Moody's affirms Japan's A1 rating; outlook stable

Moody's Investors Service has today affirmed the Government of Japan's issuer rating at A1. The rating outlook is maintained at stable.

The affirmation reflects:

o The slow but continuing progress in developing a policy and reform framework which could ultimately reflate the Japanese economy and reverse the rise in government debt.

o Our expectation that funding costs for the government will remain low and stable.

Moody's notes that the recent waning of economic momentum has prompted a pause in fiscal policy tightening, which we expect to lead to a rise in the Japanese government's debt burden. However, we expect that Japan's credit profile will continue to be consistent with an A1 rating, and the rating outlook remains stable.

Moody's has also affirmed Japan's local currency senior unsecured rating at A1.

Japan's long-term local- and foreign-currency bond and deposit ceilings remain at Aaa. The short-term foreign-currency bond and deposit ceilings remain at Prime-1 (P-1).

RATINGS RATIONALE

FIRST DRIVER -- PROGRESS ON REFLATION AND FISCAL CONSOLIDATION

While the Japanese government's progress over the past two years towards reflating Japan's economy and stabilizing its fiscal position has not been as rapid or as marked as it originally intended, it has been in the direction intended. We expect some consolidation of these developments in the next two years, with inflation broadly stable -- excluding volatile price components -- at low levels, and a largely unchanged level of government debt in relation to GDP.

Nominal GDP has expanded on a year-on-year basis for 13 consecutive quarters through to the second quarter of 2016, the longest such streak since Japan entered into deflation in the early 1990s. Moreover, the unemployment rate has reached lows last seen prior to the Asian financial crisis in the late 1990s; labor force participation has risen, helping to mitigate the negative impact of long-term demographic decline on the availability of labor. These labor market improvements owe to the implementation of the government's structural reform policies, which have also included measures addressing corporate governance, taxation, as well as the liberalization of the agricultural and energy sectors.

These economic developments, although still around a very weak trend in real GDP growth, have helped to support "core-core" inflation--which excludes food and non-alcoholic beverages and energy--notwithstanding the downward effect on headline consumer price inflation of lower commodity prices and, more recently, a stronger yen.

Core-core inflation has registered 34 consecutive months of year-on-year increases through to July 2016. Prior to October 2013, there had not been three consecutive months of positive core-core inflation since 1999. Barring significant external downward pressure on prices, we expect core-core inflation to remain broadly stable, while headline inflation will stay markedly below the Bank of Japan's target.

In addition, the primary budget deficit -- excluding interest payments -- of central and local governments narrowed to 3.2% of GDP in the year to end-March 2015 (FY2015) from 6.6% in FY2010. Revenues have been boosted by the hike in the consumption tax in 2014, while expenditure growth has been contained. In nominal yen terms, general account expenditure in the settlement account has remained below its peak in FY2009.

As a result, general government debt has stabilized at 248% of GDP, as of the end of 2015, while outstanding central government debt has fallen to 210% of GDP, as of the end of Q2 2016, from 215% in the same period last year. Combined with lower interest rates, enhanced revenue performance has also led to improved debt affordability with interest payments falling to their lowest levels as a share of revenue in the past ten years.

We do not expect the government to achieve all the objectives it had set out at the start of the Abenomics program, at least as rapidly as it had originally hoped. The halting nature of the improvements seen in real and nominal growth, and the frequency of new fiscal and monetary policy initiatives and changes of direction, are a testament to the challenges that the government continues to face.

Over the medium term, we project growth and inflation to remain below the government's projections despite the recent introduction of further policy easing. In turn, we also see fiscal deficits as wider and government debt as higher than official forecasts. The evolution of the government's objectives and the implications for growth and public indebtedness will be an important driver of the rating in coming years.

SECOND DRIVER -- LOW AND STABLE FUNDING CONDITIONS FOR THE GOVERNMENT

The risks posed to Japan's credit profile by the government's enormous debt load are mitigated by the very low interest costs it faces, which reflect in turn its ability to draw on the very large pool of domestic savings, in large part invested in government assets, the so-called 'home bias'. We expect that to remain the case and that funding costs for the government will remain correspondingly low and stable over the coming years.

A very accommodative monetary policy stance will continue to contribute to the low yields on Japanese government bonds (JGBs). Moreover, as signaled by the recent widening of the current account surplus, aggregate savings are now more ample than at the time of our sovereign downgrade in 2014 when higher import bills for energy commodities pushed the savings-investment balance into a deficit. The implementation of negative interest rates has not unmoored the home bias. Deposits in the banking system are continuing to grow, reflecting ongoing, although somewhat lower, savings by households, and large and rising corporate cash holdings.

RATIONALE FOR STABLE OUTLOOK

Japan's stable outlook reflects a balance between upside and downside risks over the next 12 to 18 months. The government will be challenged to achieve its fiscal deficit reduction goals in an environment of weak growth. In addition, the durability of the nascent departure from deflation is uncertain in the absence of further policy support. These challenges are mitigated by the stable and advantageous funding conditions that Japan faces.

WHAT COULD CHANGE THE RATING UP/DOWN

Sustained progress on fiscal consolidation and debt reduction would be credit positive and could, over time, lead us to take positive rating action.

A downgrade would be predicated on evidence that the government is unable to achieve meaningful medium-term fiscal consolidation and a stabilization of debt. A return of significant deflationary pressures that accompanies a severe loss in economic momentum, or a deterioration in debt affordability due to higher funding pressures would be credit negative.

GDP per capita (PPP basis, US$): 38,054 (2015 Actual) (also known as Per Capita Income)

Real GDP growth (% change): 0.5% (2015 Actual) (also known as GDP Growth)

Inflation Rate (CPI, % change Dec/Dec): 0.2% (2015 Actual)

Gen. Gov. Financial Balance/GDP: -5.2% (2015 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: 3.3% (2015 Actual) (also known as External Balance)

Level of economic development: Very High level of economic resilience

Default history: No default events (on bonds or loans) have been recorded since 1983.