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. Specifically, we expect general
government fiscal deficits to fall only modestly from an estimated 9.1% of GDP
in fiscal 2010 (ending March 31, 2011) to 8.0% in fiscal 2013. In the medium
term, we do not forecast the government achieving a primary balance before
2020 unless a significant fiscal consolidation program is implemented
beforehand.

Japan’s debt dynamics are further depressed by persistent deflation. Falling
prices have matched Japan’s growth in aggregate output since 1992, meaning the
size of the economy is unchanged in nominal terms. In addition, Japan’s
fast-aging population challenges both its fiscal and economic outlooks. The
nation’s total social security related expenses now make up 31% of the
government’s fiscal 2011 budget, and this ratio will rise absent reforms
beyond those enacted in 2004. An aging and shrinking labor force contributes
to our modest medium-term growth estimate of around 1%.

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, in
part due to the coalition having lost its majority in the upper house of
parliament last summer. We think there is a low chance that the government’s
announced 2011 reviews of the nation’s social security and consumption tax
systems will lead to material improvements to the intertemporal solvency of
the state. We even see a risk that the Diet might not approve budget-related
bills for fiscal 2011, including government financing authorization. Thus,
notwithstanding the still strong domestic demand for government debt and
corresponding low real interest rates, we expect Japan’s fiscal flexibility to
diminish.

That said, the sovereign ratings on Japan are supported at the lower ‘AA-’
level by the country’s ample net external asset position, relatively strong
financial system, and diversified economy. In addition, the yen is a key
international reserve currency.

Japan is the world’s largest net external creditor in absolute terms, with
projected net assets of an estimated 254% of current account receipts at
yearend 2010. The country’s current gold and foreign exchange reserves of over
US$1 trillion are second only to China’s. In addition, both the financial
sector and the corporate plus household sectors are external creditors.
Standard & Poor’s expects continued current account surpluses to further
enhance Japan’s net external asset position in the coming years.
The stable outlook on our ratings on Japan balance weak public finances and
anemic growth prospects with its strong external position and the flexibility
afforded by the yen’s international role. Should the government be able to
consolidate its finances and to enact measures to improve its growth
prospects–as it did in the early part of the last decade–upward pressure on
the ratings would build. Conversely, if we again mark down our fiscal
forecasts, downward pressure on the ratings could reemerge.

Ratings List

Ratings lowered

To From
Japan
Foreign currency AA-/Stable/A-1+ AA/Negative/A-1+
Local currency AA-/Stable/A-1+ AA/Negative/A-1+