Moody`s surprises with two-notch cut of Japan

Brushing aside government protests and signs that Japan`s economy is on the mend, Moody`s Investors Service yesterday cut Japan`s long-term credit rating by a bigger-than-expected two notches, citing debt levels unprecedented in the post-war era in the developed world.

Moody`s cut Japan`s local currency rating to A2 from Aa3 but kept its long-term foreign currency debt rating at Aa1.

It said the outlook for both ratings was stable. Japan`s local currency rating was already the lowest among major industrialised nations after an upgrading of Italy to Aa2.

The two-notch cut is a setback for the government, which has been railing for weeks against what it sees as unfair treatment of the world`s second-biggest economy by rating agencies.

The scale of the downgrade took most in the markets by surprise, but reaction was muted. Finance Minister Masajuro Shiokawa was also dismissive of the Moody`s decision.

"They`re doing it for business. Just because they do such things we won`t change our policies," he told reporters.

"The market doesn`t seem to be paying attention," he added. The yen initially dipped, rallied, then dropped again after Bank of Japan intervention. At 0613 GMT the dollar was quoted at 124.18/22 yen, up from 123.25 yen before Moody`s announcement.

The Tokyo stock market ended flat and government bonds also proved resilient, with traders saying the market was relieved the long-awaited event was now out of the way.

Market analysts and economists said it was unlikely there would be significant market impact.

One positive factor for the markets was a statement by Moody`s managing director Vincent Truglia, who told Reuters a further review was unlikely in the next one or two years. Japan has largely been immune to repeated cuts in its credit standing because its debt is entirely denominated in yen and is mostly owed to domestic investors, who see it as a safe haven.

"I think the biggest issue from this downgrade will be trust in Moody`s as a ratings agency," said Takuji Aida, fixed income strategist at Merrill Lynch.

"There will be calls saying they lack consistency in their ratings, especially after they upgraded Italy."

Brushing aside the government`s recent criticism that Japan`s rating was already too low, Moody`s said its decision "reflects the conclusion that the Japanese government`s current and anticipated economic policies will be insufficient to prevent continued deterioration in Japan`s domestic debt position".

With the change, Moody`s assigns to Japan - the world`s biggest creditor and holder of the biggest pile of foreign reserves - the same "upper medium" local rating as Cyprus, Greece, Israel, Latvia, Poland and South Africa.

It is also now ranked lower than Botswana, a situation that will be particularly irksome to Prime Minister Junichiro Koizumi, who grumbled recently about the "nonsense" of the prospect of Japan being rated lower than countries to which it provides aid.

There were more howls of protest from government officials, just as last month when Standard and Poor`s cut Japan`s long-term local and foreign currency ratings by one notch to AA-minus. The new Moody`s local rating is two notches below S&P`s rating.

"The markets may be ignoring Moody`s rating, but we will not accept such an unjust and incorrect rating decision," said Haruhiko Kuroda, vice finance minister for international affairs.

"We strongly request Moody`s review their decision." Unhappy with three downgrades in six months, Japan took the unprecedented step earlier last month of writing to the big three agencies asking them to explain and justify their decisions.

Investors use ratings to help price the risk of fixed-income securities they may buy or sell. Ratings measure the potential for credit loss due to a failure to make, or delay, payments.

The decision to downgrade comes when it appears Japan`s economy is bottoming out after three quarters of decline, thanks to a rise in exports into the recovering US economy.

Truglia agreed that Japan appeared to be experiencing a mild economic upturn. But he said the rebound was narrowly based and heavily dependent on exports, while non-tradeable areas of the economy were globally uncompetitive and in need of reform.

"What we are more interested in is how sustainable any upturn might be," he said.

In its announcement, Moody`s said the downgrade reflected its conclusion the government`s policies would be insufficient to prevent a continued deterioration in Japan`s debt position.

"Japan`s general government indebtedness, however measured, will approach levels unprecedented in the postwar era in the developed world, and as such Japan will be entering `uncharted territory`," the ratings agency said.

Japan`s public debt will stand at more than 140 per cent of gross domestic product by the end of the current fiscal year in March 2003 - more than double that of the United States.

But Moody`s said the risk of a financial crisis was remote. "...The essentially closed nature of the Japanese financial system, in which household deposits finance bank and postal savings claims on the government, provides a high level of financial stability such that the risk of an uncontrolled funding crisis is remote," the agency said.

The single-A rating could cause longer term problems, however. Some financial institutions shy away, or are outright prevented, from holding debt rated below AA and Bank for International Settlements rules to be implemented in 2005 would remove the risk-free status of bonds in the single-A category.

Under the new rules, financial institutions would have to apply a 20 percent risk weighting to such bonds, which would result in demands for higher interest rates to cover the risk.

The BIS, however, has left the decision up to individual governments on how to deal with the implicit risk.

Japanese officials point to Japan`s official reserves, a measure of a country`s ability to pay its foreign debt, as one of the fundamental reasons why Japan does not deserve a downgrade.

The reserves stood at a record $407 billion in April. Reserves held by the 12-nation euro zone and the European Central Bank stood at a combined $254 billion at the end of February.

Also, policymakers note, Japan has the world`s largest pile of personal savings - equivalent to about $11 trillion, or about $87,000 for every man, woman and child in the country.

Japan`s current account surplus, another measure of econmic muscle, expanded for the sixth straight month in March, up 52 per cent from a year earlier.