Japan is strangely not included in the list of major countries facing credit downgrade risk in 2023.
That’s strange considering the tremendous headwinds hitting Tokyo from all directions. These include a deepening economic slowdown in China, the fallout from U.S. yields at 17-year highs, and Japan’s overwhelming debt burden colliding with an expected recession.
Things are getting worse for Asia’s second-largest economy. The leadership crisis limits Prime Minister Fumio Kishida’s options to do anything about Japan’s trajectory.
As 2024 approaches, it’s no surprise that investors are focused on downgrade risks emanating from Washington and China. In recent weeks, Moody’s Investors Service has taken shots at the economic dividing line between the United States and China.
And rightfully so. America’s debt exceeded $33 trillion this year. And the Chinese government is largely glossing over a real estate sector crisis that could be as severe as Japan’s bad debt crisis in the 1990s. Therefore, as deflation creeps in, the term “Japanization” is thrown around a lot.
There are legitimate concerns here and there, but concerns about Japan are far more noteworthy given the size of its market and export industry, and its status as its largest creditor nation.
Zero to negative interest rates over the past 24 years have made Japan a funding destination of choice for investment funds around the world. Borrowing cheaply in yen and investing the proceeds in high-yield assets overseas became standard practice.
This explains why a sudden zigzag in the yen causes a zigzag in Chinese stocks, Indian real estate, Indonesian futures, New Zealand government bonds, South African goods, Latin American currencies, and all assets traded in Tokyo, London, and New York. This is to explain. And why has the yen’s rapid appreciation in recent weeks shocked global markets?
Those who expect the Bank of Japan to end quantitative easing soon are not thinking about these broader risks. Since 2001, Japan’s borrowing costs have been virtually suspended. Naturally, it distorts the financial system. Incentives fail, risk premiums go awry, and company and investment valuations fall into a dream state.
Pulling the world’s third-largest economy out of this financial wilderness that has taken more than two decades involves unprecedented risks. Indeed, the Federal Reserve, the European Central Bank, the Bank of England, and others have entered and exited quantitative easing for good measure. But nothing went as deep as the rabbit hole of free money.
The Bank of Japan had already been in quantitative easing mode for 12 years when then-Governor Haruhiko Kuroda stepped in in 2013 with the aim of supercharging policy. Mr. Kuroda stocked up on so many bonds and stocks that within five years the Bank of Japan’s balance sheet exceeded the $4.7 trillion mark of the economy.
Meanwhile, the Bank of Japan cornered the government bond market. It has surpassed the world’s largest pension reserve management agency to become the top holder of Japanese stocks.
Reversing this de facto market nationalization will not be easy. Nor would it necessarily protect the financial system from Moody’s, Fitch Ratings, or S&P Global choosing to downgrade Tokyo’s credit rating.
One problem is that Japan may already be in recession. Kishida’s Liberal Democratic Party is rushing to increase fiscal spending to stimulate growth, including tax cuts for the middle class. This comes on top of plans to increase military spending by 50% over the next few years.
Japan already has the highest debt burden of any major country, more than double its annual output. It also has the fastest aging population and a negligible birth rate. Put all this together and you have all the ingredients for the sudden spike in yields that investors have feared for years.
As Japan’s debt service burden increases, so does the risk of credit events. Among others, the United States and China have been added to the downgrade watch list.
If Mr. Kishida were not fighting for his political life, perhaps Japan could make a plausible argument to avoid that fate. As scandals plague the party, Kishida’s approval rating has fallen to 17%. This leaves Mr. Kishida with little political capital to enhance Japan’s economic strategy.
None of this is meant to downplay the grand challenges facing the United States and China. Both economies are considering a long and difficult period of reform to reduce risks and increase competitiveness. However, the same is true for Japan, where there is so much external pressure that it becomes difficult to ignore domestic issues.
Of course, there are many uncertainties. The depth of China’s stumbling blocks is one thing. Also important is how the US fares under the most aggressive Fed tightening in nearly 30 years. Europe is on track as Germany fends off fears of a recession.
But for all its problems, Japan faces a year of confluence of risks that most policymakers, whether in Washington or Beijing, would be happy with. And ratings agency analysts are almost certain to cause trouble.