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Rating action

Scope Ratings GmbH (Scope) has today affirmed the State of Japan’s long-term issuer and senior unsecured debt ratings at A in local- and in foreign-currency and revised the associated Outlooks to Stable, from Negative. In addition, the short-term issuer ratings have been affirmed at S-1 in local- and foreign-currency. Outlooks on short-term ratings remain Stable.

Summary and Outlook

The revision of the Outlooks assigned on long-term ratings to Stable, from Negative, is underpinned by the pursuant credit-rating drivers:

1. An improvement of the inflation outlook – with recent high inflation displaying elements of structurally reinforcing inflation expectations, countering a modern record of price deflation and favourably re-anchoring nominal economic growth; and
    
2. Support from stronger inflation for the challenging outlook regarding long-run debt sustainability. This acknowledges furthermore continued support as regards debt sustainability from ultra-low rates and asset purchases – even as the Bank of Japan (BoJ) appropriately exits aspects of its unconventional policy of the past decade.

The affirmation of the A credit ratings furthermore acknowledges multiple credit strengths, such as: i) a large, wealthy and competitive, and diversified economy; ii) strong funding flexibility and very-low effective interest rates – anchoring a favourable nominal growth compared against nominal rate disparity, a significant domestic investor base, independent monetary policy and debt monetisation, alongside outstanding government assets; and iii) a robust external position and yen’s reserve-currency status.

However, the credit ratings are challenged by: i) an elevated gross government debt stock – representing the highest ratio against GDP of the rated sovereign universe of the agency and reflecting a material risk over the very long run; ii) the economy's comparatively low nominal growth potential – linking to a rapidly-shrinking and ageing population alongside an historical record of deflation; and iii) rising pension and health-care-linked costs and rising investment requirements for the green transition and national defence.

The Stable Outlook reflects Scope’s view of risks to the ratings being balanced over the next 12 to 18 months.

The ratings/Outlooks could be upgraded if, individually or collectively: i) debt-to-GDP declines meaningfully, supported by higher nominal economic growth and/or ongoing fiscal-consolidation initiatives; and/or ii) stronger sustainable economic growth is achieved, such as attainment of sustainable 2% inflation and/or expectation of dividends for long-run output from growth-enhancing structural reforms.

Conversely, the ratings/Outlooks could be downgraded if, individually or collectively: i) debt sustainability weakens significantly, such as from an expectation of a material rise of debt-to-GDP or significant rise of the interest-payment burden; and/or ii) the government sees unexpected significant reductions of its funding flexibility and/or weakening of yen’s strength as a global reserve currency.

Rating rationale

First driver of the Outlook revision: an improvement of the inflation outlook – re-anchoring nominal economic growth

Headline and core inflation rose to 2.8% year-on-year as of February 2024. Annual headline inflation has stayed above 2.0% since April 2022 – a more prolonged phase with higher inflation displaying a degree of stickiness after the reflation policies of the government of the past decade – which were given significant support recently by the cost-of-living crisis. From 1995 to 2021, inflation of Japan was negative for 12 of the 27 years (and under 2% inflation during all except one of these years). The deflation record of Japan has been the core constraint as regards debt sustainability and furthermore a limitation on real economic growth.

Although it currently remains overly early to declare any defeat of deflation following such a lengthy record, the recent phase of inflation over-shooting over the past two years has been displaying evidence of more-durably positively affecting inflation expectations. Scope projects national inflation of 2.2% for 2024 and 2.5% for 2025.

The government has aimed appropriately to drive sustainable inflation by reflating wage growth and supporting a virtuous cycle of demand-led price gains. The annual pay negotiations of the largest trade-union group, the Rengo, observed this month a significant 5.28% hike of wages for this year at the first aggregated results – the biggest pay rise in 33 years compared to the final aggregated results. This much-higher-than-anticipated rise reinforced the decision of the Bank of Japan to end eight years of negative rates earlier this week – raising rates to a range of 0.0-0.1%. The severe labour-market crunch (unemployment rate fell to 2.4% in January) has furthermore contributed to the significant salary hikes. The presence of elevated wage growth helps the sustainability of reflation results. The rating agency views constructively any continued phase of inflation over-shooting currently – as this furthermore supports the central bank’s price-stability mandate given a prolonged phase of above-target inflation is likely necessary for re-anchoring inflation closer to 2% long run. This acknowledges that medium-run inflation risk remains skewed on the downside, not on the upside, for the economy given structural deflationary dynamics. Sustainable inflation furthermore supports the capacity of the central bank to slowly withdraw exceptional monetary accommodation – such as ending of yield curve control this week – and relieve associated stresses on banking-system profitability and financial-system stability.

Rising wages, government subsidies and fresh fiscal programmes are seen furthermore helping bolster private consumption as well as investment expenditure. The government aims for sustainable wage growth enhancing aggregate demand and potential output growth – the latter which the agency has estimated around just 0.4% a year. This potential-growth estimate is the lowest among economies of Scope-rated sovereigns and represents a credit-rating constraint. The government aims at ambitiously achieving potential (real) growth of 1-2% under an Economic Growth Achieved Case¹. If reflation results in healthier consumption and investment patterns in the future, this may present modest upside for the agency’s real potential-growth assumption.

