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Rating action

Scope Ratings GmbH (Scope) has today affirmed Japan’s long-term issuer and senior unsecured debt ratings at A in both local and foreign currency and has maintained the Negative Outlook. The agency also affirmed the short-term issuer ratings at S-1 in both local and foreign currency with Stable Outlooks.

Summary and Outlook

The affirmation of Japan’s long-term credit ratings with Negative Outlooks reflects Scope’s expectation of continued deterioration in Japan’s fiscal fundamentals, amid structural spending pressures related to population ageing and decline and rising investment needs for the green transition and national defence. This, coupled with weak growth prospects and low inflation will further push up Japan’s very elevated public debt ratio and increases the country dependence on the highly accommodative policy stance of the Bank of Japan to limit refinancing risks and maintain a low interest payment burden. The Bank of Japan’s ultraloose policy stance faces challenges related to rising financial imbalances and market pressures on the value of the yen as well as the central bank’s yield curve control strategy.

The affirmation of Japan’s credit ratings acknowledges multiple credit strengths however, including: i) a large, wealthy, and diversified economy; ii) very strong funding flexibility thanks to central bank support, a large domestic investor base, and the yen’s reserve currency status; and iii) a sound external position.

The Negative Outlook represents 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, 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 or a sudden rising in funding rates 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/or ii) the country’s nominal growth potential increases tangibly, for instance thanks to effective structural reform or to a virtuous cycle of stable and sustainable inflation.

Rating rationale

The first driver of the Negative Outlooks reflects structural fiscal pressures amid adverse demographics and rising investment needs. The United Nations projects Japan’s old age dependency ratio to increase to 81% by 2050, from 52% in 2020, the highest of the G10 economies¹ . At the same time, the total population is expected to decline by 17%. This presents the considerable challenge with the dual effects of rising expenditure pressures, mostly for healthcare and long-term care, and a concurrent shrinking in the tax base. Structural increases in social spending due to population ageing also increases budgetary rigidity, with spending on social security representing 32% of total expenditure in the 2023 Budget, up from 18% in 1990. In addition to the fiscal costs of population ageing, Japan also faces elevated investment needs for the green transition and national security. The government plans to raise JPY 20trn (4% of 2022 GDP) in bonds to fund green investments over the next decade as part of its Green Transformation initiative. The Defense Buildup Program for 2023-27 aimed at strengthening Japan’s defence capabilities includes around JPY 43trn (8% of GDP) in additional defence spending over the 2023-27 period² .

The government remains committed to its self-imposed target of reaching a primary surplus by 2025, but a detailed and credible consolidation plan is lacking, and Scope deems the prospects of meaningful fiscal consolidation over the medium-term to be remote. Underlying weaknesses in the economy will complicate the implementation of consolidation measures as the government continues to prioritise reflation efforts. Recently, the government extended the cutoff date for its energy subsidies which were expected to be eliminated by September 2023, while it recently announced an additional fiscal stimulus package to mitigate the cost-of-living crisis, and support investment in strategic sectors. Though the amount of fiscal stimulus is still to be defined, Japan’s repeated recourse to supplementary budgets and fiscal stimulus plans, with ten such programmes adopted since 2012, undermines the credibility of its medium-term budgetary plans. Previous episodes of VAT rate hikes, which were pushed back several times due to economic vulnerabilities illustrate the difficulties Japan faces in implementing fiscal stimulus. Still, gradual withdrawal of support measures and the carry-over of JPY 18trn in unused funds from the 2022 budget will help reduce the budget deficit near-term. As such, Scope forecasts the budget deficit to remain elevated, at 6.4% of GDP in 2023, after 7.8% in 2022, narrow to at around 4% of GDP by 2024 and stabilise at that level thereafter. Further reductions in the deficit absent additional revenue or expenditure-side reforms or a significant increase in potential growth are unlikely given the above-mentioned fiscal pressures.

The second driver of the Negative Outlooks reflects underlying weaknesses in Japan’s economic fundamentals. Japan’s recovery from the Covid-19 pandemic has been uneven, with two quarters of negative real growth in 2021 and 2022 each. After shrinking by 4.2% in 2020, real GDP grew by a mere 2.2% in 2021 and 1.0% in 2022, despite having one of the largest stimulus programmes of all advanced economies. As such, Japan is among the last G10 economies to see its GDP recover to its pre-Covid-19 levels. The economy has remained relatively insulated from the cost-of-living crisis compared to other advanced economies given lower inflationary pressures. Strong household and corporate balance sheets underpin domestic demand while recovery in tourism and the alleviation of supply chain constraints mitigates the effects of the slowdown in trading partners and rising import prices for net exports. We project modest growth of 1.3% in 2023, followed by a gradually moderation to potential growth of around 0.4%.

