Bad Idea - Picking a Fight With the Rating Agencies

By Scott B. MacDonald

The Japanese government is not happy with the rating agencies and hates the idea that its ratings could end up at the same level as the small African country of Botswana. The government has demanded Moody's, S&P and Fitch explain their reasons for lowering the rating from AAA to mid-AA, with the possibility for further downgrades. Poking at the rating agencies is not a good approach. Indeed, the strategy is likely to fail as the Japanese government is giving the agencies more space to communicate their criticism.

The views of all three major rating agencies are now well known. The key issues of concern are Japan's massive build-up in public sector debt (140% of GDP and going higher), ongoing large fiscal deficits and a troubled banking sector overburdened with bad debt, much of it from a decade earlier. In addition, deflation, dysfunctional and protected sectors of the economy, ongoing resistance to structural reform, and a rapidly aging population all have troubling implications. What makes all of this an issue to the rating agencies is how Japan compares with other countries in terms of key ratios and the government's approach, especially in terms of timing.

Japanese officials have stated that public sector debt is not a problem and do not see it falling until later in the decade. Yet Japan is easily leading the way to higher levels of public sector debt among G-7 economies. While most of this debt is held by Japanese investors, it is still growing and will someday have to be repaid. At some point there is a confidence issue - can the government make its repayments without borrowing more money? If not, how comfortable is an investor holding bonds only as good as what the next investor is willing to back?

There are a number of other ratios that draw concern from the rating agencies, but most significant is the primary budget balance. This is where a government usually generates money to pay the interest on debt. Japan has run a deficit in its primary balance since 1993 and was -5.1% of GDP in 2001, compared to surpluses in Italy (4.2% of GDP), Belgium (5.7%) and the United States (2.9%).

It has also been asked why the United States during the late 1980s and early 1990s, with large budget deficits and foreign funding via U.S. Treasury bonds, did not receive a downgrade. Although the rating agencies did not downgrade the United States nor change their outlook to negative, they did warn about the dangers of failing to address these issues. An important difference between the U.S. and Japan is timing. Following the U.S. economic slowdown of 1989/1990, the United States undertook structural reforms, including the cleaning up of its bad bank debt, in a relatively short period. Public sector debt to GDP peaked in 1993 at 75.8%, while the budget deficit peaked in 1992 at 5.9% of GDP. Japan's bubble economy burst at the end of the 1980s and problems from that period are still very much in evidence.

One last point that is hurting the Japanese government is that its claims of cleaning up bad debt and dealing with "zombie" companies are constantly being undermined by bank bailouts. For example, while the government was complaining about the rating agencies, UFJ Bank announced it will forgive Yen 470 billion ($3.68 billion) in loans to Daikyo Inc., a construction company. If this bailout goes through it would be Japan's second biggest this year, behind the Yen 520 billion in aid given in February to Daiei Inc., the nation's third-largest retailer. This is in sharp contrast to the United States, which let one of its major retailers, Kmart, file for bankruptcy in January.

The debate on ratings comes at a pivotal time for Japan. Prime Minister Koizumi is in another major fight to push his reforms through the Diet. The three major items on the reform agenda now are to dissolve the state housing loan corporation, pass legislation to privatize the postal office, and speed up the disposal of non-performing loans in the banking sector. Postal system reform is probably the most significant. It is felt the postal system has too much power with its huge amount of savings and it is distorting the banking system and helping to feed wasteful public works programs. The reform bills are expected to face strong opposition from the LDP as the postal office has considerable clout among senior party members.

These reform bills are highly important to Koizumi. He is putting considerable pressure on the LDP to support him. The Prime Minister has hinted he might reshuffle his cabinet in July to include conservative LDP members. This is meant to show that cooperation will be repaid with cabinet positions. However, if LDP conservatives still seek to stop his reform bills in the Diet, Koizumi has also indicated he could call another general election. This is expected to reduce the number of conservative LDP seats. Despite a decline in the polls, Koizumi remains by far Japan's most popular politician. Moreover, the opposition parties remain weak and ineffectual.

Japan is not Botswana or Argentina. It will remain the world's second largest economy, with a huge amount of national savings and internationally competitive corporations. However, Japan does have problems and the basic fundamentals upon which all countries are compared are getting worse and have been doing so for over a decade. When this happened to Canada, Sweden and Italy in the early 1990s, those countries lost their AAA ratings, with Italy falling to A1. All three of those countries have regained AAA or high AA ratings, but only after maintaining tight fiscal policies for a number of years, reforming their banking sectors, implementing structural reforms and greatly reducing public sector debt. Japan is expected to do the same.

Prime Minister Koizumi recognizes the next few months are critical for his government. With some degree of economic recovery behind him and the passage of his reform bills, he could recover lost ground in the opinion polls while strengthening the economy. It could also prevent the economy from falling back into recession in late 2003. This would also reduce the pressure on Japan's ratings and make the references to Botswana go away. Consequently, Japanese politics will guide the country's economic agenda in the next few months. If the reforms pass, prospects for a sustainable recovery improve considerably; if not the ratings agencies will have their day, arguing that the Japanese government is not capable of reform. We wish Mr. Koizumi well.