Sovereign Ratings Watch: Japan – Under Pressure
Summary: A COVID-19 pandemic, rising business bankruptcies, pressure on government finances, a global economic meltdown and an increasingly tenser relationship with China – what else could go wrong for Japan? Apparently, there is one more thing: Fitch has changed its outlook for Japan’s “A” sovereign rating from stable to negative. Moody’s rates Japan “A1” (stable) and S&P gives Japan a sovereign rating at “A+” (stable). We think it is possible to see Moody’s and S&P follow with negative outlooks later in the year. Smith’s shares many of the same concerns with Fitch about Japan’s credit picture and has a negative outlook. Moreover, Japan’s deteriorating creditworthiness is significant in that the Asia-Pacific country is the world’s third largest economy, a leading exporter and staunch U.S. ally. The deeper Japan sinks, the messier Asia’s geopolitical landscape becomes.
Fitch’s reasons for changing the outlook to negative are straightforward:
• The COVID-19 pandemic caused a considerable contraction in the Japanese economy, despite the country’s early success in containing the virus. The rating agency is looking to a 5 percent contraction this year and a 3.2 percent rebound in 2021. (A more positive outlook than the IMF).
• Fitch expects to see sharply wider fiscal deficits in 2020 and 2021, which will add significantly to Japan’s public debt, “which even before the pandemic was the highest among Fitch-rated sovereigns as a share of GDP.” Fitch projects Japan’s gross general government debt will rise to around 259 percent of GDP, and stabilize just above 260 percent in 2021-22, before heading back down. It also projects a government fiscal deficit of 14.3 percent in 2020, from an estimated 3.1 percent in 2019 due to the operation of automatic stabilizers and discretionary measures contained in the two supplementary budgets approved in April and June this year.
• Fitch also noted that the banking system, which was already seeing structural challenges from an extended low interest-rate environment and anemic growth prospects, faces deteriorating asset quality.
• The Negative Outlook (on the sovereign) reflects that the higher debt ratio and downside risks to the macroeconomic outlook will exacerbate the challenge of placing the debt ratio on a downward trend over the medium term.
• Not to end on a totally down note, Fitch did indicate that the tight labor market will help in the recovery.
Moody’s announced on July 25, 2020 that it was completing its periodic review of Japan. Although the rating agency has maintained a stable outlook prior to the review, it also released a note in late June about the rise of sovereign debt as countries grapple with COVID-19. This could signal that thinking on sovereigns has become more bearish and may portend a change of the outlook to negative.
On the political front, Japan enjoys a high degree of stability. A major issue is what happens to the 2020 Olympic Games, which are seen as a confirmation of Japan’s important role in the world. The Games have currently been postponed to 2021. The risk is that if the Games are finally cancelled, it could weaken the government. Shinzo Abe is Japan’s longest serving prime minister and has indicated that he wants to remain in office through 2021 and the world sporting event. As the virus has worsened lately, this has fueled more talk of cancelling the Games. Consequently, Prime Minister Abe could call a snap election in October or November, well before any actions are taken on the Olympics. We do not see such a development as injecting any major political instability into Japan’s sovereign creditworthiness as there is broad consensus on policy and the ruling Liberal Democratic Party would most likely win re-election.
What could complicate Japan’s political life is if its relations with China deteriorate further. A head-to-head summit between Prime Minister Abe and Chinese President Xi Jinping was already put off this year due to the COVID-19 pandemic. Moreover, the Japanese government is offering its companies financial support in moving their supply chains out of China and back home. This cannot be seen as a friendly act in Beijing.
One area to watch closely is the trade in rare earth metals: China accounts for 85 percent of the world’s production of rare earths and over 90 percent of its exports. Japan depends on rare earths imports for a little over 50 percent of its needs, especially for its tech industry. In the past (as in 2010), China has resorted to stopping rare earth exports to get Japan’s attention. This has pushed Japan to encourage recycling and diversification of rare earth supplies. Nonetheless, Japan remains vulnerable on this front. A Chinese cut-off would be yet another blow to Japan’s already struggling economy.
Looking ahead, Japan faces a bearish economic outlook, which is likely to maintain pressure on its sovereign ratings. If COVID-19 becomes more problematic, forcing tougher government measures (like stricter enforcement on social distancing or closure of businesses) which causes a further deterioration is the fiscal outlook, chances for an actual downgrade increase. We believe that the rating agencies are likely to wait through the fall to get a better grasp of COVID-19 and how Japan handles it.