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Japan was affirmed by rating agency Fitch at 'A' with a negative outlook adding it expects the Bank of Japan inflation target of 2% to remain out of reach. Fitch expects growth of 2.5% in 2021 and 3.0% in 2022, as the economy recovers from a 4.6% contraction in 2020.

Japan Exports

Fitch has retained a Negative Outlook on Japan's ratings, given uncertainty about the medium-term macroeconomic and fiscal outlook from the continuing pandemic.

Key Rating Drivers For Japan

  • Japan's ratings balance the strengths of an advanced and wealthy economy, with correspondingly robust governance standards and public institutions, against weak medium-term growth prospects and very high public debt.
  • The government's financing capacity is supported by the central bank's monetary strategy, which generates very low interest rates along the sovereign's yield curve, and the home bias of Japanese private-sector investors.
  • Strong external finances are underpinned by persistent current account surpluses, a large net external creditor position, and the yen's status as a reserve currency.

While general elections are to be held by November 2021, we assume broad economic policy continuity over the next few years, given the likelihood that leading candidates will stay the course on near-term policy support and medium-term fiscal consolidation plans. The latter means that large fiscal support is likely to be unwound gradually, but downside risks to growth exacerbate the challenge of placing the debt ratio on a downward path.

Fitch expects growth of 2.5% in 2021 and 3.0% in 2022, as the economy recovers from a 4.6% contraction in 2020.

The recovery has been delayed by weak domestic demand owing to coronavirus containment measures, but will continue to be supported by the government's large stimulus measures and a continued strong export and manufacturing performance. Moreover, after a slow start, Japan's vaccination drive has recently accelerated, and the government expects to make vaccines available to all eligible citizens by 4Q21.

Risks to our forecasts are to the downside, however, as an ongoing fifth Covid-19 wave and a state of emergency in several prefectures may further delay the recovery, even though social distancing restrictions and the impact on mobility appear light compared with measures in many other countries.

Economic scarring from the pandemic over the medium term is likely to be less severe than in many peers.

The extent of relief measures and domestic hiring practices that favour labour retention have prevented a significant rise in unemployment, which peaked at 3.1% in October 2020 and slightly fell to 2.9% in June 2021, and kept bankruptcies to a minimum. Limited wage growth, in particular small bonus pay-outs, has so far prevented inflationary pressures from increasing in a tight labour market.

Inflation is likely to remain subdued, averaging 0.3% in 2021 and 0.7% in 2022, given muted wage dynamics and entrenched low inflation expectations. A temporary period of deflation, from October 2020 to May 2021, in part due to a reduction in mobile phone tariffs, appears to have subsided.

Pandemic-related supply shortages and higher energy prices are likely to boost consumer price inflation in the months ahead, as was visible in the June outturn of 0.2% yoy.

However, we expect the Bank of Japan's (BoJ) inflation target of 2% to remain out of reach in the next few years.

The BoJ is likely to maintain its current monetary policy settings over the next few years, with a policy rate of -0.10%, yield curve control (with a 0% target for the 10-year yield), and quantitative and qualitative easing through large-scale asset purchases. The BoJ recommitted to these policies at its assessment of the effectiveness and sustainability of monetary policy in March 2021, and announced only some minor revisions to the operating framework.

Its policy has been effective in anchoring interest rates, which in turn have contributed to Japan's ability to continue financing its large government debt, with negative bond yields up to 10 years on the sovereign's yield curve. The central bank's holdings of around 45% of outstanding Japanese government bonds and T-bills have been broadly stable. Its holdings of the lion's share of outstanding exchange-traded funds, in particular, imply longer-term risks to the BoJ's balance sheet.

Japan's relief measures are among the largest globally, even though the uptake of various programmes in the fiscal year that started April 2020 (FY20) was smaller than budgeted.

The government can carry over some of the unused resources of its three pandemic-related supplementary budgets to the current fiscal year, including around JPY4 trillion (0.7% of GDP) still left in a contingency fund. The government so far also extended less than half of the JPY110 trillion available in loan and credit guarantees, and has provided capital support to policy banks to cover contingent liabilities from their non-fiscal relief measures. We expect only a gradual reduction in the general government deficit to 8.9% of GDP in 2021 and 6.1% in 2022 from 11.7% in 2020, as some relief expenditure will likely be prolonged, another supplementary budget may be announced later in the year, and any revenue-enhancing measures would be unlikely during the recovery.

We expect fiscal consolidation to remain a core policy goal, but the deterioration in fiscal metrics from the pandemic makes achieving the government's target of a primary surplus by FY25 for the consolidated central and regional balances unlikely. The Cabinet Office's recently updated projections show a primary deficit of 1.3% of GDP in FY25 under baseline assumptions and 0.5% in an upside scenario without further fiscal reforms.

We expect Japan's government debt ratio to broadly remain stable over the next few years, after a sharp rise to 255.1% of GDP in 2020 from 232.0% in 2019, already the highest among all Fitch-rated sovereigns. A gradual reduction in primary deficits should largely offset lower growth rates, as the output gap is closing over the next few years. It may become a greater challenge to stabilise the high public debt over the longer run, however, if costs related to population ageing rise further without major social security reforms.

The government has prioritised structural reforms on digitalisation, which may raise productivity over the medium term and enhance the government's IT capability to better target some of its relief measures, if implemented effectively. Cash transfers last year equivalent to JPY12.7 trillion (2.4% of GDP), or JPY100,000 per person, appear to have had only a limited impact on consumer spending, with much of it saved by households. Another pillar of government policy is the promotion of a greener society, such as through funding of innovative technologies.

Japan's external finances are supported by a large net external creditor position and 30 consecutive years of current account surpluses. We expect the current account surplus to slightly pick up to 3.9% in 2021 from 3.3% in 2020. The strong rebound in Japan's exports since the summer of 2020 has been broad-based in terms of both destinations, including to its main trading partners in Asia and the US, and products, including machinery and electronics.

ESG - Governance: Japan has an ESG Relevance Score (RS) of '5[+]' for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Japan has a high WBGI ranking at 88th percentile (A median: 76th), reflecting its long track record of stable and peaceful political transitions, well established rights for participation in the political process, strong institutional capacity, effective rule of law and a low level of corruption.

Japan's Exports

 

Japan Exports

Japan's Imports

Japan Imports

RATING SENSITIVITIES FACTORS THAT COULD, INDIVIDUALLY OR COLLECTIVELY, LEAD TO NEGATIVE RATING ACTION/DOWNGRADE:

- Public Finances: Expectations of a persistent rise in the government debt/GDP ratio over the medium term, for example due to a more pronounced and longer period of fiscal loosening and economic contraction, or failure to establish a credible consolidation strategy after the coronavirus shock.

FACTORS THAT COULD, INDIVIDUALLY OR COLLECTIVELY, LEAD TO POSITIVE RATING ACTION/UPGRADE: -

Public Finances: Confidence in the government´s ability to implement fiscal consolidation sufficient to place the government debt/GDP ratio on a downward path over the medium term once the coronavirus crisis subsides. - Macroeconomic: A sustained improvement in real GDP growth prospects and restoration of significantly positive inflation dynamics resulting, for example, from implementation of structural reforms to boost medium-term growth potential.

Source: Ministry of Finance, Japan,  Fitch

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