Longer-term, Japan faces considerable macro-economic challenges. Its already low growth potential will suffer from the decline in its working-age population (those aged 15-64), which the United Nations estimates at 27% over 2020-50¹. Unless the country substantially increases its productivity or reverses the demographic decline, it is likely that growth will slow down, with tangible risks of economic contraction in decades to come. In 2018, IMF staff simulations estimated that Japanese real GDP could decline by over 25% over the next 40 years relative to a scenario where productivity and population continue to grow at their recent pace due to demographics³. The government is pursuing a multipronged strategy to address the demographic challenge, through incentivising labour force participation, fostering innovation and digitalisation, and supporting a sustained rise in wages. But these reforms have not yet yielded substantial benefits for growth and are unlikely to fully compensate the adverse effects of a declining population for growth.

Our baseline forecasts project a modest reduction in Japan’s public-debt-to-GDP to 257% by 2024, down from 261% in 2022 thanks to the debt-reducing impact of elevated inflation and favourable growth. Thereafter, weakening growth and persistent fiscal deficits will place the debt-to-GDP ratio on an upwards trajectory, reaching 268% by 2028. Japan’s debt sustainability will thus increasingly rely on the Bank of Japan’s ultra-accommodative policies and the yen’s reserve currency status. However, the monetary policy stance is increasingly challenged in a context of higher global interest rates, which underpinned the Bank of Japan’s decision to implement yield curve control with greater flexibility of +/-0.5pps around the zero percent 10-year government bond yield target. A material increase in long-term interest rates, in line with those observed in other advanced economies, could place Japan’s interest payment burden on a rapidly rising path and raise debt sustainability concerns⁴. The Japanese Ministry of Finance estimates that a 1% increase in interest rates in 2023 could increase interest payments by JPY 3.6trn (0.6% of 2022 GDP) by 2026⁵.

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 for trade complexity⁶. Similarly, the country benefits from a strong governance framework with resilient institutional checks and balances, and strong observation of the rule of law.

Second, Japan benefits from its very strong funding flexibility and excellent market access owing to a large domestic investor base and the yen’s safe-haven status, while its favourable debt profile limits refinancing risks. While gross government financing needs are very high, refinancing risks are significantly reduced by a large, savings-rich domestic investor base, with 85% of outstanding JGBs and T-Bills being held domestically and 47% held by the Bank of Japan in June 2023. Interventions from the BoJ in government bond markets have maintained funding costs very low. The Bank of Japan 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, underpin demand for Japanese sovereign debt at low rates. In September 2023, the 10-year Japanese government bond yield stood at around 0.7%, which underpins the government’s low debt-servicing costs. Refinancing risks are further mitigated by a long average debt maturity of 9 years and 2 months as of end FY2022.

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 80% of GDP as of June 2023. Japan’s large net external creditor position supports its current account balance via substantial primary income flows which benefitted from recent yen depreciation. This helped mitigate the deterioration in goods and service trade balances in the context of the Covid-19 and cost-of-living crises. Japan’s large net international investment assets, low external debt of 110% of GDP in Q2 2023, large reserve holdings of USD 1.3trn, and reserve currency status significantly lower external 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 an indicative credit rating of ‘a’ for Japan. The ‘a’ indicative rating is further supported by the Sovereign Rating Methodology’s reserve currency adjustment, which provides a one-notch uplift to the CVS indicative rating. The ‘a+’ indicative ratings can thereafter be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on relative qualitative credit strengths or weaknesses against a peer group.

For Japan, the following relative credit strengths have been identified: i) debt profile and market access; ii) current account resilience; and iii) resilience to short-term shocks. Japan’s relative credit weaknesses are: i) growth potential of the economy; ii) fiscal policy framework; iii) debt sustainability; iv) banking sector performance; v) financial imbalances; and vi) environmental factors.

