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Standard & Poor's yesterday (Thursday) reduced Japan's long-term sovereign debt rating for the first time in nine years, saying Tokyo lacked a plan to deal with its mounting debt and persistent deflation.
The agency cut Japan's rating by one notch to AA minus, the fourth-highest level, citing the country's political gridlock for undermining efforts to reduce an $11 trillion (943 trillion yen) debt burden.
"The downgrade reflects our appraisal that Japan's government debt ratios – already among the highest for rated sovereigns – will continue to rise further than we envisaged before the global economic recession hit the country and will peak only in the mid-2020s," the firm said.
At the same time, S&P said Japan's outlook is stable, citing the country's strong external balance sheet and the "flexibility" that comes from the yen's international role. Japan has the world's second largest foreign reserves at more than $1 trillion.
The S&P downgrade puts the world's most indebted nation's credit rating one notch below both Fitch Ratings and Moody's Corp. (NYSE: MCO) and on a par with China and Saudi Arabia. The new level is one notch below Spain.
The ratings cut may serve as a warning for heavily indebted developed nations that have increased their spending following the global credit crisis, leaving some in a fragile financial state.
Debt problems in Europe have already prompted financial bailouts of Greece and Ireland, and the U.S. budget deficit is expected to hit a record $1.5 trillion this year.
Japan has piled up government debt that now totals nearly 200% of annual gross domestic product (GDP). Politicians and credit ratings agencies have been calling for it to lower its public debt for years but the government's efforts have yet to yield meaningful results.
While Japanese Prime Minister Naoto Kan has made tax and social security reform top priorities, the S&P downgrade took a swipe at his party's inability to unify a divided parliament.
"In our opinion, the Democratic Party of Japan-led government lacks a coherent strategy to address these negative aspects of the country's debt dynamics," S&P said in the release.
Opposition parties seized on the news to again press the attack on the government.
Yoshimasa Hayashi, who serves as the shadow finance minister for the Liberal Democratic Party, told The Journal that S&P's action is "proof of what the LDP has been warning to government," adding that "we all need to take the S&P decision to heart."
Fitch Ratings said that it was maintaining its stable outlook on the basis that the current low interest rates would allow it to fund itself, although it noted that the longer-term pressures from an aging population could threaten funding stability.
The yen and bond futures fell on concern the downgrade would push up the cost of borrowing for Japan.
Markets in the past have not worried too much about the country's high debt because it is well serviced by ample domestic savings and few foreign investors hold Japanese government bonds.
However, Japan's population is aging quickly, so entitlement programs will soak up an increasing proportion of the budget unless the government implements painful reforms, which will further constrain Japan's already weak fiscal flexibility, S&P said.
Japan's government must fix its finances to avoid a debt crisis that could trigger a "global depression," Vice Finance Minister Fumihiko Igarashi said earlier this week.
"I hope this serves as a warning for the government, they have absolutely no sense of crisis," Azusa Kato, an economist at BNP Paribas in Tokyo told Bloomberg News. "Once bond yields spike and the fire is lit, the amount needed to finance Japan's borrowing needs is going to jump and it's going to be too late."
Economy Minister Yosano warned the same day that a reliance on such sales could lead to a jump in borrowing costs.
"If we continue relying on bond sales to make up for spending that exceeds revenue, we could see long-term interest rates increase or a deterioration in our debt ratio, causing Japan to lose credibility globally," Yosano told Parliament.
Japan's borrowing costs are among the lowest in the industrialized world, helping it fund its debt load. The yield on the benchmark 10-year bond touched 1.26% on Jan. 19, the highest since Dec. 16.
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Japan's Credit Rating Cut to AA- by S&P on Debt Load