Standard & Poor's cut Japan's credit rating on Thursday for the first time since 2002, saying Tokyo had no plan to deal with its mounting debt, a warning that could rattle other heavily indebted rich countries. The agency cut Japan's long-term sovereign debt rating by a notch to AA-minus, its fourth highest rating. It said an ageing population, persistent deflation and the government's loss of its upper house majority compounded the fiscal challenge.
Politicians and ratings agencies have warned for years that Japan must cut its public debt, which is double the size of its $5 trillion economy - by far the worst among rich nations. Other developed countries are also struggling with high debt burdens. Outstanding US public debt has ballooned to more than 60 percent of total output since the financial crisis, and with a record $1.5 trillion budget deficit expected this year, is set to grow further.
Emergency rescues for Ireland and Greece, meanwhile, have left some investors to reconsider whether it's always a safe bet to lend to rich governments. If Japan fails to get its fiscal house in order, "further downgrades will surely follow," said Julian Jessop, chief international economist at Capital Economics in London.
"Given the size of Japan's economy and the current sensitivity of global financial markets to sovereign debt concerns, the impact would be felt world-wide," he added. "It supports our fear that 2011 could be the year when Japan's dire fiscal position finally impacts markets both at home and internationally." Japanese Prime Minister Naoto Kan has made tax and social security reform top priorities and the S&P downgrade adds pressure on him to galvanise a divided parliament.
The yen and Japanese government bond prices fell and the cost of insuring Japanese debt against default rose after the announcement. S&P's rating for Japan is now one notch below both Fitch's and Moody's. It is on a par with S&P's ratings for China and Saudi Arabia and one notch below Spain's.
Fitch on Thursday said its rating was based on Japan's ability to fund itself, although a failure to reduce the country's fiscal burden could put pressure on its rating. Moody's Investors Service reaffirmed its rating on Thursday. Both agencies have a stable outlook on Japan.
So far, fear of a Japanese default has been muted. Unlike the United States, which relies primarily on foreigners to finance its debt, Japan can draw on domestic savings. At some 1,400 trillion yen, household assets amount to three times the size of total output, more than enough to fund borrowing.
But Japanese society is ageing quickly, and social welfare costs will take up an increasing proportion of the budget in the absence of reforms, a trend that S&P said reduces Japan's already weak fiscal flexibility. "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," S&P said in a statement. Japanese yields rose only slightly, with the 10-year note up 2 basis points to 1.250 percent.