S&P Affirms Ratings of, Issues Commentary on Japan

On Sept. 25, 2014, Standard & Poor's Ratings Services affirmed its long- and short-term unsolicited sovereign credit ratings on Japan at 'AA-' and 'A-1+', respectively. The outlook on the long-term ratings remains negative. Our transfer and convertibility (T&C) assessment remains 'AAA'.

RATIONALE

Our ratings on Japan balance the country's strong external position, its prosperous and diversified economy, political stability, and its stable financial system against a very weak fiscal position that the country's aging population and persistent deflation exacerbate.

Japan's high-income economy remains a key factor underpinning its credit quality, despite years of low growth and deflation. We estimate per capita GDP at close to US$37,000 in fiscal 2014 (ending March 31, 2015). In the period to fiscal 2017, we project average nominal GDP growth of just below 2.5% annually as the yen exchange rate remains little changed. This projection partly reflects our belief that the government's economic strategy--termed "Abenomics"--will help to sustain annual real GDP growth at slightly above 1% and return inflation to positive territory. We estimate the 10-year weighted average income growth at 1.1% in fiscal 2014.

The strength of Japan's institutional and governance effectiveness remains a key factor supporting the sovereign ratings. Japan's homogeneous and cohesive society, generally effective checks and balances in the government, strong respect for the rule of law, and free flow of information facilitate policymaking. This has helped popular acceptance of challenging policy changes such as the recent increase in the sales tax rate in April 2014. However, we see slow decision-making among policy institutions impairing policy implementation somewhat.

Japan's strong external position and monetary policy settings also support its sovereign credit fundamentals. The free-floating yen's status as a reserve currency is a reason for these strengths. We believe that the status of the yen derives from the credible political and policy institutions in the country--including the Bank of Japan (BOJ), a sound financial system, freedom of capital flows, and sizable domestic capital markets. Demand for the yen as a reserve currency reduces Japan's vulnerability to large fluctuations in international capital flows and augments the BOJ's ability to conduct monetary policy.

A strong external balance sheet further strengthens support for the sovereign rating. Despite the slide in the household saving rate as the population ages, the current account remains in consistent surplus. This indicates that private-sector savings in the country continues to exceed dissaving in the government sector. We project that financial assets held by the financial and public sector will continue to outsize total Japanese external debt by between 35%-40% of current account receipts (CAR) in the next three years. Other external assets held by the nonfinancial sector are even more substantial. We expect the net international asset position of Japan to amount to above 270% of its CAR in the next few years.

Japan's very weak fiscal attributes are an important weakness in its credit metrics. Since fiscal 2008, the damage dealt to the Japanese economy by the global economic crisis and the Great Tohoku earthquake has depressed government revenue. However, general government spending continued to grow partly as a result of growing social security spending associated with population aging.

Despite the increase in the sales tax in April and the expected improvements in economic conditions, we project annual general government deficits at approximately 7%-8% of GDP in 2014-2017. By our projections, the corresponding increase in net general government debt will bring it to 160% of GDP in fiscal 2017 from 148% in fiscal 2014. Japanese banks already hold more than 20% of their assets in government debt. If demand for loans in the private sector picks up strongly, the banks may not be able to absorb more government securities unless real interest rates rise significantly. We project interest expenses to rise to 8.6% of general government revenue by the end of this period from a little less than 6% in fiscal 2014.

OUTLOOK

The negative outlook on the long-term ratings reflects our view of the still-sizable risk of a slow return to sustained inflation and healthier economic performance. Following several quarters of strong growth, the economy contracted sharply in the wake of the sales tax hike in April 2014. Economic sentiments could have turned more cautious as a result. We see at least a one-in-three chance that nominal GDP growth could fail to improve sufficiently to stabilize the general government debt level vis-a-vis GDP in the near future. If we believe that this scenario is likely, we could lower the sovereign ratings on Japan. Conversely, we could revise the outlook back to stable if we expect the economy to sustain healthy growth and the monetary authorities to succeed in achieving their inflation target of 2% annually. This is possible if, for instance, investors and businesses are encouraged by the government's implementation of important structural reforms. In this scenario, we expect the general government deficit to shrink sufficiently to stabilize the level of government debt with respect to GDP.

KEY STATISTICS

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RATINGS SCORE SNAPSHOT

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