Moody's Investors Service on Monday downgraded Japan's sovereign debt rating by one notch to A1, citing rising uncertainty over the country's ability to hit its debt-reduction goal.
The announcement briefly sent the yen to a seven-year low against the dollar and pushed 10-year Japanese government bond (JGB) futures down by 10 ticks.
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The downgrade came less than two weeks before Japanese Prime Minister Shinzo Abe seeks re-election at a snap poll where his stimulus policies and a decision to delay a second sales tax hike will be among the key campaign issues.
The jury is out over whether Abe's strategy will revive the economy and restore the country's tattered finances.
"This is particularly bad for Abe because the opposition can attack him for this before the election," said Hiroshi Miyazaki, senior economist at Mitsubishi UFJ Morgan Stanley Securities.
The U.S. rating agency said the outlook was stable.
Tom Byrne, regional credit officer of Moody's, said the downgrade was closely linked to Abe's decision to delay next year's scheduled sales tax hike, which made it more challenging for Japan to achieve its target of reducing the primary budget deficit in fiscal 2020.
"There is concern that fiscal policy in its current state will not achieve the long-term fiscal goals," he said.
ABE SAYS REMAINS COMMITTED
Hours before Moody's announcement, Abe had stressed in a televised public debate that Japan remained committed to fiscal reform, and that the Bank of Japan's ultra-loose policy was not aimed at monetising public debt.
But Moody's warned that the BOJ's efforts to achieve its 2 percent inflation target through aggressive money printing may eventually push up bond yields and raise government borrowing costs.
"Rising interest rates would increase expenditure and offset gains from revenue buoyancy," it said, adding that there was increasing uncertainty about how quickly Abe can deliver his "third arrow" policies to boost Japan's long-term growth.
Byrne said that while the BOJ's stimulus policy was "unorthodox," its benefits still outweighed the costs.
"If you take Abe's three arrows and combine them, the third arrow of economic growth policies hasn't been supportive yet," he said. The first two arrows are aggressive monetary and fiscal stimulus deployed to end nearly two decades of deflation.
Japan's A1 rating is one notch lower than China and South Korea, and four lower than the United States and Germany, which have retained their top Aaa ratings.
The Moody's downgrade brings its Japan rating into line with that of Fitch and one notch below Standard and Poor's.
Japan's public debt, at twice the size of its economy, is larger than Italy's or any other troubled euro-zone nation.
The country's ample domestic savings have financed most of the debt so far, although analysts warn that a rapidly aging population will erode those savings in coming years.
The BOJ, under a massive stimulus launched in April last year and expanded on Oct. 31, bought more JGBs than the government issued last month, stoking fears of debt monetisation. (Editing by Mike Collett-White)