Moody's: Japan's A1 rating supported by fundamentals, despite heavy debt burden and weak growth

Moody's Investors Service says Japan's A1 issuer and senior unsecured ratings and stable outlook are supported by fundamental features that make an extraordinarily high level of government debt affordable.

But the foremost credit challenge is bolstering debt sustainability through fiscal consolidation. It is unclear how the government can reach its balanced or near balanced primary fiscal balance target by 2020 in the absence of stronger growth.

More robust economic activity will likely depend on the nature, speed of implementation, and effectiveness of structural reforms.

Moody's conclusions were contained in its just-released credit analysis "Japan, Government of", which looks at the country's credit profile in terms of Economic Strength [assessed as "High (+)"]; Institutional Strength ["Very High"]; Fiscal Strength ["High (-)"]; and Susceptibility to Event Risk ["Low (-)"].
These represent the four main analytic factors in Moody's Sovereign Bond Rating Methodology. The analysis constitutes an annual update to investors and is not a rating action.

Since Moody's downgrade of the sovereign in December 2014, Japan has emerged from one recession only to fall into another, as weakening global demand weighs on economic output. Labor markets have tightened and corporate profitability has remained robust, but neither has translated into higher wages or greater investment.

Moody's "High (+)" assessment of Japan's economic balances the economy's size, wealth, and diversity against its weak growth performance. In nominal dollar terms, the economy is the third largest in the world at $4.6 trillion in 2014, smaller than only the United States (Aaa stable) and China (Aa3 stable).

But structural factors -- most prominently worsening demographics -- temper prospects for higher growth rates and will hamper the government's attempts to resolve its debt problem.

The "Very High" assessment of institutional strength reflects Japan's very strong adherence to the rule of law, effective government, and strict control of corruption.

Breaking Japan's deflationary cycle remains the key challenge for the Bank of Japan (BOJ). The central bank's inability to generate stable price growth reflects some weaknesses in Japan's policy credibility and effectiveness, which are part of Moody's assessment of institutional strength. Nevertheless, the very low volatility in inflation has kept price uncertainty to a minimum.

Moody's "High (-)" assessment for fiscal strength takes into account Japan's stabilized debt burden and improved revenue performance, both of which have enhanced debt affordability.

While Japan's debt burden as a share of GDP is higher than any other country in our rated universe, its sustainability over the rating horizon is reinforced by its favorable structure and the very low interest rates the government pays on its debt.

The "Low (-)" assessment for susceptibility to event risk is driven by fairly muted political risks, a healthy external payments position, deep domestic capital markets, and a stable banking system.

Given the large gross borrowing requirement, the most severe event risk would be a Japanese government bond (JGB) funding crisis. But this is unlikely to happen given the persistence of the home bias of Japanese investors, as well as the extension of BOJ's quantitative and qualitative monetary easing, stronger private sector balance sheets, and a wider current account surplus.