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 CREDIT RATING CONSIDERATIONS

The confirmation of Japan’s A (high) rating and Stable trend reflects DBRS Morningstar’s view that the country’s credit fundamentals offset the increasing global uncertainty due to tightening of global financial conditions and geopolitical tensions. Japan’s post-pandemic recovery has been supported by accommodative financial conditions and government measures. Economic growth continues to be led by manufacturing, business investment, and consumption, which has resulted in above potential growth that averaged 1.6% during 2021-2022. As the government withdraws supportive measures, the Bank of Japan expects the economy to slow to 1.3% in 2023 and 1.2% in 2024. On the other hand, Japan’s public finances remain a key constraint to its rating. Following the pandemic related fiscal measures, Japan’s deficit rose to 9.1% in 2020 and remained high averaging 6.5% during 2021-22 due to government measures to subsidize energy prices following the conflict in Ukraine. The IMF expects the deficit to fall to 5.6% and 3.7% respectively in 2023 and 2024. Japan’s public debt ratio also rose from 236.4% of GDP prior to the pandemic to 260.1% in 2022 and is likely to trend marginally lower to 252.8% by the end of its forecast horizon in 2028. An additional impediment to growth is its ageing and shrinking working-age population.

Despite Japan’s structural weaknesses, Japan’s A (high) ratings reflect its fundamental strengths, including its large and diverse economy and its robust macroeconomic policy framework. 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. That said, with global inflation spilling over to Japan and headline inflation remaining over 3% for the 13th consecutive month, the BoJ will face a delicate balancing act: to normalize monetary policy while maintaining financial stability. The BoJ’s holdings of Japanese government bonds (JGBs) and Treasury Discount Bills (T-Bills) in June 2023 now stand at 47.1% of total debt. 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.

CREDIT RATING DRIVERS

Japan’s ratings could be upgraded if one or a combination of the following occur: (1) continued structural reforms that improve growth potential, or (2) a sustained improvement in the fiscal stance, resulting in a downward trajectory of the debt-to-GDP ratio. Conversely, the following could lead to a downgrade: (1) persistent fiscal underperformance, or if (2) the policy response fails to achieve a durable exit from the cycle of weak growth and entrenched low inflation.

CREDIT RATING RATIONALE

Japan’s Economic Recovery Continues Despite External Headwinds
Japan’s post-pandemic economic recovery continues to be led by manufacturing, business investment and consumption. The recovery is supported by accommodative financial conditions, government measures and the materialization of pent-up demand which resulted in an above potential growth of 1.6% during 2021-2023. The uptick in business investment is due to high corporate profitability – a result of the pass-through of high import prices and falling raw material prices. Consequently, in addition to digitalization and decarbonization, areas seeing a pickup in investment include the strengthening of supply chains and measures to address labor shortages. The recovery in manufacturing is led by exports, and domestic industry is benefiting from order backlogs and easing supply side constraints. The BoJ expects pent-up demand and savings to continue to support consumption and tourism demand to increase in the year ahead. However, given the uncertainty in the global economy and the waning effects of the government’s economic measures, the BoJ expects headline growth to slow to 1.2% in 2024, slightly higher than the IMF estimates of 1.0%.

However, Japan’s medium-term outlook remains clouded by demographic-related structural weaknesses. Japan’s potential growth stands at a mere 0.6%, leading to a negative adjustment in the Economic Structure and Performance building block assessment. Japan’s ageing and shrinking population have resulted in the highest old age dependency ratio among OECD countries exceeding 50% and the figure is projected to rise to 80.7% in 2050. That said, the implementation of the Work Style Reforms in June 2018 (relating to a 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 all bode well for alleviating Japan’s labor market challenges. The reform measures have resulted in Japan’s labor supply increasing from 65.7 million workers in 2012 to 69.0 million in 2022, with about 25% of the increase due to foreign workers. Furthermore, the increase in labor supply coupled with the increase in working-age female and elderly participation in the workforce have resulted in Japan’s labor force participation rate rising from 59.1% in 2012 to 62.5% in 2022. This increase has partially mitigated current demographic pressures and could have positive implications for stabilizing debt dynamics.

