Land of the Sinking Credit Rating

Another downgrade strikes.

Another debt rating agency issued another high-profile credit downgrade on Wednesday. Moody's Investor's Service dropped Japan's credit rating from Aa2 to Aa3, reflecting the results of a review which began in May. Back then, the agency noted that long-term fiscal concerns, stemming from the 2009 global recession, coupled with the costs of re-building after March's devastating earthquake and tsunami, along with Japan's political turmoil, led to the downgrade. “Several factors make it difficult for Japan to slow the growth of debt-to-GDP and thus drive this rating action,” Moody’s said.

Moody's also noted that Japan's debt levels "looked bad" compared to international standards. That is an understatement. According to the International Monetary Fund (IMF), Japan has the highest debt-to-GDP ratio in the world, with a current projection of 233 percent for 2011. Japan's Cabinet Office apparently disputes that figure, citing a level of 181 percent. Regardless of the numbers, neither entity sees the kind of political progress being made necessary to address the debt burden. Moody's noted that reality, citing “frequent changes in administrations” as one of the primary causes for concern.

Coincidentally, another political change is coming by the end of the month. On Tuesday, Japanese Prime Minister Naoto Kan told members of his cabinet he will step down as soon as the Japanese Parliament passes three important bills. The first is a "second extra budget," enacted in July. Next is a bill allowing the government to issue "deficit-covering bonds" for FY 2011. The third is a piece of legislation introducing a "feed-in tariff system" requiring utility companies to buy renewable energy-sourced power at fixed prices. The process is expected to be completed by the end of the week. "I will quit after all three conditions are in place," Kan said, according to cabinet members present at a meeting of his ministers.

Kan had survived a recall vote aimed at removing him last June, when senior figures in his left-of-center Democratic Party of Japan (DPJ) initially indicated they could no longer support the man most Japanese held responsible for the mishandling of that nation's Fukushima nuclear power plant crisis.

Whoever replaces Kan will be Japan's sixth prime minister in five years. Six candidates are vying for the job: finance minister Yoshihiko Noda, farm minister Michihiko Kano, trade minister Banri Kaieda, former transport minister Sumio Mabuchi, ex-environment minister Sakihito Ozawa, and former foreign minister Seiji Maehara, who is the most popular candidate despite a scandal which engendered his resignation in March. Maehara had taken an illegal $3,000 political donation from a foreign national, an issue he promised to address on Friday.

Due to the shortage of time, none of the candidates were expected to delve into detailed policy issues. The focus will be on who is perceived by the voters as the candidate best able to unite the DPJ and work with opposition parties. "The whole point of the race is to replace Kan, who has been criticized for his lack of leadership and inability to work with the opposition," said Tomoaki Iwai, a political science professor at Nihon University. "The race will be about intra-party power balances. Tax hikes and other issues will be put on the back burner."

DPJ and its allies maintain 309 of the 480 seats in the House of Representatives, and the current crisis arose when Kan was unable to reach agreements with the center-right Liberal Democratic Party (LDP) on how to rebuild Japan's devastated communities or infrastructure. Iwai noted that neither party has put forward a comprehensive plan for dealing with the issue. That sentiment was echoed by Yuuki Sakurai, CEO and president of Fukoku Capital Management Inc. "I had expected that the rating cut would have taken place after the election for the leadership of the Democratic Party of Japan," he said. "But looking at the candidates, there seems to be nobody among them who would seriously tackle financial reform, so that's why Moody's went ahead and cut the rating."

Thus, the downgrade was hardly surprising. Yet even as it issued the downgrade, Moody's contended Japan's outlook was now stable, due to the "undiminished home bias of Japanese investors and their preference for government bonds, which allows the government's fiscal deficits to be funded at the lowest nominal rates globally." This was Moody's first Japanese downgrade since 2002, when the agency dropped the nation's rating six levels to A2. Since then it has upgraded Japan three times, most recently in 2009. The current downgrade aligns Moody's with Standard & Poor's and Fitch Ratings. Both agencies rate Japan's debt at double-A-minus. But unlike Moody's, both Standard & Poor's and Fitch Ratings have issued a negative outlook on Japanese credit going forward. This latest downgrade puts Japan's credit rating on the same level as China, which recently replaced Japan as the world's second largest economy.

Unlike the heavy criticism leveled by the Obama administration against S&P when America's credit rating was lowered by that agency, Prime Minister Kan had nothing to say about the downgrade. Finance Minister Yoshihiko Noda declined to answer direct questions posed by reporters in Tokyo on Wednesday. However, Noda did defend Japan's overall credit worthiness. "The smooth sales of Japanese government bonds at recent auctions show that confidence remains unshaken," Mr. Noda contended.

Despite that confidence, serious problems in addition to debt must be addressed. A soaring yen threatens Japan's critical export competitiveness, a revamped approach to energy policy in the nuclear power-dependent nation must be found, and the conflicting priorities of reigning in debt even as massive amounts of financing are required for reconstruction (possibly as high as $130 billion), and an aging population evermore dependent on government services, must be reconciled.

Toward those ends the government has already enacted tax increases to cover social welfare costs, put together a $100 billion emergency credit facility making it easier for Japanese companies to purchase foreign firms (a moved aimed at stabilizing the currency), and sent requests to major financial firms to report their currency positions through September, as a means of curbing speculation.

Moody's noted that Japan must bring its nominal growth (growth without inflation factored in) up to 3 percent annually in order to get its debt under control, citing the reality that the government's intention to double the 5-percent sales tax by mid-decade "would not be enough to achieve fiscal rebuilding." Japan is aiming for nominal growth of 3 percent and real growth of 2 percent by 2020. Such a level is far higher than what the nation achieved in the so-called "lost decade" leading up to the financial crisis.

Yet amidst all of its troubles, including that lost decade, where economic recession became a way of life, Japan has remained stable. No doubt much of that stability is attributable to a cultural stoicism highlighted during the tsunami, when Japan remained enviously immune from the kind of cultural breakdown such disasters have precipitated elsewhere, including the United States. It is a stoicism reflected in the reality that Japan's 127 million people have amassed $15 trillion of household savings to weather their ongoing economic storm. It is also reflected in the fact that Japan has managed to fund almost 95 percent of its debt domestically, via banks and pension programs, which help to keep yields lower than they would otherwise be.

Joe Biden, who visited Japan on Tuesday, took notice of that stoicism. "I came to express not only my commitment to say we will do whatever we can to help, but to tell you how much the president, how much I, how much the American people admire your character," he said. Biden also used the visit as an opportunity to express the contention that neither Japan nor the U.S. was in decline. "While you're struggling to deal with one of the greatest natural disasters any country has faced and we are dealing with getting our budget in order, there are voices in the world who are counting us out," Biden said. "They're making a very bad bet," he added.

Unfortunately, Mr. Biden is comparing apples and oranges. The cultural factors that keep anti-social behavior to a minimum in Japan are in critically short supply in America, where shame is almost non-existent, and a sense of self-entitlement has become endemic. Japan is a valuable reminder that culture, good or bad, may be the ultimate factor in determining how well a nation can handle adversity. Despite all of its financial and political troubles, Japan remains largely united as a nation.

America? Perhaps the Obama administration, dedicated to stoking divisions within the public for the purposes of political gain, might want to reconsider such a profoundly misguided approach.