DBRS Morningstar Confirms Japan at A (high), Stable Trend

DBRS, Inc. (DBRS Morningstar) confirmed Japan’s Long-Term Foreign and Local Currency – Issuer Ratings at A (high). At the same time, DBRS Morningstar confirmed Japan’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (middle). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

Japan’s A (high) ratings reflect its strong credit fundamentals as one of the wealthiest and most diversified economies in the world. The country enjoys exceptionally low financing costs due to its large pool of private savings and its large domestic investor base. DBRS Morningstar expects Japan’s safe-haven status and the Bank of Japan’s (BoJ) bond purchases, as part of its yield targeting framework, to help maintain low borrowing costs despite the very high public sector debt-to-GDP ratio. Japan’s external position is another core credit strength. Its large current account surplus reflects high private sector savings that offset government dissaving, while its net creditor position – the highest among advanced economies – generates large income flows from abroad. The Japanese yen functions as a global reserve currency and supports the government’s capacity to finance its high debt burden. Governance indicators are among the strongest globally, reflecting the high degree of social and political stability.

Despite these strengths, Japan’s ratings are constrained by structural credit challenges. Public finances remain Japan’s main credit weakness. Persistent deficits have contributed to gross government debt of 237.1% of GDP, the highest ratio among advanced economies. An aging and shrinking working-age population and a slow pace of domestic investment weigh on GDP growth potential and inflationary expectations. However, Abenomics – now in its seventh year – has eased financial conditions, reduced the fiscal deficit and have led to an increasing participation of women and elderly in the workforce which, coupled with an increase in foreign workers, partially mitigates near-term demographic pressures.

RATING DRIVERS

Upward rating drivers include: (1) Japan’s ability to sustain economic growth that results in a persistent downward trajectory of the debt-to-GDP ratio and (2) continued structural reforms that improve growth potential. Downward rating drivers include one or both of the following: (1) the government persistently underperforms relative to deficit targets or if (2) the policy response fails to achieve a durable exit from the cycle of weak growth and entrenched low inflation.

RATING RATIONALE

Public Finances Remain a Key Challenge, But Financial Flexibility is High, and Consumption Tax is in Play

Chronic fiscal deficits since 1991 have weakened the government’s balance sheet resulting in Japan’s gross debt rising to 237.1% of GDP in 2018, the highest ratio among advanced economies. Attempts at fiscal consolidation during the 2000s were derailed by the shocks in 2009 and 2011, with the deficit averaging nearly 9% of GDP during 2009-2013. Since then, the improvement in tax revenues and removal of stimulus measures have stabilized the deficit at 3.4% during 2015-2018. The recent implementation of the consumption tax increase and containment in expenditures (39.4% of GDP in 2013 to 37% in 2018) bodes well for near-term fiscal consolidation, with the deficit expected to decline to 2.2% in 2020.

Despite near-term stabilization, Japan’s long-term public finances are challenged by its high gross debt and rapidly aging population. This is reflected in established spending pressures with debt service at 24% and social security expenditures at 34% of total expenditure. Japan thus needs a sustained increase in tax revenue to not only stabilize its public debt to GDP ratio but also to support long-term demographic changes. To this end, the recent consumption tax hike from 8% to 10% in October 2019 is positive as the government has linked additional social security expenditures to increased consumption tax receipts. (see Japan – Third Time’s the Charm for the Consumption Tax?). Over the medium term, a well specified framework with credible assumptions and measures to attain the primary balance target for 2025 would help bolster the credibility of fiscal policy.

