Key Points

• Japan’s sovereign foreign and local currency bond rating was cut from "AA" to AA- with a stable outlook
• A panic driven sell-off is quite impossible for the Japanese government bonds as the government is unlikely to default
• We do not expect Japanese interest rates to rise until the private sector’s borrowing appetite recovers
• The fiscal consolidation will harm the momentum of economic recovery. The eventual budget deficit could further deteriorate due to shrinking tax revenues
• New cap on bond issuances could cause deflation

Standard & Poor’s has downgraded Japan’s sovereign credit rating for the first time since 2002 on 27 January 2011. Japan’s foreign and local currency bond rating was downgraded from AA to AA- with a stable outlook. Just a year ago, the rating agency placed a negative outlook on the country’s long-term credit rating, implying a possible downgrade over the medium to long-term. Thus, the ratings downgrade did not come as a big surprise.

S&P criticised the Japanese government, led by Prime Minister Naoto Kan, for its lack of a "coherent strategy" to tackle its skyrocketing government debt. The agency expects Japan’s Debt-to-GDP ratio – already among the highest for rated sovereigns – to continue to climb further, peaking only in the mid-2020s. S&P also noted in its media release that Japan’s fiscal deficit is expected to decline "only modestly" to 8% of GDP in the fiscal year starting from April 2013, compared to an estimated 9.1% for this fiscal year. However, the S&P’s ratings have limited predictive value as proven by the financial crisis in 2008 and the recent Europe debt crisis. We believe the downgrade was anticipated by investors and there will not be turmoil of a European debt crisis nature in the bond market.

European-styled turmoil in the bond market unlikely

It is quite impossible that the Japanese government bonds will see a panic sell-off as the government is unlikely to default. There are 3 major reasons:

1. Japan is the world’s second-largest holder of foreign reserves after China. These mainly consist of securities and deposits denominated in foreign currencies, International Monetary Fund (IMF) reserve positions, IMF special drawing rights (SDRs) and gold. In January 2011, the country’s foreign reserves totaled US$1.096 trillion. The ample reserves can help to stabilise the Japanese government bonds (JGBs) should the need ever arise

2. In addition to huge foreign reserves, Japanese households own 1,441 trillion yen of financial assets (of which 800 trillion yen is in cash or bank deposits), against a total debt of 365 trillion yen (see chart 1). This amounts to a net savings surplus worth 1,076 trillion yen (two times the size of national GDP), which should serve as a powerful cushion against any economic stress for the JGBs.
   
   Chart 1
   
3. Furthermore, the strong home bias of the domestic financial institutions and relatively low holdings of government debt by foreign investors helps stabilise the JGBs. As shown in chart 2, according to the Ministry of Finance, as of June 2010, Japanese banks (including the state-owned Japan Post Bank) are the largest holders of total outstanding Japanese government bonds (JGBs), which amounted to 280 trillion yen (44% of the total outstanding debts). The second largest holder is the domestic life and non-life insurance sector which hold 20% in total. On the other hand, foreign investors hold only a small part of the total outstanding debts (chart 2 and chart 3). The strong home bias of the local financial institutions provide a stable source of funding for the government. It is an advantage when compared to other countries like the United States which rely heavily on external financing
   
   Chart 2

Chart 3

Long-Term Interest Rate Will Soar Sharply?

JGBs were downgraded continuously in 1990s to a level below Botswana’s, a country in Southern Africa. The rating agencies believed that the country’s long-term interest rate would go sky-high to reflect its huge debt burden. However, this scenario never materialised as the Japanese government has been the financial institutions' last resort as households and corporates have been unwilling to borrow. The lack of borrowing by the private sector has driven down the long-term interest rate to an extremely low level. The total amount of money that the government has borrowed to sustain the country’s GDP was almost equal to the amount of excess savings within the private sector (see chart 4). Hence, the banks would be happy to lend to the government and we do not expect a rate hike until the private sector's borrowing appetite resumes.

Chart 4

Kan Fails To Contain Bond Sales

Although the rating agencies have been widely criticised for magnifying market fears instead of being preventive, this time the ratings downgrade came at the right time as Kan’s government surprisingly broke his promise of capping bond sales in the fiscal year ending March 2013.

After issuing a record 53.5 trillion yen of debt in fiscal year 2010 (ended in March 2010), Kan unveiled his election manifesto in June 2010 that government targets to cap the new bond issuance at 44.3 trillion yen for the next three years. However, in 21 January 2011, the Cabinet Office said new bond sales will expand to 46.7 trillion yen in the fiscal year ending 2013. The government even estimated that new issuances could rise to as high as 54.2 trillion yen by the fiscal year ending March 2015 if it does not undertake any fiscal reforms such as reducing public expenditure or raising taxes. Even if the government meets its spending goal of 71 trillion yen per year, the new bond issuance would still exceed its cap due to the shrinkage in tax revenue.

In December 2010, the Japanese government approved the tax reform proposal in order to boost the country’s sluggish economy. Starting from the next fiscal year, Japanese corporation tax will be cut by 5% to 35%. The government said the tax cut would create more jobs and help maintain the attractiveness of the country’s business environment as compared to other developed countries. Although the tax cut is intended to encourage local corporations to increase domestic investment and employment, it is estimated that a 5% cut will result in a 1.5 trillion yen loss in tax revenue. This has stirred up anxieties among investors about the widening of Japan’s budget deficit.

