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Rating agency Standard & Poor's cut Japan's long-term sovereign debt rating on Thursday for the first time since 2002, saying the country's government lacked a coherent plan to tackle its mounting debt.
It reduced the rating by one notch to AA minus, three levels below the highest possible rating and providing a sharp reminder to other developed nations, such as those in Europe and the United States, of the growing concerns about the debt built up during the global financial crisis.
Politicians and credit ratings agencies have been warning for years that Japan needs to lower its public debt pile, by far the worst among rich nations at double the size of its $5-trillion economy US, but progress has proved elusive.
Julian Jessop, chief international economist at Capital Economics in London, warned of the consequences if Tokyo failed to get its fiscal house in order.
"If it looks like making a mess of this, further downgrades will surely follow. Given the size of Japan's economy and the current sensitivity of global financial markets to sovereign debt concerns, the impact would be felt worldwide."
The yen fell broadly and credit default swaps on Japan widened after the announcement, but markets in the past have not worried too much about the country's high debt because, for now, it is well serviced by ample domestic savings and few foreign investors hold Japanese government bonds (JGBs).
However, Japan's society is aging quickly, so social welfare costs will take up an increasing proportion of the budget in the absence of reforms, which S&P said reduces Japan's already weak fiscal flexibility.
S&P's downgrade leaves its credit rating on Japan one notch below both Fitch and Moody's.
"The downgrade reflects our appraisal that Japan's government debt ratios -- already among the highest for rated sovereigns -- will continue to rise further than we envisaged before the global economic recession hit the country and will peak only in the mid-2020s," S&P said in a statement.
"In our opinion, the Democratic Party of Japan-led government lacks a coherent strategy to address these negative aspects of the country's debt dynamics, in part due to the coalition having lost its majority in the upper house of parliament last summer."
Japan's government is well aware of its debt problem but, like governments before it, has struggled to tackle it head on. Just this month, Economics Minister Kaoru Yosano warned that the country faced a fiscal dead end. He said on Thursday the S&P move was regrettable.
Prime Minister Naoto Kan is pushing for a debate on increasing the national sales tax, which at 5 percent is among the lowest among major economies, that he says is vital to pay for huge welfare costs.
Kan's key economic ministers have promised to impose fiscal discipline, something Finance Minister Yoshihiko Noda reiterated in reaction to the S&P downgrade.
Still, the government is pressing ahead with a proposed budget from April with record spending of 92.4 trillion yen ($1 trillion US) and new debt issuance that will exceed tax revenues for a second year in a row.
S&P said there was a risk that some budget related bills will fail to be approved.
Still, the chairman of Nomura Holdings, Junichi Ujiie, said the downgrade offered Kan's government an opportunity.
"It will make it easier for Yosano to push through laws on fiscal reform," Ujiie said on the sideline of the World Economic Forum in Davos. "Foreign investors might short-sell but they don't hold very much -- only around 5 percent. I don't expect turmoil in markets."
The yen fell broadly, with the dollar rising 1 percent on the day against the Japanese currency to a session high of 83.20, and 10-year Japanese government bond futures dipped.
MASSIVE DEBTS IN DEVELOPED WORLD
While other developed countries are tackling massive public debt built up during the global financial crisis, Japan's debt has been growing for years as it tried to revive the economy after a massive property bubble burst in the early 1990s.
"Japan, compared to other developed economies, has the worst fiscal position. Having said that, the reason why Japan was able to sustain its ratings for so long is the fact that the proportion of domestically owned debt was the highest at more than 90 percent or so," said Thomas Lam, group chief economist at DMG & Partners Securities Pte Ltd in Singapore.
"I don't think this is a shocking downgrade. This is the signal that rating agencies are looking closely at the debt and they should do something about this, otherwise they will eventually face a bigger problem than Europe if they take this for granted."
S&P said the outlook on the long-term rating was stable, reflecting its view that Japan's strong external balance sheet and monetary flexibility partially offset the pressures stemming from the fiscal side.
Japan's outstanding long-term government debt is set to reach 869 trillion yen ($10.57 trillion US) at the end of March this year, or 181 percent of gross domestic product (GDP), the Ministry of Finance says.
If short-term debt is added, Japan's liabilities will hit 204 percent of GDP this calendar year, larger than 137 percent for Greece and 113 percent for Ireland, according to the OECD.
Analysts say a Japanese debt default is unlikely because of Japanese household assets of some 1,400 trillion yen, three times bigger than economic output provide a healthy pool of savings to fund the borrowing.
"Japan's public finance problems are a long-fuse issue. The downgrade doesn't mean a crisis is imminent. It signals increased vulnerability," said Tim Condon, head of research in Asia for ING Financial Market in Singapore.
"Foreigners don't buy Japanese government bonds so the crisis risk comes from Japan's death-spiral demographics. The downgrade is bad for G3 government debt because it spotlights their weak public finances."