Moody's Investors Service warned on Tuesday that it may cut Japan's sovereign credit rating if government policies fall short of comprehensive tax reform needed to bring ballooning public debt under control.
The ratings agency said Japan, where the fifth prime minister since 2006 is facing mounting pressure to quit after less than a year in office, needed stability at the top if it was to enact effective fiscal reform.
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Japan's struggle to put a lid on the ever-rising public debt, which at double the size of the $5 trillion economy is the biggest among leading nations, has triggered a Standard & Poor's rating cut and a slew of warnings from other rating agencies.
"Effective fiscal reform most likely requires stability at the top levels of government," said Tom Byrne, Moody's senior vice president and regional credit officer.
He told a news conference that Japan has seen regular changes of leadership since Junichiro Koizumi left office in 2006 after more than five years as prime minister.
"Since Koizumi, there have been three Liberal Democratic Party prime ministers and one Democratic Party prime minister who have served for a year or less," Byrne said.
The dollar blipped up against the yen after Moody's changed the outlook on Japan's Aa2 rating to negative from stable, although government bond futures showed little reaction and maintained earlier gains.
Prime Minister Naoto Kan, who took office last June, has staked his career on fiscal reforms, including a rise in the 5% sales tax to fund bulging social security costs, and urged the opposition to join talks on the topic.
But the opposition has refused to come to the table and is instead piling pressure on the unpopular Kan to call a snap election by threatening to block budget-related bills, including one allowing the government to issue new bonds.
Kan also faces rebellion in his own party but said on Tuesday that Japan needed to press ahead.
"To firmly carry out the unified reform of tax and social security systems is the most important thing in gaining market confidence," he told reporters after Moody's announcement.
Japan is not the only country with debt problems. The 2007/08 financial crisis prompted a dramatic rise in developed world sovereign debt, as governments spent billions on economic stimulus packages and bank rescues.
In Europe, Greece and Ireland have been driven by the bond markets to take bailouts, frightening many other governments into adopting austerity measures.
But Japan and the United States have faced criticism from the IMF and ratings agencies for lacking credible plans to bring their deficits under control.
Analysts point out that Japan's reliance on domestic investors, who hold about 95% of its debt, shields it from the sort of turmoil that has rattled high-debt euro zone economies and explains the subdued market response to rating agencies' stern messages.
But mounting welfare costs and shrinking savings as a result of a rapidly ageing population raise questions about the longer term sustainability of Japan's debt burden.
Moody's acknowledged that a funding crisis was unlikely in the medium-run, but warned that without urgent government action debt pressures would pile up over time to reach a dangerous tipping point.
"Although a JGB funding crisis is unlikely in the near to medium term, pressures could build up over the longer term which should be taken into account in the rating, even at this high end of the scale," it said in a statement.
Echoing the point, Byrne said a fall in household savings could create a risk premium on Japanese government bonds in the longer term.
Neither Japan's Economics Minister Kaoru Yosano nor Finance Minister Yoshihiko Noda would comment on Moody's action.
Some analysts say that Moody's outlook cut and last month's rating downgrade by S&P's may play into the hands of Kan and his allies by highlighting the dire state of Japan's finances.
"Credit downgrades by international rating agencies will raise awareness among the Japanese population on the seriousness of the Japanese public sector finance. Such perception by the Japanese population may help Japanese politicians get their act together in fixing fiscal problem," said Takuji Okubo, chief Japan economist at Societe Generale.
One concern of rating agencies and economists alike is that a political deadlock in the divided parliament may stump Kan's efforts to get public finances in order. Another worry is that even if the government manages to overcome the impasse its action may prove not ambitious enough.
"The markets may take a body blow from the downgrade in the mid-term if not in the short term," said Koichi Haji, chief economist at NLI Research Institute in Tokyo.
"If there is uncertainty over the passage of the next fiscal year's budget and related bills, there may be some repercussions such as domestic investors' reluctance to buy Japanese government bonds by the end of the fiscal year."
Moody's said the rating action was prompted by heightened concern that the government's economic and fiscal policies may get bogged down in political squabbles and prove not strong enough to achieve its deficit reduction targets.
Under long-term fiscal plans announced last June, the government aimed to return the primary budget, which excludes bond sales and debt servicing costs, to the black by 2020.
As if to underline the point, a tiny party that was formerly in the ruling coalition confirmed it would oppose key bills to enact a workable budget.
Standard & Poor's downgraded its rating on Japanese debt last month, its first cut in nine years, citing similar reasons. That brought S&P's rating for Japan one notch below Moody's but to the same level as Fitch, another ratings agency.
Moody's said that if the government managed to present comprehensive tax reform proposals in June as promised it would monitor its effectiveness in stabilising public finances.
It also said that while the sheer size of the world's third-largest economy and the depth of its financial markets allowed it to absorb economic shocks, the rise in government debt could not continue unchecked.
It listed a lack of tax reform, a possible decline in household savings and the shift to a current account deficit from a surplus as possible tipping points that could put severe downward pressure on ratings.