A 5% Consumption Tax Rate Hike Is A Double-Edged Sword

On the other hand, Kan appointed Kaoru Yosano as the Economic and Fiscal Policy Minister in 14 January 2011. Yosano is widely known as a fiscal hawk as he has long advocated for the raise of the 5% sales tax to balance the government budget and to fund the social security costs. The message of the appointment is very clear - the Kan’s government attempt to raise the consumption tax or to implement other types of financial reform, aiming to balance the nation’s budget by FY 2020 as it has pledged in June 2010. The sales-tax plan is estimated to be outlined by the middle of this year.

While fiscal consolidation is a good way to reduce debt levels and to balance the fiscal budget under normal circumstances, it is never welcomed during a recession or in the early stages of a recovery. When an economic recovery remains fragile, households and corporates tend to increase their savings rather than borrow aggressively. Deleveraging (debt repayment) and the savings of the private sector would stay in the banking system due to the lack of credit creation. The decline in the velocity of money would end up driving down the money multiplier. In this situation, it is definitely not a wise move for the government to implement fiscal consolidation such as tax rate hikes and government expenditure cuts as it would further the endanger the already fragile economic recovery. The eventual budget deficit would be even worse as the tax revenues shrink. Instead, when the government acts as a borrower, it can foster a higher velocity of money which previously stays in the banking system through government spending (stimulus package). A well-timed fiscal stimulus could prop up the GDP, hence indirectly supporting the fiscal budget.

Hashimoto’s Fiscal Reform Destroyed The Green Shoot Of Recovery

We have seen the budget deficit balloon sharply when the Japanese government called for fiscal consolidation and withdrew the stimulus. For example, in 1997, the Hashimoto administration announced the country’s first fiscal reform programme in the post-bubble era to reduce the fiscal deficit by 15 trillion yen. This was implemented after International Monetary Fund (IMF), Organisation for Economic Co-operation (OECD) and rating agencies had made strong criticisms that massive fiscal stimulus had been wasted on unnecessary investments and had aggravated the country’s debt burden. Prime Minister Hashimoto proposed a plan called “Big Bang” in 1997 including raising consumption tax from 3% to 5%, cancelling special income tax and drastically scaling back the government’s expenditure (including shelving a large supplementary budget).

After the asset bubble burst in 1990, Japan’s GDP continued to grow almost every year until 1998, thanks to the government’s massive fiscal stimulus. The huge amount of government expenditure explained why Japan’s GDP never fell below its pre-bubble level in either real or nominal terms even after the wealth evaporation amidst the bursting of the asset bubble. However, after the announcement of “Big Bang” programme, the ensuing massive capital outflow caused a drastic fall in both the yen and the stock market. Japanese banks’ capital ratio thus fell below the regulatory requirement of 8%. The economy then proceeded to shrink for five straight quarters amidst the credit crunch, the country’s worst post-war meltdown.

The eventual outcome of this fiscal restructuring enlarged the fiscal deficit from 18 trillion yen in 1997 to 34 trillion yen in 1998 (see Chart 5). This was far worse than the expected 15 trillion deficit reduction. After realising his mistake, Hashimoto marked a turnaround in his policy stance and submitted a large simulative supplementary budget in June 1998 to prevent an economic slump. The condition started to stabilise in 1999 after the then Prime Minister Obuchi unveiled a larger stimulus package.

Chart 5

Koizumi’s New Bond Issuance Cap Caused Deflation

After taking office in 2001, Junichiro Koizumi showed his ambition to tackle the budget deficit with a series of fiscal reforms and a 30 trillion yen cap on new government-bond issuance. After the dot-com bubble burst, Japan’s economy was yet to recover. It was estimated that the country’s deflationary gap was far in excess of 30 trillion yen due to the sharp increase in household savings and corporate debt repayment over the period. Again, the cap limits the government borrowing and hence reduced the money multiplier. Tax revenues plunged while budget deficit expanded to 35 trillion yen in the first two years of the new administration 2001 to 2002. Finally, Koizumi abandoned the promise in his manifesto and adopted a so-called "automatic stabiliser" function of policy in which government expenditure is based on the economic situation.

The Question: Is Japan Back In Its Old Rut?

We believe that the sovereign downgrade is not a critical point for the Japanese market outlook prospect and there will not be a sell-off for the JGBs. The downgrade would make the 5% consumption tax hike more persuasive to the public. However, past experience shows that fiscal restructuring is never welcomed during a recession period or the early stage of recovery as it will harm the momentum of economic recovery. The fiscal deficit will worsen due to the reduction in tax revenue.

In the past, the Japanese government succumbed to external pressure to propose fiscal reform and missed the opportunities for a full recovery. With the capping of new bond issuances as well as a propsosed consumption tax hike, it appears that history is repeating itself, with the Kan government treading down a path its predecessors have been before. We take these actions in a negative light at the moment but we will continue to monitor these crucial factors that determine the market and economic outlook for Japan in 2011.

We are optimistic over the outlook of the Japanese stocks especially when the US and European economies are on the road to recovery. Most of the revenue of Japan's largest companies actually come from their overseas business units. The earnings growth in FY 2012 and FY 2013 are estimated to rise 13.9% and 23% respectively as at 8 February 2011. Estimated PE for the Japan’s market is at 16.1X and 13.1X for FY 2012 and FY 2013 as at 8 February 2011. Relative to its historical mean, the current valuation is attractive. It means the downside risk of the market is limited. However, the valuation is highest among the regional markets and countries that we cover. Therefore, we still give Japanese market an attractive rating of 3 stars.

**Japan’s fiscal year ends in March (e.g FY 2012 ends in March 2012)

Recommended Japan Equity funds:

DBS Japan Growth 
LionGlobal Japan Fund