1 in 3 risk of S&P downgrade of Japanese sovereign debt
In a report entitled “No Risk, No Gain: Japan’s Credit Quality Hinges On Its Bold Strategy To Reignite Growth”, the credit rating agency S&P has held its ‘AA-‘ rating of Japanese government debt steady, but also indicated a significant risk to this rating being downgraded.
The report includes the following:
“Japan’s latest effort to escape deflation and revive economic growth is a drastic departure from the policies of previous governments, Standard & Poor’s Ratings Services said in a report published today. At this stage, however, a more than one-third chance remains that we will lower our ‘AA-‘ long-term sovereign ratings on the nation. The continuing prospect of a downgrade arises from risks associated with recent government initiatives and uncertainty of their success. Japanese Prime Minister Shinzo Abe’s plan to lift Japan out of deflation and spur economic expansion–known as “Abenomics”–has three pillars: bold monetary easing, fiscal efforts to spur growth, and a strategy to induce private sector investment. Of the three engines that Mr. Abe foresees reinvigorating the nation’s economy, so far only one, monetary easing, has kicked into full gear. The others remain idle.“
In other words, the S&P remains sceptical about material changes to what we here at NipponMarketBlog think is the main requirements for real change to occur in Japan, i.e. structural reform, especially in the domestic demand orientated sectors of the economy. More specifically, S&P cite the efforts jointly enacted by the Japanese government and the BoJ as the risk to the outlook, and not a factor that might mitigate risk to the credit rating. Possibly not what those two actors would like to have heard, but it remains a reality that both Abenomics and especially the unprecedented quantitative easing by the BoJ can only be seen as a (possibly necessary) gamble.
The S&P report also mentions what it perceives to be “nervousness” in the JGB market, and highlights that JGB yields are “still low considering the risk of higher inflation and interest rates.”
Of course, inflation is what the BoJ is trying to achieve, but it seems the S&P is less than convinced that this can be brought about in a manageable fashion, and that the risk remains that the BoJ will ultimately lose control of rates and thus render Japan insolvent.
NipponMarketBlog very much shares this fear. The issue is simply one of timing. If Japanese consumers and companies in aggregate start to raise their inflation expectations, then that will end up being reflected in interest rates. Afterall, interest rates (especially in supposedly ‘risk-free’ assets such as JGBs) are the free capital market manifestation of inflation expectations.
The crucial point to understand here is that interest rates will start to rise well before actual inflation rates start to rise. This means that the Japanese government’s refinancing costs will rise (as old debt matures and has to be rolled over into new debt issuance), well before inflation kicks in and brings with it higher tax revenues to cover those increasing interest expenses.
BoJ governor Kuroda is obviously praying that the latter does not run away from the former, as this will ultimately result in government insolvency.
As an aside, it is interesting in itself that the S&P has not joined the other global cheer leaders (such as the IMF) in pouring praise on the Japanese experiment. The phrase ‘Once bitten – Twice shy’ springs to mind, when one considers the reputational damage suffered by S&P and other ratings agencies in the aftermath of the sub-prime debacle in the US, where bundled sub-prime products were deemed by these agencies to be high quality products with negligible risk of default. Perhaps the S&P are now being more cautious (and perhaps even realistic) in their appraisals.