DBRS Confirms Japan at A, Trend Changed to Positive

DBRS Inc. has confirmed Japan’s Long-Term Foreign and Local Currency – Issuer Ratings at A. The Short-Term Foreign and Local Currency – Issuer Ratings have been confirmed at R-1 (low). The trend on all ratings has been changed to Positive from Stable.

The Positive trend reflects DBRS’s view that the upward momentum seen in growth combined with accommodative financial conditions and policy reforms may sufficiently offset the challenges rising from Japan’s chronic deficits and high public debt. Since DBRS’s last review, a combination of higher economic growth, higher inflation, and statistical revisions have pointed to improved debt dynamics. Although doubts persist over Japan’s medium-term outlook, a continuation of current growth trends combined with evidence of better prospects for inflation could be sufficient to return Japan’s ratings to the upper end of the ‘A’ category (A (high)).

CREDIT STRENGTHS AND CHALLENGES

Japan’s A ratings reflect its strong credit fundamentals as one of the wealthiest and most diversified economies. The country enjoys low financing costs due to its large pool of private savings and large domestic investor base. DBRS 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. Governance indicators are among the strongest globally, reflecting the high degree of social and political stability. The Japanese Yen functions as a global reserve currency, supporting the government’s capacity to finance its high debt burden.

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 government debt of 240% of GDP, the highest ratio among advanced economies. Japan’s debt burden has been exacerbated by structural constraints to output growth and intermittent deflation. An ageing and shrinking working age population, and a slow pace of domestic investment weigh on GDP growth potential. Low growth expectations have entrenched deflationary expectations among firms and households.

STRUCTURAL REFORM COULD IMPROVE LABOR SUPPLY AND AID GROWTH
Following two decades of sub-par growth coupled with deflation, PM Abe launched Abenomics in 2013 focusing on monetary easing, flexible fiscal policy, and structural reforms. This has resulted in the economy expanding above potential, with growth averaging 1.2% during 2015-2017. Current growth trends have been aided by expansionary monetary and fiscal policies, the synchronized global recovery, and investment towards the 2020 Olympics and labor-saving equipment. The medium-term outlook nonetheless remains clouded by unresolved structural weaknesses, resulting in low potential growth of 0.5-1.0%. These include Japan’s deteriorating demographics, entrenched labor market rigidity, and decreasing stock of risk capital from high savings.

The Cabinet Office’s “Economic Revitalization” scenario assumes real output goal of 1.5% by 2020. Given negligible contributions from labor and capital, the estimates assume that total factor productivity (TFP) will revert to 1980s levels of 2.2% by 2020. This appears ambitious in comparison to recent trends in TFP, where growth has averaged -0.1% during 2010 to 2017 according to calculations by the Conference Board. Structural reforms are key to raising Japan’s potential growth. To this end, there has been some progress on Abenomics’s ‘third arrow’ of structural reform, with measures implemented including improved corporate governance, financial sector reforms, and tax adjustments. Implementation of the recently released “Work Style Reforms,” which include a cap on excessive overtime, income and productivity policies, and policies to address labor market duality could further improve labor supply and aid growth.

MONETARY POLICY REMAINS EXPANSIONARY

Price deflation has been a main contributor to Japan’s economic stagnation and high public debt ratio. As a result, the BoJ adopted unconventional monetary policies such as Quantitative and Qualitative Monetary Easing (QQE) in 2013. The subsequent ¥80 trillion in JGB purchases per year meant to break the low growth-deflationary cycle showed some initial progress at lifting prices, with CPI rising to 1.5% in April 2014, prior to the implementation of the consumption tax. However, this was short-lived with CPI retreating below target due to both domestic and external factors. The BoJ adopted a negative interest rate policy (NIRP) in January 2016, setting the short-term reference interest rate at -0.1% and targeting the yield on the 10-year benchmark JGBs in September 2016 at “around zero percent.” Despite ongoing expansionary monetary policies (JGB purchases now stand at ¥40 trillion), headline inflation was 1% as of December 2017. While the BoJ has stated that subdued inflation in the context of a tightening labor market is in part driven by corporate efforts to improve labor productivity and to absorb costs, in its latest policy (January 2018) it has said it would continue with "quantitative and qualitative monetary easing with yield curve control" for "as long as it is necessary" to achieve its 2 percent inflation target.

Expansionary monetary policy has helped improve financial conditions, but DBRS believes there are structural limits to the NIRP and the JGB yield targeting framework. Bank lending rates and corporate bond yields are near historic lows, illustrating easy financing conditions for firms. Moreover, spurred by recent reforms to corporate governance and the portfolio allocation changes to the Government Pension Investment Fund (GPIF), pension and insurance investors have accelerated their rebalancing of portfolios towards riskier foreign bonds and equity. However, despite evidence of portfolio rebalancing, financial institutions reserves have risen as loan demand remains muted due to excess savings. While low interest rates have taken a toll on bank’s net interest margins, 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.