The Bank of Japan Faces Policy Challenges As It Continues With Its Accommodative Monetary Policy
The Bank of Japan (BoJ)'s loose monetary policy stance remains an outlier relative to most other central banks. Headline CPI rose to a four decade high of 4.3% YoY in January 2023, driven largely by the lagged impact of higher commodity prices and yen depreciation. While Japan’s core inflation (ex-food) has also risen to a four decade high of 4.2% in January 2023 overall inflationary trends remain much lower than in Europe and the United States. Although headline CPI has started to decline due to lower energy prices and government measures, it remains above 3% levels due to the depreciation of the currency which has impacted import prices. The BoJ expects prices to rise modestly due to an improvement in the output gap and higher inflation expectations due to potential changes in firm’s wage and price-setting behavior. That said, there remains uncertainty on the inflation path as despite higher Shunto negotiations, the change in wages due in 2024 may be limited as most of the small and medium enterprises which employ over 70% of the workforce may not be able to afford large pay increases. Consequently, in its latest policy statement in September 2023, the BoJ said it would continue with its Negative Interest Policy (NIRP) with short term rates at -0.1%, and Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control (YCC), until the annual increase in the CPI (ex food) exceeds 2% and stays over that in a stable manner. That said, given the uptrend in global market rates, the BoJ widened the band around the YCC from +/- 0.25% to +/-0.5% in December 2022, and further to 1% in July 2023, while significantly expanding its purchases of JGBs. Meanwhile the divergence in global rates continues to put downward pressure on the yen which has weakened ever since the US Federal Reserve began raising rates in October 2021. From trading at USD/JPY 110 in October 2021, the yen traded at a historic 25 year low of USD/JPY 150 before recovering to USD/JPY 145 currently. While the BoJ has historically maintained that a weak yen is positive for the export sector, it now notes the need to pay attention to the impact of foreign exchange markets on Japan’s economic activity including the pass through on consumer prices. To offset a tightening global monetary policy environment, Japanese authorities have begun intervening in the currency markets for the first time since 1998.

From a financial markets point of view, Japanese households have stuck to their risk-averse investment style with a strong home bias despite a long period of low interest rates in domestic markets. This has helped Japan fund its deficits at low interest rates. While we expect Japan to retain its considerable financial flexibility, we will be monitoring the risks of a change in the historical home bias of Japanese households. Looking ahead, the BoJ’s key challenge is determining whether the rise in inflation can be sustained and whether it could be compelled to dial back its expansionary monetary policy stance. But it will entail a delicate balancing act: to normalize monetary policy while maintaining financial stability. The BoJ in its 2022 Financial Stability Report (FSR) stated that due to the pandemic-related increase in fiscal spending and higher deposit inflows, financial institutions have been actively investing in securities and long term yen denominated bonds, leading to a sharp rise in interest rate risk if not managed appropriately. The FSR states that the ratio of the amount of interest rate risk to the amount of capital has risen to 10% for major banks, 20% for the regional banks and 30% for Shinkin co-operative banks. Moreover, while pension and insurance investors rebalancing their portfolios towards riskier foreign bonds and equity, financial institutions have maintained abundant liquidity, which significantly reduces the risk of needing to sell JGBs at a loss. Loan demand has increased both in Japan and overseas, higher rates have benefited the megabanks' overseas operations, and credit costs have remained low - all of which have thus far helped offset the impact of rising JGB yields on profits. DBRS Morningstar has closely been monitoring JGB holdings at the megabanks, and in particular their impact on CET1 ratios. Including unrealized gains or losses on securities, CET1 ratios have been consistently above regulatory requirements. In addition, stress tests suggest major banks have the necessary capital buffers to absorb large shocks. Nevertheless, while the financial sector fundamentals are strong, contingent liabilities for the government stemming from the banking sector could increase if rates rise by more and faster than expected. For more details please see DBRS Morningstar Commentary (Japan: Incoming BoJ Governor Faces A Delicate Balancing Act)

Japan’s Public Finances Remain A Challenge, But Its Financial Flexibility Remains High
Japan’s fiscal and debt metrics remain a key constraint to its ratings. Japan’s deficits have averaged around 4% of GDP since the 1980s and edged higher during global and domestic shocks. Deficits touched 9% levels in 2009 (global financial crisis), 2011 (earthquake) and 2020 (global pandemic). Japan’s fiscal policy response to the pandemic resulted in the deficit rising from an average of 3.2% during 2015-2019 to 9.1% in 2020. Since then, the deficit has declined but remains high at 6.2% in 2021 and 6.9% in 2022 as a result of the government’s expansion of the fuel subsidy to combat rising energy prices. The IMF projects Japan’s fiscal deficit to decline to 5.6% in 2023 and average 3.0% during 2024 to 2028.

