Why Japan May Join China, U.S. On Moody’s Downgrade Watchlist

Japan could perhaps make a plausible argument for avoiding that fate if Prime Minister Fumio Kishida weren’t fighting for his political life.

Lists of major economies facing credit downgrade risks in 2023 share a curious omission: Japan.

Odd, given the bewildering number of headwinds zooming Tokyo’s way from all directions. They include a deepening Chinese slowdown, fallout from the highest U.S. yields in 17 years, and a crushing Japanese debt load colliding with a likely recession.

Making things even worse for Asia’s No. 2 economy: a leadership crisis that limits Prime Minister Fumio Kishida’s options to do anything about Japan’s trajectory.

As 2024 beckons, investors are understandably focused on downgrade risks emanating from Washington and Beijing. In recent weeks, Moody’s Investors Service fired shots across the bows of the U.S. and Chinese economies.

And rightfully so. America’s debt topped $33 trillion this year. And China’s government is largely papering over a property-sector crisis with the potential to be as bad as Japan’s 1990s bad-loan crisis. Hence “Japanization” chatter as deflation stalks China Inc.

Though valid worries all around, those concerning Japan deserve far more attention considering the scale of its markets and export industry and status as the top creditor nation.

The last 24 years of zero-to-negative interest rates morphed Japan into the funding nation of choice for investment funds everywhere. Borrowing cheaply on yen and investing the proceeds in higher-yielding assets abroad became standard practice.

This explains why any sudden zigs in the yen causes zags in Chinese equities, Indian real estate, Indonesian futures, New Zealand debt, South African commodities, Latin American currencies and all assets traded in Tokyo, London or New York. And why the sharp yen rally in recent weeks shook global markets.

Anyone betting the Bank of Japan is about to end quantitative easing isn’t thinking about these broader risks. Since 2001, Japanese borrowing costs have effectively been suspended. Naturally, that warps a financial system. Incentives go awry, risk premiums out of whack and corporate and investment valuations enter a dream-like state.

Yanking the world’s third-biggest economy out of this financial wilderness 20-plus years in the making entails unprecedented risks. Sure, the Federal Reserve, European Central Bank, Bank of England and others entered and exited QE well enough. None, though, went as deep down the free-money rabbit hole.

The BOJ was already stuck in QE mode for 12 years when then-Governor Haruhiko Kuroda entered the scene in 2013 to supersize things. Kuroda hoarded so many bonds and stocks that the BOJ’s balance sheet topped the size of the $4.7 trillion economy within five years.

Over that time, the BOJ cornered the government bond market. It surpassed the Government Pension Investment Fund, the world’s largest such entity, as the top holder of Japanese stocks.

This effective nationalization of markets isn’t easy to reverse. And it won’t necessarily shield the financial system from Moody’s, Fitch Ratings or S&P Global opting to slash Tokyo’s credit rating.

The recession in which Japan might already be in is one problem. Kishida’s Liberal Democratic Party is racing to increase fiscal spending to jolt growth, including cutting taxes for middle-class families. That’s on top of plans to increase military spending by 50% over the next few years.

Japan already has the biggest debt burden among major economies, more than twice the annual output. It also has the fastest-aging population and negligible birth rate. Put it all together and you have all the ingredients of the sudden yield surge investors have feared for years now.

As Japan’s debt-servicing burden increases, so does the risk of credit events. Not least of them, joining the U.S. and China on the downgrade watchlist.

Japan could perhaps make a plausible argument for avoiding that fate if Kishida weren’t fighting for his political life. As scandals plague his party, Kishida’s approval rating has fallen to 17%. This leaves little political capital for Kishida to raise Japan’s economic game.

None of this is to downplay the epic challenges facing the U.S. and China. Both economies are looking at long and arduous periods of reform to reduce risk and increase competitiveness. But so is Japan as all too many external pressures make domestic challenges hard to ignore.

There are loads of uncertainties, of course. The depth of China’s stumble is one. The ways in which the U.S. might buckle under the most aggressive Fed tightening in nearly 30 years matters, too. Europe is walking in place as Germany fends off recession fears.

But Japan, for all its troubles, faces a year of overlapping risks that few policymakers, be they in Washington or Beijing, would relish. And troubles almost certain to trigger rating company analysts.

Thai Bao