An assumption of stronger inflation than the past underscores a meaningful shift of underlying nominal-growth assumptions currently. A present assumption of nominal economic growth of 2.6% (2024-28F) compares against the 1995-2022 nominal growth average of only 0.4%. This significant shift is (predominantly) driven by the assumed change of inflation environments.

Second driver of the Outlook revision: support of inflation for challenging debt-sustainability outlook

The rating agency projects a comparative stabilisation of the government-debt ratio over the forecast horizon – rooted in an assumption of reflation of the GDP deflator to 1.9% on average (2024-28F). Under the baseline economic scenario, debt-to-GDP concludes a forecast horizon to 2028 around 255%, roughly unchanged from an estimated 253% as of end-2023. In 2023, debt-to-GDP fell from record highs of 2022 of 260% (to around 253% by 2023) thanks to elevated nominal growth (of 5.8% last year). Nevertheless, general government deficits are assumed staying elevated around 3.5% of GDP on average (2024-28F). This reflects nevertheless a stronger debt-sustainability assessment for the borrower than that as of the agency’s last October-2023 review.

Sovereigns such as Japan and Greece (upgraded recently to BBB-/Stable Outlook) – the two highest-indebted states of Scope’s sovereign universe – have been among select sovereigns on balance helped, rather than harmed, by the cost-of-living crisis – being supported by elevated inflation curtailing very-elevated debt ratios when many other debt-reduction strategies of past decades have proven less effective, having furthermore uniquely very-low outstanding interest-cost structures (and, resultantly, significant space for rises in interest) and each having seen their modern records of deflation be helpfully addressed (partly structurally) by this crisis. Net interest payments of Japan stood at a comparatively-low 0.5% of revenue (2023) – and is projected rising gradually to a nevertheless low 2% by 2028 under an assumption of higher rates for longer. As such, Japan pays among the lowest net interest of Scope’s sovereign universe even though the borrower has the highest debt ratio of any rated sovereign. The effective interest rate on Japanese debt remains near 0% across the forecast horizon.

Debt sustainability remains anchored by a favourable structure of debt, such as debt being largely domestically held (86%), comparatively long (9 years and 4 months for securities as of December 2023) and entirely denominated in yen. The long maturity supports a comparatively-gradual transition of higher rates to higher interest costs – although annual gross financing requirements are exceptionally high. The Bank of Japan furthermore owns (has monetised) 48% of the debt – so the amount of rateable debt of Japan owed to the private sector is much lower than the observed gross debt ratio of 253% of GDP. Although the BoJ ended its policy of yield curve control earlier this week, it continues to purchase bonds within secondary markets broadly the same as before² – ensuring further rises of the share of government debt held by the central bank over the indefinite future.

Finally – Japan, as the world’s largest creditor nation, holds gross government financial assets of around 96.7% of GDP (IMF, 2023³) – nearly equal in size to the gross debt stock of the sovereign due to the private sector. As such, the aggregate debt-sustainability picture is more benign than the very-elevated gross debt ratio might portray – even if the gross-debt stock of Japan remains very challenging to curtail to any sustainable ratio.

The government has furthermore consistently re-affirmed its commitment to fiscal consolidation – even if the solution to the elevated debt of Japan rests rather around reflating nominal economic growth and financial repression.

Rating challenges: elevated government debt and budgetary and economic bottlenecks from historic demographic decline

The rating faces constraints long run from: i) the sovereign’s elevated gross debt; ii) the economy's comparatively tepid nominal economic-growth potential; and iii) rising pension and healthcare-related costs, alongside rising investment requirements as concerns the green transition and national defence.

Real growth is forecast at just 0.6% for 2024 followed by 1.2% for 2025 – slowing from the 1.9% last year. The working-age population (15-64 years of age) is seen by the United Nations dropping 0.6% on average over the years 2024-28⁴. New births declined to a record low last year, and the National Institute of Population and Social Security Research projects the population declining around 30% to 87 million by 2070⁵, with four of every 10 people aged 65 or older. The government’s reform programme centres around birth-rate policies, such as enhancing child-care benefits and promoting wage hikes for younger workers.

The IMF projects the net present value of pension and health-care spending changes (2022-50) around 48% of GDP³.

Sovereign Quantitative Model (SQM) and Qualitative Scorecard (QS)

The agency’s SQM, which assesses core sovereign credit fundamentals, provides a first indicative rating of ‘a’ for Japan. Under Scope’s rating methodology, this first indicative rating receives: i) a further one-notch positive adjustment for the yen – reflecting a global reserve currency; and ii) no negative adjustment for outstanding political risks. As such, a ‘a+’ final SQM indicative rating is assigned and can next be reviewed by the lead analyst vis-à-vis the methodology’s Qualitative Scorecard (QS) and be changed by up to three notches up or down depending on the size of qualitative credit strengths or weaknesses of Japan against an SQM-assigned peer group of sovereign states.