Japan’s high deficit and drop in output during the pandemic resulted in its public debt-GDP ratio rising from 236% of GDP in 2019 to 260.1% of GDP in 2022 and 255.2% in 2023. The IMF projects Japan’s gross and net public debt ratios to average 251.7% and 153.9% of GDP over the projected horizon of 2024 to 2028. However, a reversal in Japan’s ultra-loose monetary policy could have implications for Japan’s public finances. The IMF in its 2022 Article IV report indicates that a 2% interest rate shock in 2023 could result in the debt-to-GDP ratio rising by 6 percentage points by 2027 relative to current levels. Sharply higher rates could also reverse the downward trend in the debt-service ratio, which has been declining for over two decades. A one-time capital injection equivalent to about 10% of regional bank assets could increase government debt by 5.9 percentage points of GDP.

That said, despite Japan’s high debt ratios, DBRS Morningstar takes the view that Japan’s financial flexibility is high. Government debt is all yen denominated, and is financed by a high rate of national savings which stand at 29.7% of GDP currently. The Bank of Japan’s extraordinary easing measures mitigate risks to the government’s ability to service debt. The central bank’s holdings of Japanese government bonds (JGBs) and Treasury Discount Bills (T-Bills) has increased significantly from 13.1% of total debt in March 2013 to 47.1% of total in June 2023. 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 and potentially jeopardize financial stability.

Japan’s Current Account Surplus Narrows But External Position Remains A Key Credit Strength

Japan’s external accounts are characterized by a structural current account surplus and a positive net creditor position. Its strong current account balance and high level of net foreign assets insulate it from external financial market shocks and is a core credit strength. Japan has been running perennial current account surpluses averaging 3% of GDP over the last few decades primarily due to robust income from foreign assets and a positive trade balance. The current account surplus narrowed to 2.1% in 2022 reflecting higher commodity prices and travel restrictions which impacted the services balance. That said, Japan’s income balance remains the main contributor to the current account surplus. The country’s net international investment position (NIIP) remains relatively high at 75.1% of GDP in 2022 and generates large income flows from abroad. The high NIIP reflects Japan’s ample USD 1.2 trillion foreign reserves and net portfolio assets and is a direct reflection of Japan’s high domestic savings. In addition, Japan holds a degree of resilience with the shock-absorbing benefits of the yen being one of the world’s most widely used currencies.

Strong Institutional Quality And Relatively Stable Politics Support Japan’s “A” Ratings

Japan’s institutional quality is strong and is reflected in its status as one of the best performers on Worldwide 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 political stability. The Liberal Democratic Party (LDP) has maintained a majority in Parliament for much of the post-war era, with Fumio Kishida being elected as the 100th prime minister of Japan in October 2021.
Since taking office, the government strategy has been to achieve sustainable and inclusive growth through its “New Form of Capitalism” policy designed to encourage both the public and private sector to address that social problems, that cannot be solved by the private sector alone. Measures include promoting wage hikes, narrowing the wage gaps between genders and regular and non-regular workers, and facilitating support for business restructuring and productivity improvements by small and medium enterprises. The administration aims to solidify Japan’s status as a scientific and technological powerhouse and has introduced policies focusing investments into areas such as green technology, digital transformation and artificial intelligence, quantum computing and biotechnology. Lastly, to address the problem of Japan’s declining birth rate, the government has committed to prioritizing child policy, including financial assistance towards higher education and subsidies to child care.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

Environmental (E) Factors
There were no Environmental factors that had a relevant or significant effect on the credit analysis.

Social (S) Factors
There were no Social factors that had a relevant or significant effect on the credit analysis.

Governance (G) Factors
There were no Governance factors that had a relevant or significant effect on the credit analysis.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (July 4, 2023) https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/422164.

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 (06 October 2023) https://www.dbrsmorningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and credit ratings are monitored.

The primary sources of information used for these credit ratings include Japanese Ministry of Finance, Cabinet Office of Japan, Bank of Japan, IMF, OECD, Bank of International Settlements, International Monetary Fund, World Bank, UN, and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing these credit ratings was of satisfactory quality.

The credit rating was not initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

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

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