Fitch cut Japan's sovereign credit status on Tuesday to the lowest level among global ratings agencies as a political stalemate dims the chance that the country can curb its snowballing debt.
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Fitch Ratings cut Japan's long-term foreign currency rating by two levels from AA to A plus, the fifth highest investment grade. It cut the more important local currency rating by one notch from AA minus to A plus. Both were given a negative outlook.
Fitch warned further downgrades were possible unless the government takes new fiscal policy measures to stabilise public finances and its ratio of debt to gross domestic product.
"The downgrades and negative outlooks reflect growing risks for Japan's sovereign credit profile as a result of high and rising public debt ratios," Andrew Colquhoun, head of Asia-Pacific sovereigns at Fitch said in a statement.
"The country's fiscal consolidation plan looks leisurely, relative even to other fiscally challenged high-income countries, and implementation is subject to political risk."
The downgrade could serve as a chilling reminder to highly indebted countries in Europe that urgent action is needed to trim public debt and prevent concerns about sovereign debt from weighing further on the global economy.
Several euro zone countries have been hit with multiple downgrades as the region struggles to deal with its mounting debt crisis.
The United States is expected to reach a $16.4 trillion government debt ceiling after November presidential elections, laying the ground for another protracted political battle over how to cut the budget, similar to a bitter debate that rattled financial markets last year.
After Japan's ratings cut, the dollar rose against the yen to a session high of 79.85 yen. But analysts said the downgrade is unlikely to have a lasting impact on markets because Japanese government bonds are mostly held by domestic investors.
Fitch's A plus local currency rating for Japan is the one most closely followed by investors because the government's debt is largely funded by domestic investors, who are backed by about $15 trillion in household savings.
Bank of Japan data shows that domestic investors held 93 percent of government debt as of December.
The Fitch rating is one notch below its rival ratings agencies. Moody's Investors Service rates Japan Aa3 with a stable outlook. Standard & Poor's rates Japan at AA minus with a negative outlook.
All the ratings are broadly in the middle of the investment grade range of ratings.
Concerns among ratings agencies over Japan's debt and the inability of successive governments to come up with a credible plan to deal with it are not new.
Moody's downgraded Japan by one notch in August last year, blaming a revolving door political leadership, a reference to Japan's six prime ministers in five years.
S&P cut Japan's ratings in January last year, saying Japan lacked a convincing plan to deal with its debt and also citing political risks.
Japan's debt burden, at twice the size of its $5 trillion economy, is by far the worst among industrialised countries. It has been built up as the government tried to stimulate the economy during two decades of sluggish growth and deflation.
Fitch said Japan's gross general government debt is projected to rise to 239 percent of GDP by the end of 2012, the highest of any Fitch-rated sovereign.
Based on that projection, the ratio would have risen 61 percentage points since the global financial crisis, compared with a median of 39 percentage points for countries in the Organisation for Economic Co-operation and Development and 8 percentage points for 'A' range sovereigns.
The government's own plan to reduce its debt burden doesn't foresee the debt/GDP ratio coming down until 2020/21.
"Fitch regards this as a slow pace of consolidation given the scale of Japan's debt," it said.
Prime Minister Yoshihiko Noda has staked his political career on plans to boost the country's sales tax, currently 5 percent, to fund swelling social security costs in the world's fastest ageing population.
At the end of March, Japan's government submitted laws to double the sales tax by 2015, setting up a showdown that could split the ruling party, force early elections and deepen policy paralysis.
Opposition parties are unwilling to cooperate with Noda's plan and the government lacks the numbers to force legislation through parliament.
"Given the political inaction and relatively weaker growth, and no development in regard to sales tax and the fiscal outlook, the downgrade is not a surprise," said Derek Halpenny, European head of currency research at Bank of Tokyo-Mitsubishi in London.
"The yen has sold off a little bit, but the history of downgrades of sovereign debt in Japan is that yen selling is not sustained."
After Fitch's downgrade, Japanese Finance Minister Jun Azumi said that the government will try to implement social welfare and tax reforms.
The OECD said earlier on Tuesday that a credible fiscal consolidation plan must be a top priority for Japan.
Swift action was needed, it said in an economic outlook report, because budget deficits projected at about 10 percent of GDP for 2012 and 2013 would further push Japan's debt into unchartered territory.
Ratings agencies have repeatedly warned Japan that its pace of fiscal consolidation is too slow to lower its debt burden and budget deficit.