Scope has identified the following qualitative credit strengths for Japan under the QS against assigned sovereign peers: i) debt profile and market access; ii) current account resilience; and iii) resilience to short-term external shocks. By contrast, the following credit weaknesses have been identified relative to indicative sovereign peers via the QS: i) growth potential and outlook; ii) fiscal policy framework; iii) long-term debt trajectory; iv) banking sector performance; and v) environmental factors.

The QS generates an aggregate one-notch negative adjustment and indicates final 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 issues in its rating process via the Sovereign Rating Methodology’s stand-alone ESG sovereign risk pillar, with a 25% weighting under the quantitative model (SQM) and 20% weight in the methodology’s qualitative overlay (QS).

Japan is comparatively average on aggregate under the SQM’s environmental sub-pillar (5% weight in the model). This includes performing poorly under the SQM for the economy’s CO₂ emissions per unit of GDP and greenhouse gas emissions per capita. In the model, the economy performs comparatively well, however, on climate-changed related natural-disaster risk exposure (measured by the ND-GAIN) but weakly on ecological resources compared against patterns of consumption. Alongside the SQM, the agency furthermore considers environment and climate-change related risks for the sovereign via the complementary QS, with an assessment of ‘weak’ for Japan as compared against Japan’s SQM-assigned sovereign peers. The economy is comparatively reliant on fossil fuels – accounting for 73% of aggregate power generation in fiscal year 2022⁶. This exposes the economy to transition risk. The country aims at achieving net-zero greenhouse gas emissions by 2050, with an interim objective of curtailing emissions 46% by 2030 compared against 2013 levels. The Green Transformation (GX) policy underscores the government transition strategy, aiming to channel JPY 150trn of public and private investment over the next ten years. Average annual losses for Japan from physical risks are estimated around 3% of GDP by the United Nations Economic and Social Commission for Asia and the Pacific⁷. The January-2024 Noto-Peninsula earthquake compelled the government to double general-contingency reserves to JPY 1trn.

Japan’s performance on core social metrics included under the SQM (“S” having a 7.5% model weight) is mixed. Japan performs near a global median on income inequality (as measured by the share of income earned by the bottom 50% of income earners), strongly on labour-force participation within the economy (81% of the active labour force for the 15-64 age group) but very weakly on the society’s old-age dependency ratio – projected as being the highest of Scope’s sovereign universe and seen continuing to pick up rapidly. This places greater pressures on pension and health-care systems. The society’s high degree of social cohesion, alongside excellent health and education systems, remain core social strengths. Aside from the weak SQM assessment on social metrics, Scope assigns a ‘neutral’ assessment for ‘social factors’ under the complementary analyst QS.

On governance, Japan performs very strongly under the SQM as measured by the World Bank’s Worldwide Governance Indicators (12.5% model weight) and furthermore receives no negative indicative-rating adjustment from the model’s separate stand-alone political-risk adjustment. The country benefits from very-strong democratic institutions, regular free and fair elections, and a strong record of press freedoms. Nevertheless, Japan displays a record of unstable governments and public backing for the Liberal-Democrat incumbent administration has declined, which may see renewed instability and slow progress on crucial policy priorities. Aside from the SQM, the rating committee assigned a ‘neutral’ assessment under the QS assessment category: ‘governance factors’ for Japan against its sovereign peers.

Rating committee
The main points discussed by the rating committee were: i) inflation dynamics and outlook; ii) wage growth; iii) nominal-growth outlook; iv) debt sustainability; v) structure of public debt and government assets; vi) fiscal policy; vii) monetary policy; viii) interest-rate sensitivity; ix) banking-system performance; and x) sovereign peers considerations.

Rating driver references
1. Ministry of Finance (Japan): Updates on Japan’s economic and fiscal policy [March 7, 2024] – not publicly available
2. Bank of Japan: Changes in the Monetary Policy Framework [March 19, 2024]
3. International Monetary Fund: October 2023 Fiscal Monitor (Methodological and Statistical Annex)
4. United Nations Department of Economic and Social Affairs [Population Division]: 2022 Revision of World Population Prospects
5. National Institute of Population and Social Security Research: Population Projections for Japan: 2021-2070 (2023)
6. Agency for Natural Resources and Energy (Japan)
7. United Nations Economic and Social Commission for Asia and the Pacific: Risk and Resilience Portal (Japan)

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Sovereign Rating Methodology, 29 January 2024), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for these Credit Ratings and Outlooks is (Sovereign Quantitative Model Version 3.0), 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: public domain, and the Rated Entity.
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 and/or Outlooks 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: Dennis Shen, Senior Director
Person responsible for approval of the Credit Ratings: Dr. Giacomo Barisone, Group Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings in January 2003. The Credit Ratings/Outlooks were last updated on 6 October 2023.

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

Conditions of use / exclusion of liability
© 2024 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.