Rating action

Scope Ratings GmbH (Scope) has today affirmed the State of Japan’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at single-A and maintained the Stable Outlook. The short-term issuer ratings are affirmed at S-1 in foreign- and local-currency, and associated Stable Outlooks are unchanged.

Japan’s single-A long-term ratings remain anchored by: i) a large, wealthy and competitive economy – the fourth largest globally in nominal dollar terms; ii) Japanese government bonds (JGBs) being a core global safe asset, associated strong funding flexibility and very-low effective interest rates on the outstanding debt – anchoring a highly favourable nominal growth compared against nominal rate differential, alongside a significant domestic investor base, an independent monetary policy, monetisation of debt, and significant government assets; and iii) a robust external position and yen’s reserve-currency status.

Nevertheless, the credit ratings are challenged by: i) the very elevated gross government debt stock – representing the highest debt to GDP of the agency’s rated sovereign universe and representing a continued risk specifically over the very long run; ii) the economy's comparatively moderate nominal growth potential – linking to a rapidly-shrinking and ageing population alongside the history of low inflation – although the inflation outlook has meaningfully improved with headline inflation having stayed above 2% since April of 2022; and iii) rising pension and health-care-linked costs and increasing investment requirements for the green transition and national defence.

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Key rating drivers

Improved inflation strengthens the nominal growth outlook. Inflation picked up further last month, increasing to 4.0% year-over-year from the recent low of 2.2% in January 2024. Core inflation rose to 3.2%, from the April-2024 lows of 2.2%. Although the reflation policies of the Bank of Japan (BoJ) for more than a decade displayed limited efficacy, inflation has been given a meaningful boost since the global cost-of-living crisis.

Record wage growth supports the sustainability of price rises. Last year, the 5.1% pay rise agreed in the annual pay negotiations of the largest trade-union group, Rengo, reinforced a BoJ decision to end eight years of negative rates. Subsequently, the record 5.1% rise in the minimal wage in effect since October last year coupled with strong bonus pay-outs resulted in strong wage growth towards the end of the year. This year’s wage negotiations began last month, with the Rengo requesting at least a 5% hike in wages (and 6% at smaller firms aiming to narrow the gap with the largest firms). In addition to wage growth, government subsidies and fresh fiscal-support programmes are seen further helping to bolster private consumption as well as investment expenditure.

The recent years of inflation over-shooting have displayed evidence of durably shifting inflation expectations – increasingly signalling a possible end of the years of so-called “Japanification”. The BoJ upgraded its inflation outlook sharply last month, expecting 2.4% core inflation in the next fiscal year (compared against 1.9% in its October forecasting).

On balance, Scope views inflation over-shooting constructively so far because this supports the central bank’s price-stability mandate as a prolonged phase of above-target inflation is likely needed to re-anchor inflation nearer to 2% long run. The deflation record of Japan has been the main challenge to debt sustainability and furthermore a limitation for real economic growth. Sustainably leaving deflation behind changes this debt-sustainability outlook. Scope projects headline inflation of 3.9% on average for this year before 2.4% next year. The agency assumes the economy growing 1.3% this year before 0.9% in 2026, with this forecasting having been revised slightly up. The assumptions on nominal growth of 3.2% a year on average from 2025 to 2029 compares against the average nominal growth from 1995-2022 of only 0.4%. This change, driven especially by the assumed structural changes of the inflation ecosystem, represents a considerable support for debt sustainability.

The public-debt sustainability assessment projects a continuation of a modest decline in the general government debt ratio over forthcoming years – reaching 238.7% of GDP by 2026, from the 258.4% at 2020 peaks, before edging roughly sideways concluding at 239.6% in 2029.

Funding flexibility, the strong structure of public debt and significant government assets. Debt sustainability remains anchored by JGBs’ status as a core global safe asset, the significant domestic investor base, an independent monetary policy alongside the strong structure of the government debt. This includes the debt being largely domestically held (88%)¹, having comparatively long maturities (8.6 years²⁾ and being denominated entirely in yen. The long maturity supports a comparatively-gradual transition of higher rates to higher interest costs – although annual gross financing requirements remain exceptionally high. The Bank of Japan furthermore owns (or has monetised) 47% of JGBs¹ – so the amount of rateable debt of the sovereign due to be repaid to the private sector is considerably lesser than an observed gross general government debt level of nearly 250% of GDP. The BoJ ended the policy of yield curve control in March 2024³, and it decided thereafter on a plan to reduce the amount of its monthly outright purchases of JGBs.

