concerns regarding the limits and sustainability of the BoJ’s policies are rising amid a build-up of financial imbalances and a growing divergence with the policy stances of other major central banks. According to the IMF, the prolonged low interest rate environment is weighing on bank profitability and could erode capital buffers, lead to more risk taking and a build-up of vulnerabilities 5. In addition, the BoJ is increasingly playing a dominant role in key financial assets. As of 20 April 2022, it holds JPY 528trn in government securities, JPY 11trn in commercial paper and corporate bonds and JPY 38trn in stocks (indirectly through ETFs or trusts). It has increased its total government debt holdings to about 43% of the total in September 2021 and is now the single largest holder of Japanese stocks. Scope expects this trend to continue as the BoJ has indicated that it will continue expanding the money supply until inflation stabilises above the target inflation while the central bank projects inflation to remain below the 2% target through 2024 6. In addition, the growing divergence between the monetary policy stance in Japan and a weak economy versus other advanced economies has led to a marked devaluation of the yen (-18% versus the US dollar since September 2021), which fell to a 20-year low of around 130 per USD. While the policy stance of the BoJ is appropriate and in line with the fundamentals of the country, a persistent environment of negative policy rates, increasingly forceful policy interventions and sustained devaluation of the yen could give rise to credibility concerns and threaten to erode the yen’s reserve currency status.
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 also benefits from its high levels of economic sophistication and the presence of many internationally competitive companies, ranking 1st in the world in the Observatory for Economic Complexity’s Index 7. Similarly, the country benefits from a strong governance framework with resilient institutional checks and balances, and strong observation of the rule of law. 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 population 8.
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 43% is held by the BoJ, according to IMF data. Interventions from the BoJ in government bond markets have maintained funding costs very low. The BoJ thus remains 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 end-April, the 10-year Japanese government bond yield stood at around 0.25%, which underpins the government’s low debt-servicing costs. Refinancing risks are further mitigated by a long average debt maturity of 9 years and 3 months.
Third, Japan’s A rating is supported by its very robust external position as the world’s leading external creditor reflecting a record of 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 77% of GDP as of December 2021. Japan’s large net external creditor position supports its current account balance via substantial primary income flows which have been increasing since the mid-1990s. This helped mitigate the impact of lower exports in the context of Covid-19 on Japan’s current account which posted a 3% of GDP surplus in 2020. Japan’s large net international investment assets, low external debt of 94% of GDP (in Q4 2021) and reserve currency status significantly lower vulnerability to external shocks and external debt sustainability risks.
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, which was approved by the rating committee at ‘a’ for Japan. Japan receives a one notch uplift to this indicative rating via the reserve currency adjustment under the methodology. As such, the ‘a+’ 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) Debt profile and market access; ii) Current account resilience; and iii) Resilience to short-term shocks. The following QS relative credit weaknesses have been identified: i) Growth potential of the economy; ii) Macro-economic stability and sustainability; iii) fiscal policy framework; iv) debt sustainability; v) banking sector performance; vi) financial imbalances and vii) environmental risks.
The QS generates two negative notch adjustments and indicates A long-term 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).
Environment-related credit risks of Japan are elevated in Scope’s assessment. Japan is frequently exposed to natural disasters like tsunamis, floods, typhoons, earthquakes, and cyclones due to its location in the Pacific earthquake belt and the circum-Pacific zone. The climate is characterised by extreme temperature variations throughout the year and is influenced by the monsoon circulation. Japan is likely to become increasingly exposed to such risks due to climate change which could result in these events becoming more frequent and severe. Japan is a net importer of fossil fuels including coal (28% of the energy mix) and oil (37%). The government aims to achieve carbon neutrality by 2050 by raising the share of renewable energies in the energy mix to 36-38% and to cut targets for coal use by 2030 to tackle climate change. More clarity on how the government plans to phase out fossil fuels is needed. The Climate Action Tracker assesses Japan’s climate targets, policies, and finances as ‘insufficient’ to be consistent with the Paris Agreement’s 1.5°C temperature limit 9.
Socially related credit factors are similarly captured under Scope’s CVS. High labour force participation rates and low income inequality support the ratings while high and increasing old age dependency rates are a credit weakness. The qualitative assessment of social factors is reflected in the ‘social risks’ evaluation category of the QS, under which Japan is assessed as ‘neutral’ compared with its sovereign peers. A rapidly ageing population is likely to pressure public pension, healthcare, and long-term care systems. The needed reforms to reduce the fiscal pressures of age-related costs could pose social risks as Japanese citizens could face less generous social benefits or be required to work more to sustain them. This could exacerbate rising challenges that the elderly face, including rising poverty and social isolation. Still, the country benefits from high levels of social cohesion as well as high quality health and education systems.
Under governance-related factors in the CVS, Japan’s performance is strong as assessed by the World Bank’s Worldwide Governance Indicators. Japan typically benefits from high degrees of political stability. Still, recent elections signal weakening influence of the ruling LDP party while the risk of rising political uncertainty due to changes in political leadership has increased. Japan faces some geopolitical risks related to relations with foreign powers in the Asia Pacific including China and North Korea, leading to pressures to increase defence spending.
The main points discussed by the rating committee were: i) economic developments; ii) fiscal policies and prospects; iii) monetary policy stance of the Bank of Japan; and iv) financial stability risks.
Rating driver references
1. Japanese Cabinet Office (2021), Mid-year Economic Projection for FY2021
2. United Nations (2019), World Population Prospects (medium fertility variant)
3. Japanese Cabinet Office (2021), Economic and Fiscal Projections for Medium to Long Term Analysis
4. IMF (2022), Japan: 2022 Article IV Report
5. IMF (2022), Japan: Selected Issues
6. Bank of Japan (2022), Outlook for Economic Activity and Prices
7. The Observatory of Economic Complexity (2020), Economic Complexity Index Rankings
8. World Economic Forum (2019), Global Competitiveness Report 2019
9. Climate Action Tracker (2022), Japan: Country Profile
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings, 8 October 2021), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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-governance/definitions-and-scales. 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://scoperatings.com/governance-and-policies/rating-governance/methodologies.
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.
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Lead analyst: Thibault Vasse, Senior Analyst
Person responsible for approval of the Credit Ratings: Giacomo Barisone, Managing Director
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