S&P Downgrades Japan to 'A+/A-1', Outlook Stable

Standard & Poor's Ratings Services lowered its long-term foreign and local currency unsolicited sovereign credit ratings on Japan to 'A+' from 'AA-'. The outlook is stable. We also lowered the short-term foreign and local currency unsolicited sovereign credit ratings to 'A-1' from 'A-1+'. We revised our transfer and convertibility (T&C) assessment to 'AA+' from
'AAA'.

RATIONALE
We believe the likelihood of an economic recovery in Japan strong enough to restore economic support for sovereign creditworthiness commensurate with our previous assessment has diminished. Over 2011-2014, average per-capita income in Japan slipped to US$36,000 from close to US$47,000. Apart from a sharp depreciation in the exchange rate between the yen and the U.S. dollar, this also reflected weak average economic growth during the period and persistently weak price trends. Despite showing initial promise, we believe that the government's economic revival strategy--dubbed "Abenomics"--will not be able to reverse this deterioration in the next two to three years.

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

Japan remains a relatively high-income economy despite years of low growth and deflation. We estimate per capita GDP at close to US$33,100 in fiscal 2015 (ending March 31, 2016). We estimate Japan's 10-year weighted average per-capita income growth at 0.9%.

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 achieve popular acceptance of challenging policy changes such as the 2014 increase in the sales tax rate. However, we see slow decision-making among policy institutions somewhat impairing policy implementation.

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 reflects these strengths. We believe that the yen's status 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 ratings. 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 continue to exceed dissavings in the government sector. We project that Japan's total external debt will exceed financial and public sector financial assets by less than 20% of current account receipts (CARs) at the end of 2015, i.e., the nation will have a small narrow net external debt position. This metric does not include external assets held by the nonfinancial sector, which are very substantial. We expect Japan's net international asset position to be about 270% of its CARs or more in the next few years.

Japan's very weak fiscal attributes are an important weakness in its credit metrics. Since fiscal 2008, the damage that the global financial crisis and the Great East Japan Earthquake have dealt to the Japanese economy has
depressed government revenue. However, general government spending has continued to grow, partly as a result of expanding social security spending associated with the nation's aging population. Despite the 2014 increase in the national sales tax and stronger tax revenue from exporters, we project annual increases in general government debt will equal 5% of GDP or more over 2015-2018. By our projections, the corresponding increase in net general government debt will reach 135% of GDP in fiscal 2018 from 128% in fiscal 2015.

The Bank of Japan's sizable purchases of Japanese government debt have kept the government's borrowing costs low. The central bank now holds about 30% of Japanese government bonds outstanding. However, interest rates could rise, increasing pressure on the budget, when the central bank normalizes its monetary policy stance. Japan will face by far the world's highest debt rollover ratio (including short-term debt) (see "Global Sovereign Debt Report 2015: Borrowing To Drop By 5.7% To US$6.7 Trillion," March 5, 2015).

OUTLOOK
The stable outlook on the long-term rating on Japan reflects our expectations that modest growth and stabilization of price levels will slow an increase in government indebtedness over the next two years and eventually stabilize it. We could raise the sovereign ratings on very significant improvements in the government's fiscal performance, likely brought on by the economy returning to low and sustained inflation accompanied by stronger growth. We could lower the sovereign ratings on indications that the government debt burden could rise more significantly than we currently expect, potentially due to continuously weak economic growth and prices trends.

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