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Thursday’s move by S&P to downgrade Japan’s sovereign credit rating was about as surprising as the inevitably tragic outcome of a much-loved kabuki play. Equally predictable, the rating agency cited the government's lack of a clear strategy in reducing Japan’s large debt burden, currently around 200 per cent of GDP.
In fact, as we noted earlier this week, various top officials including the former chief government spokesman, Yoshito Sengoku, and the newly-appointed economy and fiscal affairs minister, Kaoru Yosano, foreshadowed ominous things to come — Yosano with his memorable “dreadful dream” remarks last week.
Not only that, to remind readers, almost exactly one year ago, S&P issued a stern warning to Japan as it cut its outlook to negative. Such long-held concerns, however, do make it surprising that it has taken this long. There have been no moves on Japan’s ratings since 2007 — when S&P actually upgraded Japan — and no cut to the rating since 2002, with reviews last done in 2009.
Nevertheless, the yen slumped against the dollar on the news, falling 1 per cent to Y92.98 as of 08:15 GMT, as the move eclipsed investor focus on the Fed’s cautious upgrade to the US economic outlook and dominated morning trading in Europe.
As Markit notes in its CDS market update on Thursday:
…The downgrade wasn't a huge surprise as S&P already had the sovereign on negative outlook. And it is not the first time Japan has been here, having been upgraded from AA- back in 2007. But Japan is the world's third largest economy and the news is bound to have a bearing on spreads today. Italy and Belgium, two European sovereigns with large debt/GDP ratios, have underperformed this morning.
The next big question is whether Moody’s and Fitch, the other key rating agencies which now find themselves a notch above S&P on Japan, will follow suit. Some investors might also wonder whether S&P’s cut will have any impact on Japan’s ability to service its debt, while others may fret about any resulting fall-out on the ever-resilient market for Japanese government bonds.
As Peter Tasker, a veteran Japan analyst for Arcus Research, points out, Japan — unlike some of the eurozone’s peripheral economies — is entirely self-financing. While government debt is at monstrous proportions, Japan’s private sector saves enough to cover domestic needs and also manages to export capital equal to about 3 per cent of annual output. The result, he says, is “a vast nest-egg of overseas assets”.
Indeed, in the view of NAB market strategist Gavin Friend:
Today's cut will not have any impact on Japan's ability to service its huge debt. Most of this is financed domestically. Any foreign investors who have been buying Japan debt at AA, will not be deterred by AA- and in any case the other two agencies remain one notch above (for now).
China increased its purchases of Japan debt last year as it sought to diversify from USDs and we would not expect today's decision to have any material impact here. This downgrade then should have little lasting impact on markets but at the margin can be used to justify a risk-off approach.
For USD/JPY the move should harden the view that this pair is forming a base above the 2005 low of 79.75 and give support to the notion that the JPY is losing some of its safe-haven lustre. In recent months the CHF has been more popular in times of distress, though this is in part because of its proximity to Europe and investor's desire to have exposure to something close to Europe, but unaffected by the debt issues directly.
We have argued that a decline through 79.75 would risk plunging Japan into a more pernicious bout of deflation and therefore would expect the MoF/BoJ to protect that level. We continue to forecast USD/JPY will gradually push up through the 80's to 88 by year end…Until USD/JPY climbs above 84.75… today's move "“ however uncomfortable for Japan – is likely to be something of a storm in tea-cup. A break above 85 and everyone will be a buyer.
Similarly, Tohru Sasaki, JPMorgan’s currency strategist, says the move will have little “material meaning or impact” on the FX market — not least because “95 per cent of JGBs are held by Japanese investors”, he says in a research note, concluding:
I am almost sure that not many Japanese JGB holders will sell JGBs (or the yen) on this news. If anything, they are probably looking forward to buying JGBs at a higher rate… [As for FX rates] Actually, when S&P downgraded Japan to AA- from AA in April 2002, USD/JPY spiked 0.5 per cent after the announcement, but fell off soon after that. Not only that, but USD/JPY declined about 12 per cent over three months after this downgrade — so, I believe this news will just provide us with a good opportunity to sell USD/JPY at better levels.
Finally, we’d just like to point out, following big JGB purchases earlier last year, China’s about-face in its net sell-off of Y81.3bn worth of JGBs in November — Tokyo’s latest official monthly figures for JGB transactions — seems prescient.
We can’t quite say the same thing for the Bank of Japan's (comparatively) bullish growth forecasts for Japan this year, issued on Tuesday…
Related links: S&P downgrades Japan – Lex Recipe for Japanese "?healthiness' eludes Kan "“ FT The Italy of Asia - WSJ A ticking, aging time-bomb in JGBs "“ FT Alphaville
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