A car drives past wreckage from the March earthquake and tsunami in Japan.KIM KYUNG-HOON/Reuters
Japan has become the latest target of credit raters, which have lost patience with heavily indebted governments that are proving unable or unwilling to tackle sky-high debt and increasingly unmanageable deficits.
The country has struggled for most of two decades with protracted economic and fiscal problems, including chronic deflation, sluggish growth, spiralling debt and falling consumption – all exacerbated by an aging population, shrinking work force and years of inept or weak political leadership.
On Wednesday, Moody's Investors Service concluded that the worsening risks made its bond rating unsustainable, prompting it to cut Japan's debt rating a notch to the equivalent of double-A-minus. The move follows rival Standard & Poor's controversial decision earlier this month to strip the United States of its coveted triple-A rating.
Yet like the S&P cut, Japan's latest downgrade was quickly shrugged off by bond and currency traders. Japan's benchmark 10-year bond yield remained at 1 per cent, slightly higher than its low for the year of 0.98 per cent on Aug. 19. The yen has shot up nearly 8.6 per cent against the U.S. dollar since Japan's devastating March 11 earthquake, tsunami and nuclear disaster, hitting 76.78 in trading Wednesday.
Moody's cited poor Japanese growth prospects, higher borrowing and continuing political turmoil, all of which make it harder to reduce a yawning budget deficit. The agency also reduced ratings on Japanese banks, which hold large amounts of government debt.
The ruling Democratic Party of Japan is expected on Monday to choose its next leader and the country's sixth prime minister in the past five years, highlighting a failure of political leadership on the fiscal and economic fronts that stretches back years before the March disasters that marked off the downfall of Naoto Kan, the current prime minister.
"Japan is probably the slowest train crash that people can predict coming, because they've been in this state for some time," said Andrew Busch, global currency and public policy strategist with BMO Nesbitt Burns in Chicago. "It's 20 years and counting for the Japanese, and no light at the end of the tunnel, as far as I can see."
Yet Japan's currency remains one of the world's strongest, a magnet for global investors seeking shelter from volatile equity markets and troubled currencies elsewhere. The yen's climb in recent months has eroded exporters' profits and inflicted more misery on an economy still reeling from three consecutive quarters of contraction.
The Bank of Japan has intervened – most recently in early August – to take the steam out of the yen. But government officials may have decided that such intervention is ultimately futile in the face of massive global capital flows, which have driven the yen to its highest level against the U.S. dollar in decades. Finance officials announced a new tack on Wednesday, pumping $100-billion (U.S.) of foreign exchange reserves into assistance for exporters.
But that could worsen the currency problem, Mr. Busch said. "It keeps perpetuating the cycle whereby they have a stronger and stronger yen. The more profitable their exporters become, the more likely they're going to be under pressure to draw on this [new government]facility, which will worsen debt and make it even more difficult to resolve."
Alone among advanced economies, Japan won an exemption last year from new targets for G20 countries designed to rein in public spending, get budget deficits under control and stabilize debt-to-GDP ratios. At a total in excess of 200 per cent, Japan's debt-to-GDP level is by far the largest in the world. But unlike the United States and struggling euro zone countries, most of its debt is financed internally by a captive market of Japanese institutions, which has kept government financing costs low.
That situation will change as pension funds are forced to liquidate securities outside Japan to meet soaring costs stemming from the aging population. Last year, the national pension system had to pay out more than it took in for the first time. Within several years, the government will be forced to tap foreign markets to continue financing its debt, which will cause a dramatic spike in its costs, analysts say.
Yet bond yields remain at historic lows in both the U.S. and Japan. "The reason that yields aren't exploding upwards is because, ultimately, the austerity that's going to be required to rectify the situation is going to be totally deflationary," said David Rosenberg, chief economist with Gluskin Sheff + Associates Inc. "At these yield levels, the bond market is saying that things are not going as expected on the macro level."
Japan's economy has contracted for the past decade and deflation is running at about 2.5 per cent year over year.
"Deflation and slow growth are winners for people who hold debt," Mr. Busch said.