PUBLIC FINANCES REMAIN A KEY CHALLENGE, BUT FINANCIAL FLEXIBILITY IS HIGH

Chronic fiscal deficits have gradually weakened the government’s balance sheet. Japan’s deficit, which averaged 3.9% of GDP during 2004-2008, was derailed by the shocks in 2009 (global financial crisis) and 2011 (earthquake), with the deficit averaging nearly 9% during 2009-2013. The deficit fell to 3.5% in 2015 as automatic fiscal stabilizers were phased out and revenues grew. Improvements in tax revenue were due to higher corporate earnings and the increase in the consumption tax from 5% to 8% in April 2014. However, the decision to raise the consumption tax in 2014 caused the economy to lose its initial momentum and slip back into recession. In response, the government delayed the second increase (to 10%) of the tax from 2017 to 2019 and announced three supplementary budgets in 2016. This resulted in the deficit widening marginally to 4.3% of GDP in 2016 and 4.1% in 2017.

The government’s “Economic and Fiscal Revitalization Action Program” commits to the basic principle ‘Without economic revitalization, there can be no fiscal consolidation’ and aims for both a 600 trillion-yen economy and a primary surplus by FY2020. This assumes that the economy will grow by 2% in real terms annually (3% nominal terms), and that revenue increases will offset the continued rise in social spending. However, Japan’s long-term public finances are challenged by rising age-related expenditures and high debt service costs. Social security expenditures grew from 20% of total expenditure in 2000 to 33% due to rising medical and long-term healthcare costs. Debt service constitutes 24% of total expenditure. Progress on sustaining the higher pace of growth and deeper fiscal reforms would help ease the long-standing spending pressures and make the government’s medium-term deficit reduction strategy more achievable.

Japan’s large public debt burden which has risen from 70% in 1990 to 240% in 2017 is a key vulnerability. In DBRS’s baseline scenario, improving the primary balance and a positive growth-interest differential will cause Japan’s gross and net public debt ratios to decrease marginally over the projected horizon at 232% and 115% of GDP by 2022. Beyond 2022, the IMF expects the debt-GDP ratio to increase to 250% of GDP in 2030, as the growth-interest differential reverts to negative territory. Furthermore, the high stock of debt makes Japan vulnerable to various shock scenarios.

Fortunately, government debt is held domestically and financed by a high rate of national savings, at 27.2% of GDP. The BoJ currently holds over 40% of JGBs. Moreover, the composition of debt is favorable, and thanks to the BoJ’s expansionary policies, liquidity and refinancing risks are low. 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. A decline in the household savings rate, the persistent increase in age-related spending pressures, and the lack of a long-term strategy for debt consolidation could ultimately weigh on investor sentiment toward Japan.

EXTERNAL POSITION REMAINS A CORE CREDIT STRENGTH

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 since the 1980s primarily due to robust income from foreign assets and a positive trade balance. The country’s net international investment position (NIIP) has been on a steady rise, reaching 65% of GDP in 2016 and generates large income flows from abroad. Maintaining its positive saving-investment balance is key for the country to finance domestic investment and keep external vulnerabilities low.

INSTITUTIONAL QUALITY IS STRONG

Japan’s institutional quality is strong and is reflected in it being among the best performers on World Bank governance indicators within DBRS’s “A” rated peer group and globally. The country benefits from a high degree of social and political stability. Following his victory in the October 2017 parliamentary elections, PM Abe is likely to focus on legislation already in the pipeline. These include the pending work-style reforms, the implementation of the consumption tax hike, and the allocation of increased tax revenues towards social security expenditures centered on free education. In addition, since the LDP and its coalition partner Komeito have held on to a two-thirds super majority, the government can push forward the revision of Article 9 of the Japanese Constitution.

RATING DRIVERS

Upward rating action would come from (1) Japan’s ability to sustain economic growth that stabilizes the trajectory of the debt-to-GDP ratio and (2) continued structural reforms that improve growth potential. The ratings could stabilize if (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 deflation.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AA (low) to A range. The main points of the Rating Committee discussion included: the economic outlook and on-going reforms, fiscal situation, debt dynamics, monetary policy and financial sector stability and external sector.

KEY INDICATORS

Fiscal Balance (% GDP): -4.2% (2016); -4.1% (2017F); -3.3% (2018F)
Gross Debt (% GDP): 239.2% (2016); 240.3% (2017F); 240.1% (2018F)
Nominal GDP (USD billions): 4936.5 (2016); 4884.5 (2017F); 5063.1 (2018F)
GDP per capita (USD thousands): 38882.6 (2016); 38550.1 (2017F); 40063.3 (2018F)
Real GDP growth (%): 1.03% (2016); 1.5% (2017F); 0.6% (2018F)
Consumer Price Inflation (%, eop): -0.1% (2016); 0.4% (2017F); 0.6% (2018F)
Domestic credit (% GDP): 158.4 (2016); 159.1 (Jun-2017)
Current Account (% GDP): 3.1% (2016); 3.8% (2017F); 3.6% (2018F)
International Investment Position (% GDP): 64.0% (2016); 66.9% (Oct-2017)
Gross External Debt (% GDP): 74.0% (2016); 74.2% (Oct-2017)
Governance Indicator (percentile rank): 95.7 (2016)
Human Development Index: 0.93 (2016)

Notes:
All figures are in Japanese Yen unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS 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 sources of information used for this rating include the Ministry of Finance, Cabinet Office of Japan, Bank of Japan, IMF, OECD, BIS, World Bank, UNDP, Conference Board and Haver Analytics. DBRS 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 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.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve-month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Rohini Malkani, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global Financial Institutions Group
Initial Rating Date: November 20, 2013
Last Rating Date: December 28, 2016

Information regarding DBRS ratings, including definitions, policies and methodologies, is available on www.dbrs.com.