In addition, Japan, as the world’s largest single creditor nation, holds government financial assets of around 95% of GDP⁴ – nearly equal in size to the gross debt stock of the sovereign due for repayment to the private sector. Moreover, Japan has USD 1.24trn of official reserves (30.5% of GDP). As such, the aggregate debt-sustainability picture is more benign than the very-elevated gross debt ratio might suggest – even if the gross-debt stock of Japan remains very challenging to reduce to any moderate level.

Robust external position and reserve-currency status. Finally, Japan benefits from its robust external position and the reserve-currency status of yen. There has not been any observable loss of market confidence in the yen as a global reserve currency or challenge to the credibility of the Bank of Japan.

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

The ratings face constraints from: i) the sovereign’s elevated gross debt; ii) the economy's comparatively moderate (even if meaningfully improved) nominal economic-growth potential; and iii) rising pension and healthcare-related costs, alongside increasing investment requirements supporting the green transition and national defence.

The elevated sovereign debt stock, representing the highest general government debt as a share of GDP of any rated sovereign, presents credit risk mainly over the very long run.

The budget deficit remains elevated over the forecast horizon. The current minority government might see increasing pressures to hike spending. Japan has no modern record of primary budgetary surpluses, and the government’s most-recent target for a primary budget surplus by the fiscal year (FY) 2025 is being further delayed. As interest rates have risen (including the 10-year JGB trading around 1.4% at the time of writing), net interest payments of a limited 0.3% of revenues as of the calendar-year 2024 are increasing to a still-moderate 4.4% by 2029 under the assumption of higher rates remaining for longer.

Additional structural challenges are relevant over the medium to longer run. Despite higher real growth forecasts for this year and next, potential growth remains a modest 0.4% (Scope estimate). The working-age population (15-64 years of age) is seen by the United Nations declining 0.6% a year over 2025-29. New births declined to a record low last year (for the ninth straight year) and the National Institute of Population and Social Security Research sees the population diminishing 30% to 87 million by 2070⁵, with four in 10 persons aged 65 or older. The government reform programme centres around birth-rate policies, such as the enhancements of child-care benefits and promoting wage hikes for younger workers. Nevertheless, ageing remains a core credit rating constraint. The IMF forecasts the net present value of pension and health-care spending changes (2023-50) at 59% of GDP².

Rating-change drivers

The Stable Outlook reflects the opinion that risks for the ratings are balanced during the next 12 to 18 months.

Upside scenarios for the ratings and Outlooks are if (individually or collectively):

1. Public debt-to-GDP declines meaningfully, supported by higher nominal economic growth and/or the ongoing fiscal consolidation; and/or
    
2. Stronger sustainable nominal growth is achieved.

Downside scenarios for the long-term ratings and Outlooks are if (individually or collectively):

1. Debt sustainability weakens significantly, such as from the expectation of a material rise in government debt-to-GDP or significant rise in interest payments above and beyond the present projections; and/or
    
2. The government sees an unexpected deterioration in its funding flexibility and/or there is weakening of yen’s strength as a global reserve currency.

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

Scope’s SQM, which assesses core sovereign credit fundamentals, signals a first indicative credit rating of ‘a+’ on Japan. Under the methodology, this indicative rating receives a further: i) one-notch positive adjustment from the model reserve-currency adjustment; and ii) no negative adjustment from the methodological political-risk quantitative adjustment. On such bases, a final SQM quantitative rating of ‘aa-’ is determined. This indicative rating is thereafter next reviewed by the analyst-driven Qualitative Scorecard (QS) and the rating can be adjusted by up to three notches up or down from the model rating depending on the size of the qualitative credit strengths or weaknesses of the sovereign compared against an SQM-assigned sovereign peer group.

