DBRS Upgrades Japan to A (high), Trend Changed to Stable

DBRS Inc. upgraded Japan’s Long-Term Foreign and Local Currency – Issuer Ratings from A to A (high). At the same time, DBRS upgraded Japan’s Short-Term Foreign and Local Currency – Issuer Ratings from R-1 (low) to R-1 (middle). DBRS also changed the trend on all ratings from Positive to Stable.

KEY RATING CONSIDERATIONS

The rating upgrade reflects DBRS’s view that Japan’s ongoing policy reforms combined with continued growth momentum and accommodative financial conditions have reduced the risks associated with Japan’s chronic deficits and high public debt. Since DBRS’s last review, the passage of Work Style Reforms in June 2018, the Immigration Control Act in December 2018 and the government’s commitment to fiscal consolidation point to continued progress in achieving sustained growth, inflation (albeit still below the BoJ’s target), and a stabilization of debt dynamics.

In DBRS’s assessment, Japan’s strong credit fundamentals support its A (high) rating. It is one of the wealthiest and most diversified economies. The country enjoys exceptionally low financing costs due to its high levels of governance, large pool of private savings, its large domestic investor base and the Bank of Japan’s (BoJ) bond purchases as part of its yield targeting framework. 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. Despite these strengths, Japan’s ratings remain constrained by structural credit challenges. Public finances remain Japan’s main credit weakness. Persistent deficits have contributed to gross government debt of 237.6% of GDP, the highest ratio among advanced economies. An ageing and shrinking working age population, and a slow pace of domestic investment weigh on GDP growth potential and inflationary expectations.

RATING DRIVERS

Upward pressure on the rating could emerge if (1) further structural reforms support meaningful improvements in growth potential and (2) sustained economic growth combined with fiscal consolidation results in a persistent downward trajectory of the debt-to-GDP. Downward rating drivers could 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 expectations of low or negative inflation.

RATING RATIONALE

Growth Remains Above Potential; Ongoing Reforms Could Further Improve Labor Supply and Aid Growth

Five 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 2013-2017. Growth is expected to remain near potential at 0.9% in 2018 and 2019. Current growth trends have been aided by expansionary monetary and fiscal policies, the synchronized global recovery, consumption demand led by tight labor markets and investment towards the 2020 Olympics and labor-saving equipment. To mitigate the impact of the scheduled increase in consumption tax due in October 2019, the government is planning offsetting measures to avoid repeating economic downturns seen during past attempts to raise taxes.

While Japan’s near-term prospects are positive, the medium-term outlook nonetheless remains clouded by structural weaknesses, resulting in low potential growth of 0.5-1.0%. Japan’s ageing and shrinking population coupled with labor market rigidities have resulted in labor shortages. Due to entrenched wage price setting behavior, wage growth has been muted, resulting in subdued domestic demand and high corporate savings. To this end, there has been progress on Abenomics’s ‘third arrow’ of structural reform, with measures implemented including improved corporate governance, financial sector reforms, and tax adjustments. More recently, the passage of both the Work Style Reforms in June 2018 (relating to cap on overtime and equal pay for equal work) and the Immigration Control Act in December 2018 (opening up to more foreign workers) – bode well for addressing Japan’s labor market challenges. The rising participation of women and elderly in the workforce coupled with an increase in foreign workers partially mitigates adverse demographic pressures. This has positive implications for increasing Japan’s long-term output potential and stabilizing debt dynamics. (See Japan’s Labor Reforms).

BoJ’s Expansionary Policies to Continue as Inflation Remains Below Targets and Consumption Tax Comes into Play

The Bank of Japan (BoJ) has adopted a series of unconventional monetary policy tools in response to price deflation and entrenched low inflationary expectations. Setting the inflation target at 2% in 2013, the BoJ launched its Quantitative and Qualitative Monetary Easing (QQE) entailing ¥80 trillion in 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 ¥40 trillion annually), five years of nominal growth averaging 2% and tightening labor markets, headline and core inflation remain below the BoJ’s 2% target at 0.3% and 0.7% in December 2018, respectively. The BoJ attributes subdued inflation in the context of a tightening labor market to entrenched wage-price setting behavior mainly due to the experience of prolonged low growth and deflation. This has resulted in corporate efforts to improve labor productivity and absorb costs rather than raise wages or prices. In its latest policy on January 23, 2019, the BoJ cut its inflation forecast for fiscal year 2019 from 1.4% to 0.9%, citing oil prices as the primary reason. DBRS expects inflation to be muted due to expected cuts in cell phone fees and free education for young children – both of which are offsets to the scheduled increase in consumption tax later this year.

In response to concerns about the side-effects of prolonged easing, the BoJ made a modest adjustment in July 2018 to widen the yield cap range for the 10-year benchmark to 0.2% from 0.1%. The central bank also introduced forward guidance saying that it intends to maintain the current extremely low levels of interest rates for an extended period of time, taking into account uncertainties regarding economic activity and prices, including the effects of the consumption tax hike scheduled to take place in October 2019.

Expansionary monetary policy has helped improve financial conditions, but DBRS believes there are structural limits to the NIRP and the JGB yield targeting framework. In addition, policy normalization by other central banks and concerns about the side-effects from prolonged monetary easing has complicated BoJ’s reflation efforts. 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, bank reserves continue to rise as loan demand remains muted due to excess savings. While low interest rates have taken a toll on 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.

