by Jeff Allan
At the beginning of December, Moody’s Investors Service downgraded the sovereign debt of Japan from its then current rating of Aa3, down a notch to A1. This was the first time ?any major rating company had downgraded Japan since 2012, prior to the Abe administration taking office, and the first downgrade by Moody’s since 2011. Somewhat surprisingly, the market largely ignored the downgrade.
Bond yields rose slightly after the news, and the yen traded lower against the dollar, but by the close of the trading day, the five-year and seven-year yields were at record lows, while the 10-year yield was lower than before the downgrade.
Moody’s downgrade followed a pattern that has established itself in Japan since the first warning that Japan might lose its top rating back in 1998. According to data from the Financial Times, the 1998 situation resulted in bond yields being halved within two months of the warning. This precedent has since saw downgrades and upgrades maintain an inverse relationship to bond yields ? downgrades have consistently resulted in lower yields while upgrades in higher yields.
With the news that they would downgrade Japan’s sovereign debt rating, Moody’s provided its justification for the action, describing what they saw as challenges facing the Japanese economy and the initiatives of the Abe administration.
The three key reasons cited were “heighted uncertainty over the achievability of fiscal deficit reduction goals? uncertainty over the timing and effectiveness of growth enhancing policy measures, against a background of deflationary pressures? and in consequence, increased risk of rising JGB yields and reduced debt affordability over the medium term.” They further warned about Japan’s rising deficit and debt, and the increasing difficulty of fiscal consolidation.
Indeed, recent recessionary economic data, combined with the delay in the next consumption tax hike make it seem impossible for Japan to achieve its goal of primary government balance, where tax revenue matches spending, by 2020.
The Market’s Lack of Response
It might be easy after Moody’s announcement to write-off lower bond yields as simply a lack of investor confidence in the ratings company. Jonathan Pain of JP Consulting put it bluntly when he told CNBC that, “These were the institutions that were rating toxic collateralized debt obligations at AAA in the lead up to the great crash, so I don’t think they have significant credibility in the financial markets today.”
To be certain, there is a good amount of truth in Mr. Pain’s statement, but it also goes far deeper than that. Like many things in Japan, its market is a very unique one that presents some very interesting aspects that affect bond yields.
At the core of the market’s underwhelming response is the fact that very few foreign investors actually buy Japanese debt, whether it is public or corporate. The Ministry of Finance’s latest figures show that savings-rich domestic investors hold over 90 percent of Japanese public debt, and are likely to keep these bonds until maturity.
Furthermore ?if Japan controls the currency in which it borrows, as well as the central banking system, do sovereign ratings actually have any meaning within this type of situation? The market consensus seems to be resounding “no” on that issue. As Hideo Shimomura of Mitsubishi UFJ Asset Management said to Bloomberg, Japanese investors are essentially not too concerned with Moody’s A1 rating.
Shimomura and many others in the industry see measures, such as the delay in the consumption tax increase, as temporary and not a sign that the central government has abandoned its greater fiscal policy measures.
Bond Yield Realities
Investors in Japan are leaning toward the thinking ?monetary easing by the Bank of Japan is now the major factor influencing JGB yields. In 2014, the Bank of Japan became the largest owner of Japanese debt for the first time ever. It continues to buy around $101 billion in Japanese bonds monthly, which is more than enough to take on all of the new bonds issued by the Ministry of Finance each month.
Debt concerns have largely taken a back seat to speculation that the BOJ’s continued purchases of Japanese bonds will force prices up over the coming term. Although the BOJ has a target of 2 percent inflation for the coming quarters, most economists are expecting that figure to fall short, with core prices rising only 1.1 percent through March 2016, according to a survey published by the Japan Center for Economic Research. Investors anticipate that the BOJ will continue their buying spree of bonds and other assets to compensate for the missed target.
Aside from Moody’s, other ratings companies have largely taken a wait-and-see stance to the most recent developments in Japan. Fitch Ratings currently has Japan at A+, which is the same as Moody’s A1 rating, but did change its outlook from stable to negative on December 9. Likewise, S&P has Japan at AA- or the equivalent of Moody’s Aa3 rating, where Japan stood prior to the rating downgrade. It has made no adjustment to that rating since October.
Perhaps most importantly, Japan Credit Rating and Rating and Investment Information (R&I), both of which are closely watched by Japanese investors, have not made any adjustments to their ratings. R&I, which currently has Japan at AA+, has voiced support for the government’s latest moves. The opinion at these rating companies is that the government is correct to be pursuing a strategy of grow over taxes, to get itself out of debt.
Despite the gloominess of Moody’s announcement, the reality is that the situation looks far better than it did just a few short years ago. Since the Abe administration came to power in 2012, corporate earnings and household wealth have seen a significant boost.
The public seems to agree that things are generally looking up. The Abe administration was returned to power after the snap election of December 14, with a mandate to continue the economic reforms, popularly known as “Abenomics,” that it started in 2012.
Fund managers and investors also continue to be optimistic about Japan’s prospects. Chris Konstantinos of Riverfront Investment Group summarized the sentiment when he told CNBC that, “Of all the major markets we track, our base case for Japan is the most optimistic frankly over the next 12 months.”