The combined relative credit weaknesses and strengths identified in the QS generate a one-notch negative adjustment to the ratings and indicate a sovereign credit rating of A for Japan.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG issues in its rating process via the Sovereign Rating Methodology’s standalone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (CVS) and in the methodology’s qualitative overlay (QS).

Japan scores relatively poorly in terms of the carbon intensity of its economy, both in per capita and per GDP terms. It is highly dependent on fossil fuels, which account for 88% of its total power generation. This, coupled with its significant carbon emissions, exposes it to transition risks. The country aims to achieve net-zero greenhouse gas emissions by 2050, with an interim target of reducing emissions by 46% by 2030 relative to 2013 levels. It’s Green Transformation initiative lays out the government’s transition strategy and aims to channel JPY 150trn in public and private investment over the next 10 years. However, the strategy continues to promote the use of fossil fuels such as coal, while there remains uncertainty as to the effectiveness and ambition of announced carbon pricing. Current policies are deemed to be inconsistent with the Paris agreement objective to limit global warming to 2°C, according to Climate Action Tracker⁷. The country also faces important physical risks. Japan is situated in the Pacific earthquake belt and the circum-Pacific zone, making it susceptible to natural disasters such as typhoons, earthquakes, tsunamis, floods, and cyclones. The climate experiences extreme temperature variations throughout the year and is influenced by monsoon circulation. Climate change will worsen the frequency and intensity of such disasters, posing greater risks for the country. Average annual losses for Japan are estimated at around 3% of GDP by the United Nations Economic and Social Commission for Asian and the Pacific⁸.

Japan performs well in terms of labour force participation thanks to its pro-employment policies and efforts to increase the participation of women and the elderly. Its labour force participation rate stood at over 80% in 2021. Japan’s old-age dependency ratio (52% in 2020)¹ is the highest in Scope's sovereign rating universe and will continue to rise rapidly as the population ages. This will put more pressure on pension and healthcare systems. To reduce the fiscal pressures of age-related costs, necessary reforms could pose social risks by reducing social benefits, raising the financial burden of health spending or requiring citizens to work more to sustain Japan’s social systems. This could exacerbate the challenges that the elderly population faces, such as increasing poverty and social isolation. The country's high level of social cohesion, along with its excellent health and education systems, remain core social strengths.

Japan benefits from very strong democratic institutions, regular elections and a strong freedom of press with good political continuity. The Liberal Democratic Party has governed almost continuously since 1955, expect in 1993-94 and 2009-12 when the opposition ruled. In October 2021, Fumio Kishida assumed the role of Prime Minister, and his Liberal Democratic Party won a substantial majority in the March 2022 general election. We anticipate that policy direction will remain largely unchanged in Japan. However, there are emerging weaknesses within the Liberal Democratic Party and declining public backing for the administration, which may result in renewed political instability and impede advances on crucial policy matters.

*. Editor's note: the title was amended on 9 October 2023. In the initial publication the title was 'Scope affirms Japan's ratings a A and maintains the Negative Outlook'.

Rating Committee
The main points discussed by the rating committee were: i) Japan’s economic outlook; ii) fiscal developments and debt trajectory; iii) monetary policies, inflationary dynamics; iv) yen depreciation; v) demographic trends.

Rating driver references
1.United Nations (2022)
2.Japanese Ministry of Defence (2022)
3.International Monetary Fund (2018)
4.Alberola, Cheng, Consiglio, & Zenios (2023)
5.Japanese Ministry of Finance (2023), Debt Management Report 2023
6.The Observatory of Economic Complexity
7.Climate Action Tracker (2023)
8.United Nations ESCAP Risk and Resilience Portal

Methodology
The methodology used for these Credit Ratings and Outlooks, (Sovereign Rating Methodology, 27 September 2023), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies. 
The model used for these Credit Ratings and Outlooks is (Core Variable Scorecard Model Version 2.1), available in Scope Ratings’ list of models, published under 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.

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   YES
With Access to Internal Documents                                YES
With Access to Management                                          YES
The following substantially material sources of information were used to prepare the Credit Ratings: the Rated Entity, and 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 Outlooks and the principal grounds on which the Credit Ratings and Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and Outlooks are UK-endorsed.
Lead analyst Thibault Vasse, Associate Director
Person responsible for approval of the Credit Ratings: 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 6 May 2022.

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

Conditions of use / exclusion of liability
© 2023 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Ratings UK Limited, Scope Fund Analysis GmbH, and Scope ESG Analysis 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.