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Japan's credit rating downgraded by Moody's By Gillian Tett in Tokyo Published: September 8 2000 02:28GMT | Last Updated: September 8 2000 12:20GMT

The Japanese government was on Friday given an embarrassing blow after Moody's Investors Service, the US credit rating agency, announced that it had downgraded its domestic currency debt for the second time.

The downgrade leaves Japan's yen-denominated debt rated at Aa2, two notches below the top-rated Aaa level and one of the lowest ratings for any industrialised country.

However, Moody's also hinted that it might soon make another downgrade: it announced that the outlook for the rating remained "negative" at present.

The move is likely to provoke less reaction among bond investors in Japan than a downgrade would in other Group of Seven countries, because in Japan only 5 per cent of the Japanese government bond market is held by foreign investors. And the domestic investors have historically shown limited interest in credit ratings.

"The risk of downgrade of JGBs had been fully discounted in the market. A one notch downgrade and credit outlook negative is just in line with market expectation," commented Takehiro Sato, economist at Morgan Stanley Dean Witter.

Mr Sato added: "The risks of further downgrade is likely to set the government on a more cautious track about expansionary fiscal stance. Mr (Kiichi) Miyazawa (the finance minister) is probably somewhat relieved, ironically, by the downgrade."

However, the downgrade is also a deeply embarrassing blow for the Japanese government, which has been seeking to persuade its trading partners that it is finally ending the gloom surrounding the world's second-largest economy. Japan is due to publish gross domestic product data on Monday which is likely to show a modest pace of growth in the second quarter of this year.

The downgrade also will fuel the domestic political debate about policymaking in Japan and, above all, the ability of the current Japanese government to produce a medium-term fiscal plan to tackle its rising debt mountain.

Japan's debt has risen to 130 per cent of gross domestic product in recent years due to extensive public spending during the 1990s that aimed to pull the economy out of stagnation. Most economists expect this to rise further in the coming years unless there is dramatic growth or fiscal retrenchment.

Nevertheless, Moody's action reveals a highly unusual split between the rating agencies about how to interpret the Japanese economy and its debt levels. Moody's believes that the rising debt levels have created a possible risk that the government will default on its yen-denominated liabilities. But it still believes that Japan's foreign currency reserves are so large, and its liabilities so small, that there is less risk attached to its foreign assets.

However, Fitch, another rating agency, fears that there is more risk attached to the foreign currency component of Japan's debt. Standard & Poor's, another rating agency, has hitherto left Japan's ratings untouched, since it believes that the country's huge pool of domestic savings should be sufficiently large to meet any debt overhang.

The downgrade initially shook the markets but the impact was limited and there was a rebound in bonds and equities. The Nikkei 225 stock average ended 1.2 per cent higher at 16,501.55 and Japanese government bonds staged a strong rally, pushing the yield on the benchmark 10-year 224th JGB down 0.085 to 1.850, falling below 1.900 for the first time in a week.

The yen weakened against the dollar, trading at %105.50 in the late afternoon, compared with the New York close of %105.08 on Thursday.

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-- Martin Thompson (mthom1927@aol.com), September 08, 2000