Solid External Position Provides a Buffer to Absorb External Shocks, While Strong Institutions Support Growth

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 60.6% of GDP in 2017 and generates large income flows from abroad. The high NIIP reflects Japan’s ample foreign exchange reserves (US$1.3 trillion) and net portfolio assets and is a direct reflection of Japan’s high domestic savings combined with somewhat limited domestic investment opportunities.

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’s “A” rated peer group and globally. The country 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. Despite a series of political scandals earlier in the year, PM Abe was re-elected to a third term as leader of the LDP in the September 2018 elections. This paves the way for Abe to remain in office until 2021 and continue the policies of Abenomics. While revisions to the war-renouncing Article 9 of the Japanese Constitution remain a priority of PM Abe and the LDP, with upcoming Upper House and unified elections in 2019, PM Abe is likely to focus on legislation already in the pipeline. These include the ongoing 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.

Chronic Fiscal Deficits Remain A Challenge, but Government Reaffirms Commitment to Fiscal Consolidation

Japan’s public finances are a key constraint to the rating. Japan’s deficit, which has averaged 3.6% of GDP since the 1980s, was derailed by shocks in 2009 and 2011 resulting in deficits averaging nearly 9% during 2009-2013. Since then, the improvement in tax revenues and phasing out of stimulus measures have stabilized the deficit at 4% during 2015-2017. In structural terms, the deficit is expected to decline further to 2.8% of GDP in 2019. Nonetheless, long-term public finances are challenged by established spending pressures with debt service at 24% and social security expenditures at 33% of total expenditure. DBRS believes that Japan’s rising structural spending pressures due age-related expenditures make further deficit-reduction challenging without higher growth. (Japan’s population is estimated to shrink by 25% from 127mn currently to 95mn in 2058). Indeed, the government’s “Economic and Fiscal Revitalization Action Program” articulates the basic principle that ‘without economic revitalization, there can be no fiscal consolidation.’ The “Economic and Fiscal Projections for Medium to Long term Analysis” released in June 2018 assumes that the economy will grow by 2% in real terms annually (3% nominal terms) in the early 2020s, with 2% average inflation, and total factor productivity of 1%. Under these assumptions, revenue increases will offset the continued rise in social spending. While the target date for achieving a primary surplus has been revised from 2020 to a more realistic 2025, the macro assumptions remain optimistic.

Progress on sustaining a higher pace of growth and deeper fiscal reforms are necessary to achieve the government’s medium-term deficit reduction strategy. To this end, after being postponed twice, the government is expected to raise the consumption tax rate from 8% to 10% on October 1, 2019 with the revenue increase to be split between social spending and fiscal reconstruction. Given the past macro impact of consumption tax increases, the government has announced several measures to mitigate the impact of planned increase in consumption tax. As per the Cabinet Office, implementation of the consumption tax would result in the deficit declining from 4.4% in 2018 to under 3% levels during 2019-2023.

High Public Debt Remains A Key Challenge, But Financial Flexibility is High

Japan’s large public debt burden, which has risen from 70% in 1990 to 238% in 2017, is another rating constraint. In DBRS’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 2022. The reported net debt figures, which includes Japan’s financial assets, are higher in the current analysis than in the past as they now exclude equity assets. Beyond 2022, the IMF expects the debt-GDP ratio to increase to 245% of GDP in 2030, as the growth-interest differential reverts to negative territory and demographic headwinds worsen. While the high stock of debt makes Japan vulnerable to various shock scenarios, DBRS believes that the BoJ’s extraordinary easing measures mitigate risks to the government’s ability to service debt.

Japan’s gross financing needs (fiscal deficit plus all maturing debt) is estimated around 52% of GDP in 2017 – the highest among advanced economies. In spite of this, the debt is yen-denominated and has remained easily financed by a high rate of national savings, at 27.9% of GDP. The BoJ currently holds over 40% of JGBs. Thanks to the BoJ’s expansionary policies, liquidity and refinancing risks are low. Nonetheless, in the long term with the BoJ’s eventual exit from extraordinary monetary easing, 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 credible long-term strategy for debt consolidation could ultimately weigh on investor sentiment toward Japan.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AA (low) to A range. The main points discussed during the Rating Committee include: 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): -4.3 (2017); -3.7 (2018E); -2.8 (2019F)
Gross Debt (% GDP): 237.6(2017); 238.2 (2018E); 236.6 (2019F)
Nominal GDP (USD billions): 4,873 (2017); 5,070 (2018E); 5,220 (2019F)
GDP per Capita (USD): 38,449 (2017); 40,106 (2018E); 41,418 (2019F)
Real GDP growth (%): 1.9 (2017); 1.1 (2018E); 0.9 (2019F)
Consumer Price Inflation (%): 0.5 (2017); 1.2 (2018E); 1.3 (2019F)
Domestic Credit (% GDP): 156.9 (2017); 157.5 (Jun-2018)
Current Account (% GDP): 4.0 (2017); 3.6 (2018E); 3.8 (2019F)
International Investment Position (% GDP): 60.1 (2017); 60.6 (Sept-2018)
Gross External Debt (% GDP): 74.4 (2017); 81.3 (Sept-2018)
Governance Indicator (percentile rank): 93.3 (2017)
Human Development Index: 0.91 (2017)

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 primary 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.

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