Japan

Probably some of you won't take a credit rating agency very seriously, following the role that a few of them played in the 2008 financial crisis, where they gave investment-grade, "money safe", ratings to mortgage backed securities (MBS). The scam involved bundling a load of dodgy (sub-prime) mortgages with less risky mortgages and wrapping the lot up in attractive paper and of course a dandy red ribbon too (the AAA rating). A brand new financial asset (MBS) was created and marketed as “money safe”. It was then flogged by swanky folks in dark Valentino suites to the most conservative of investors, the pension fund managers, who believed in what they were told and lapped it up.

Just a brief recap, Moody's credit rating agency gave Freddie Mac an investment grade rating of A1 until August 22 2008, when Warren Buffett said publicly that both Freddie Mac and Fannie Mae had tried to attract him and others. Moody's then changed the credit rating to Baa3.

Now Moody's is surprising the financial community again with its recent downgrade of Japan by 1 notch from Aa3 to A1.

What are the key drivers behind Moody's downgrade, just ahead of the all-important Abenomics snap election? Yes, you guess it, slippery politics is probably driving the game.

Perhaps we can interpret the election results like this: if support for Abe fails, then the support for Abenomics and the global stock market reflation political show may be off the table.

What are the key drivers for the downgrade?

There are three reasons, so let's look at each individually.

Firstly, the greater uncertainty over whether the monetary authorities can achieve the fiscal deficit reduction goals and keep the debt under control. It’s a difficult juggle facing many policy makers today, trying to grow the economy and simultaneously reduce the debts. Japan's deficits and debt remain very high, and fiscal consolidation will become increasingly difficult to achieve as time passes, given rising government spending, particularly regarding social programs associated with a rapidly ageing population. The government acknowledges this but fiscal reforms will be needed for Japan to achieve its primary balance target in the second half of this decade. Government debt is projected at 245% of GDP in 2014 according to the IMF. This will only start to decline under the most favourable combination of economic and fiscal reforms, including tax and social security and total factor productivity improvements, an end to deflation and achievement of annual nominal GDP growth above 3.5%. Given current domestic circumstances and lacklustre external demand for Japan's exports, achieving these conditions will be challenging, states the report. 

The second rationale for the downgrading is the uncertainty over whether the growth stimulus policy will work, particularly in an economic environment of deflation.

While some indicators suggest a pick-up in economic activity over the past year, potential economic growth remains low. GDP growth sharply contracted in the second quarter of this year following the introduction on 1 April of the first step of the consumption tax increase, from 5% to 8%. Output was also affected by adverse weather in the summer to some extent and both real and nominal GDP contracted again in the third quarter of the year. This put Japan's economy in recession for the third time since the global financial crisis. The Bank of Japan with its quantitative easing policies in October may once again move the deflator back onto positive ground in the fourth quarter of 2014, however, the task ahead for economic revitalization and price reflation is looking more challenging.

The third rationale for the downgrade is an increased risk of rising JGB yields and reduced debt affordability over the medium term. This may be less of a problem, since most of Japan's debt is locally owned. In other words, even if it were to default, which is unlikely, it would not be a big deal. This is confirmed in the report which states, “Debt sustainability will rest on the continued willingness of domestic investors to provide funding at affordable rates for the government. This looks likely to remain the case as long as investor confidence is not undermined.”

The credit rating agency gives Japan an A1 rating with a stable outlook.

“Whatever the challenges facing the government, Japan retains very significant credit strengths. Its A1 rating and stable outlook are supported by its large, diverse economy, which we characterize as having 'High' economic strength. And even with the very significant debt burden, we believe that Japan exhibits only 'Low' susceptibility to event risk.”

In other words, Japan manufactures high end technologically advantaged products that the world wants, therefore it can shoulder the burden of debts, service the interest payments without too much difficulty or risks for creditors. Moreover, the economy is robust enough to absorb labour, keeping unemployment low. So competitively speaking, Japan's economy doesn't look too bad, according to the report.

Campaigning now begins for Japanese snap elections. The Nikkei index is currently at, or near, a five year high testing resistance level. What about the difficult business of crystal ball gazing to predict trends? I forecast The Nikkei to continue its upward trajectory during the campaigning months, as indicated in my article, “The Three Arrows That Missed.” My guesstimate is that Japanese Prime Minister Shinzo Abe will win the election primarily because he supports the QE pump scheme, which is keeping stocks artificially high and projecting a powerful political message to the globe that the western financial system is buoyant and stable, even if the fundamentals are the reverse. Then, global stocks are likely to rally after Abe victory and the show game continues.