Japan’s large public debt burden, which has risen from 70% of GDP in 1990 to 237.1% in 2018, remains a key vulnerability and has led to a negative adjustment in the “Debt and Liquidity” building block. In DBRS Morningstar’s baseline scenario, due to an improving primary balance and a positive growth-interest differential, Japan’s gross and net public debt ratios are expected to remain relatively stable over the projected horizon at 235.4% and 153.6% of GDP by 2025. While the high stock of debt makes Japan vulnerable to various shock scenarios, DBRS Morningstar believes that BoJ’s extraordinary easing measures mitigate risks to the government’s ability to service debt. This is reflected in Japan’s gross interest payments to revenues ratio declining from 6.7% of GDP in FY 2013 to 4.8% of GDP in FY 2018.
Furthermore, Japan’s financial flexibility is high. In addition to the yen denominated debt, most of the debt is held domestically and is financed by a high rate of national savings (which stands at 27.9% of GDP). Thanks to the BoJ’s expansionary policies and the home bias of Japanese investors, liquidity and refinancing risks are low. Since the introduction of Abenomics, the Bank of Japan’s (BoJ) holding of Japanese government bonds’s (JGBs) has increased significantly from 13.1% of total debt in 2013 to 43.5% of total currently. In the same period, the weighted average maturity of debt has risen from 7.6 years in FY 2013 to 9.2 years in FY 2019. Nonetheless, Japan’s capacity to refinance its debt could be sensitive to shifts in market sentiment. If domestic bond investors begin to demand a risk premium and the government’s real cost of borrowing increases, debt dynamics could deteriorate. A decline in the savings rate and the persistent increase in age-related spending pressures could ultimately weigh on investor sentiment toward Japan.

Solid External Position Provides a Buffer to Absorb External Shocks

Japan’s external position is a core credit strength. Its strong current account balance and high level of net foreign assets insulate it from external financial market shocks. Japan has been running perennial current account surpluses averaging 4% of GDP since the 1980s primarily due to robust income from foreign assets and a positive trade balance. The country’s net international investment position (NIIP) remains relatively high at 62.4% of GDP in 2018 and generates large income flows from abroad. Japan’s income surplus is attributed due to high yields on foreign assets, low FDI and portfolio debt liabilities and low yields on portfolio debt liabilities. The high NIIP reflects Japan’s ample US$1.2 trillion foreign reserves and net portfolio assets and is a direct reflection of Japan’s high domestic savings combined with somewhat limited domestic investment opportunities.

Ongoing Reforms Could Further Improve Labor Supply and Aid Growth

Seven years of Abenomics (monetary easing, flexible fiscal policy, and structural reforms) have resulted in the Japanese economy growing above potential with growth averaging 1.2% during 2013-2018. Current growth trends have been aided by expansionary monetary and fiscal policies that have supported private consumption. This coupled with investments towards the 2020 Olympics and in labor-saving equipment have helped offset weaker external conditions. To mitigate the impact of the 2% increase in consumption tax enacted on October 1, 2019 and to avoid repeating economic downturns seen during past attempts to raise taxes, the government implemented several offsetting measures including rebates for cashless payments and exemptions for food and other essential items. Despite this, domestic demand appears to have weakened due to the effects of natural disasters and the consumption tax hike. To further offset the impact of lower domestic consumption, weak external demand and the phasing out of investments due to the 2020 Olympics, in December 2019, the government announced additional spending measures in its supplementary budget and raised its FY2020 GDP growth to 1.4% from 1.2%.

Japan’s medium-term outlook remains clouded by demographic-related structural weaknesses resulting in low potential growth of 0.5-1.0% of GDP and leading to a negative adjustment in the “Economic Structure and Performance” building block. Japan’s aging and shrinking population coupled with labor market rigidities have resulted in Japan’s unemployment rate falling from 5.5% in 2009 to 2.2% in November 2019 – the lowest since 1972. However, the low unemployment rate is a deceptive measure of labor market strength and illustrates shortages in Japan’s dual and rigid labor market. The active job openings-to-applicant ratio at 1.6 has risen to pre-bubble levels – the highest since 1974. Due to entrenched wage-price setting behavior, wage growth has been muted resulting in subdued domestic demand and high corporate savings.

In an effort to reduce the bottlenecks in labor supply and to improve wage-price dynamics, the government has been implementing a series of reform measures. The passage of the Work Style Reforms in June 2018 (relating to cap on overtime and equal pay for equal work), the Immigration Control Act in December 2018 (allowing more foreign workers into the country), and incentives to increase female participation in the workforce bode well for addressing Japan’s labor market challenges. Since the introduction of Abenomics in 2013, Japan’s labor supply has increased from 62.7 million to 68.5 million, with 25% of the increase due to foreign workers. Female and elderly participation in the workforce have also risen and are both at all-time highs of 71.3% and 24.7% respectively. This partially mitigates current demographic pressures and has positive implications for increasing Japan’s long-term output potential and stabilizing debt dynamics.

