With much at stake, Japan voices confidence in U.S. debt

By Kaori Kaneko and Tetsushi Kajimoto

TOKYO (Reuters) - Japanese cabinet ministers moved to shore up confidence in U.S. debt on Tuesday after Standard & Poor's threatened to lower its credit rating on the world's largest economy, touching a nerve with one of the largest holders of Treasuries.

Asian nations have amassed trillions of dollars in U.S. debt through recycled export earnings, and have a vital interest in maintaining its value. So it was no surprise that officials were keen to play down the danger.

"The United States is tackling fiscal issues in various ways, so I still think U.S. Treasuries are basically an attractive product for us," Finance Minister Yoshihiko Noda told reporters after a cabinet meeting.

Treasury prices did indeed prove resilient on Tuesday, though that did not stop stocks markets from skidding across the Asian region.

S&P, which assigns ratings to guide investors on the risks involved in buying debt instruments, slapped a negative outlook on the United States' top-notch AAA credit rating on Monday and said there was at least a one-in-three chance that it could eventually cut it unless politicians found a way to slash the yawning budget deficit within two years.

The warning came as markets were fretting over the risk of Greece having to restructure its debt and sparked a general pullback from equities and commodities.

If investors start demanding higher returns for holding riskier U.S. debt, the rise in bond yields could erode the value of Treasuries held in currency reserves and push borrowing costs up in other countries.

Japan's reserves stood at $1.12 trillion at the end of March, the bulk of which is thought to be in Treasuries.

Even that pile is dwarfed by China's $3 trillion in reserves, and again much of that is believed to be in U.S. government debt. China's foreign exchange regulator and other policy advisors had no immediate comment after the S&P move.

MONSTROUS

So monstrous have China's holdings become that it is stoking inflation in the country while making it almost a captive investor in Treasuries, the only market large and liquid enough to absorb such mountains of cash.

The scale of the potential losses from a slide in the value of U.S. debt would drive China to cut the share of Treasuries in its holdings, he said.

"It's widely believed that U.S. treasuries make up about 70 percent in China's foreign exchange reserves, but China may cut the proportion to 50 percent or less in the coming decade," Li said.

Achieving such a shift without spooking the market and driving down Treasury prices would be no small feat, however.

The danger of a U.S. downgrade could also draw unwanted attention to Japan's huge debt burden, which is likely to grow larger as the government secures funding to rebuild after last month's devastating earthquake and tsunami.

Japan is set to compile an extra budget worth about 4 trillion yen ($48.4 billion) to start reconstruction after the March 11 earthquake and tsunami, which also triggered the world's worst nuclear crisis in a quarter century.

This is likely to be the first of several spending packages. Japan's public debt is already twice the size of its $5 trillion economy, and policymakers have said new bond issuance would be needed after the first extra budget to pay for reconstruction costs.

S&P cut Japan's sovereign rating to AA-minus in January, although it said shortly after the March disaster that it did not expect to change its ratings stance on Japan.

Japan's third-largest private life insurer, Meiji Yasuda Life also expressed confidence in U.S. Treasures and said it had no plan to change its stance after the S&P downgrade. It added it planned to increase its holdings of yen bonds and foreign bonds, with a focus on dollar bonds.

SANGUINE

However, the market seemingly most threatened by a downgrade -- Treasuries -- was among the least alarmed.

Yields on 10-year notes were steady at around 3.38 percent, not far from a near four-week low of 3.36 percent hit on Monday before the S&P news broke. The sanguine reaction underlines just how long-simmering this problem has been.

"Investors won't be shocked if the rating is lowered to just double A," said a fund manager at a U.S. asset management firm. "In fact, I would wonder why Treasuries are still rated triple A."

Some investors even hoped that S&P's threat may put pressure on the White House and the U.S. Congress to reach a compromise on measures on deficit reduction, as a failure to clinch a deal could lead to government shutdown as the U.S. is expected to hit the current debt ceiling by May 16.

The White House last week announced plans to cut $4 trillion from the deficit over the next 12 years, mostly through spending cuts and tax hikes on the rich. Congressional Republicans want deeper spending cuts and no tax increases.

"The gap between the two sides seems immense but this warning of a rating downgrade might help them reach an agreement," said Arihiro Nagata, manager of foreign bond trading at Sumitomo Mitsui Banking Corp.

That was a sentiment echoed by a source familiar with managing South Korea's foreign exchange reserves, which currently top $291 billion.

"I think this is a good development in a sense that this will eventually help spur efforts in the United States to improve its fiscal health," said the source.

(Additional reporting by Hideyuki Sano; Writing by Wayne Cole; Editing by Kim Coghill)