Through this second-stage QS assessment, the following QS analytical categories are identified as being relative credit strengths of the sovereign against the assigned peers: i) debt profile and market access; ii) current account resilience; and iii) the resilience to short-term external shocks. Conversely, the following QS analytical categories are identified as being relative credit weaknesses of the sovereign: i) the growth potential and outlook; ii) macro-economic stability & sustainability; iii) fiscal policy framework; iv) long-term debt trajectory; v) external debt structure; vi) banking sector performance; vii) environmental factors; and viii) governance factors.

On the aggregate, the QS generates a two-notch downside adjustment from the model rating and indicates single-A long-term foreign- and local-currency ratings.

A rating committee has discussed and confirmed these results.

Factoring of environment, social and governance (ESG)

Scope explicitly factors in ESG issues within its rating processes via the sovereign-rating methodology’s stand-alone ESG sovereign-risk pillar, which holds a significant 25% weighting under the quantitative model (SQM) and 20% weight within the qualitative overlay (QS).

Japan is comparatively average on the aggregate under the SQM environment sub-pillar (5% weight in the model). This includes performing below average on the SQM especially on greenhouse gas emissions per capita. In the model, the economy performs comparatively well, however, on climate-change related natural-disaster exposures (measured by the ND-GAIN Index) although weakly on ecological resources compared against consumption patterns within the economy. Alongside the model, the agency furthermore considers environment and climate-change related risks via the analyst-driven QS, through an assessment of ‘weak’ for Japan on the ‘environmental factors’ QS analytical category compared against the sovereign peers. The economy is comparatively dependent on fossil fuels. This exposes the economy to transition risks. The country aims at curtailing greenhouse gas emissions 60% by FY2035 compared against the 2013 levels. The Green Transformation policy underscores the government transition strategy, aiming at channelling JPY 150trn of public and private investment over 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 Pacific⁶. 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 within the SQM (with “S” having a 7.5% model weighting) is mixed. Japan performs near a global median on income inequality (as measured by the share of income earned by the bottom 50% of earners), strongly on its labour-force participation rate (82% of the active labour force for the 15-64 age group) but very weakly on old-age dependency – projected at the highest level among the economies of rated sovereigns and seen continuing to rise. This places pressure on pension and health-care systems. The society’s strong social cohesion alongside excellent health and education systems remain core credit strengths. Aside from the weak model assessment on social metrics, Scope assigns a ‘neutral’ assessment on the ‘social factors’ analytical category of the QS.

On governance, Japan performs very strongly within the SQM on the World Bank Worldwide Governance Indicators (12.5% model weighting) and furthermore receives no negative rating adjustment from the model political-risk adjustment. The country benefits from strong democratic institutions, free and fair elections, and a strong record of press freedoms. Nevertheless, Japan displays a record of unstable governments, and the Liberal-Democrat Party is heading a minority government since losing its absolute majority during the October-2024 elections. This might see instability and slow reform momentum. Aside from the SQM, the rating committee assigned a ‘weak’ assessment for the QS analytical category on ‘governance factors’ against the sovereign’s peers.

Rating Committee
The main points discussed by the rating committee were: i) ratings history; ii) sovereign peers considerations; iii) global trade conflicts; iv) the inflation and nominal-growth outlooks; v) funding flexibility and debt structure; vi) government assets; vii) debt sustainability and budget outlook; viii) monetary policy; ix) the external sector; and x) an SQM update.

Rating driver references
1. Bank of Japan: Flow of Funds
2. International Monetary Fund: Fiscal Monitor October 2024
3. Bank of Japan: Changes in the Monetary Policy Framework [March 19, 2024]
4. IMF: World Economic Outlook Database, October 2024
5. National Institute of Population and Social Security Research: Population Projections for Japan: 2021-2070 (2023)
6. 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, 27 January 2025), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The model used for these Credit Ratings and/or Outlooks is (Sovereign Quantitative Model Version 4.0), 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 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: Eiko Sievert, Senior Director
The Credit Ratings/Outlooks were first released by Scope Ratings in January 2003. The Credit Ratings/Outlooks were last updated on 22 March 2024.

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, as well as a list of Ancillary Services and certain non-Credit Rating Agency services provided to Rated Entities and/or Related Third Parties.  

Conditions of use / exclusion of liability
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