BoJ’s Expansionary Policies to Continue as Inflation Remains Below Targets

The Bank of Japan (BoJ) has adopted a series of unconventional monetary policy tools in response to price deflation and entrenched low inflationary expectations. The BoJ set the inflation target at 2% in 2013 and launched its Quantitative and Qualitative Monetary Easing entailing ¥50 trillion (expanded to ¥80 trillion in October 2014) in Japanese government bonds (JGB) purchases per year. It then adopted a negative interest rate policy (NIRP) in January 2016 and introduced the yield curve control framework in September 2016 (setting the short-term reference interest rate at -0.1%, targeting the yield on the 10-year benchmark JGBs at “around zero percent.”).

Despite ongoing expansionary monetary policies (JGB purchases now stand at ¥20 trillion annually), six years of nominal growth exceeding 1% and tightening labor markets, inflation remains below targets. Headline and core inflation remain positive at 0.5% and 0.5%, respectively, as of November 2019. This is nonetheless lower than the 0.8% and 0.9% levels seen last year and is well below the BoJ’s 2% target. Given the relatively lower inflation levels seen in 2019, the BoJ modified its forward guidance in its October 31, 2019 policy statement to underline that it was willing to act if risks to meet the inflation target increase. The bank said that “it expects short- and long-term rates to remain at their present or lower levels as long as it is necessary to pay close attention to the possibility that the momentum towards achieving price stability will be lost”. In conjunction with JGB purchases, the BoJ said that it would maintain its purchases of ¥6 trillion ETFs and ¥ 90 billion REITs annually. BoJ said that it would maintain outstanding amounts for commercial paper and corporate bonds at ¥2.2 trillion and ¥3.2 trillion respectively.

Expansionary monetary policy has helped improve financial conditions, but DBRS Morningstar acknowledges that there are structural limits to the NIRP and the JGB yield-targeting framework. The NIRP, in combination with JGB purchases, has pushed down not only short-term but also long-term interest rates substantially. Concerns about the side effects from prolonged monetary easing has complicated BoJ’s reflation efforts leading to a negative adjustment in the “Monetary Policy and Financial Stability” building block. Bank lending rates and corporate bond yields are near historic lows, providing easy financing conditions for firms but lower margins for financial institutions. Pension and insurance investors have been rebalancing their portfolios towards riskier foreign bonds and equity. Despite evidence of portfolio rebalancing, financial institutions’ reserves continue to rise as loan demand remains muted due to structural factors such as the decline in potential growth caused by demographics. While low interest rates have taken a toll on banks’ net interest margins, overall bank fundamentals are strong and contingent liabilities for the government stemming from the banking sector appear limited. The systemically important financial institutions appear able to take on higher levels of risk, and stress tests suggest major banks have the necessary capital buffers to absorb large shocks.

Strong Institutional Quality And Relatively Stable Politics

Japan’s institutional quality is strong and is reflected in its status as one of the best performers on World Bank governance indicators, both within DBRS Morningstar’s “A” rated peer group and globally. Japan scores favorably on government effectiveness, control of corruption, and rule of law. Institutional strength reflects the capacity and willingness of the government to conduct sound economic policies and repay its debt. The country also benefits from a high degree of social and political stability. The Liberal Democratic Party (LDP) has maintained a majority in Parliament for much of the post-war era and currently governs in a coalition with the Komeito Party as a supermajority. PM Abe, who came into power in 2013, was re-elected to a third term as leader of the LDP in the September 2018 elections. With PM Abe likely to remain in office until 2021, it would make him the longest serving PM. In addition to Abenomics, PM Abe has won relatively high marks for his diplomacy. While ties with US and China have improved, relations with South Korea have come under the spotlight over their shared wartime legacy. The next national elections for the house of representatives (lower house of parliament) is scheduled on or before October 2021.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments.

Notes:
All figures are in Japanese yen unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments, which can be found on the DBRS Morningstar website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The primary sources of information used for this rating include the Japanese Ministry of Finance, Cabinet Office of Japan, Bank of Japan, IMF, OECD, BIS, World Bank, UN, Conference Board and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

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