Moody's Investors Service warned on Wednesday that a lack of success on fiscal reform would have a negative impact on Japan's credit rating, adding pressure on the government to produce a credible plan to curb public debt.
The warning follows Standard & Poor's downgrade of its rating on Japanese debt last month, its first cut in nine years that exposed the country's dire financial condition to closer market scrutiny.
Moody's Investors Service on Wednesday affirmed its sovereign rating for Japan at Aa2 with a stable outlook, saying it signified a very low probability of default.
But Tom Byrne, senior vice president and regional credit officer at Moody's, told Reuters that Japan could not achieve its goal of a primary budget balance with economic growth alone and fiscal reforms were also needed.
Political developments could also be negative for Moody's rating on Japanese debt if they hampered reforms, he said.
"There's a long fuse before Japan's fiscal problems blow up into a crisis, but the government will eventually have to take measures to cut its deficit," Byrne said.
"You have to get bills in and out of parliament. If political developments impede that, that would not be a credit-positive development."
Last month, Standard & Poor's cut Japan's rating by one notch to AA minus, three levels below the top grade, saying Tokyo lacked a coherent plan to tackle mounting debt.
S&P's downgrade puts its credit rating on Japan one notch below Moody's but at the same level as Fitch, another ratings agency.
Byrne told a media briefing that Moody's was waiting for the government to outline by the end of April changes in the pension and healthcare systems and then produce a fiscal reform roadmap, due by June.
Delays in implementing budget reforms could either lead to a rating downgrade, a negative outlook or a step towards a negative outlook depending on the situation, Byrne said.
Byrne's comments indicate Moody's is willing to wait for the results of the legislative process.
S&P was more pessimistic, justifying its downgrade with a low chance that planned changes would reduce debt and warning that bills needed to implement next fiscal year's budget may not pass a split parliament.
Any number of factors still work in Japan's favor and explain markets' muted reaction to the latest spate of warnings: the fact that most of its debt is held by local investors, its strong international payments position, the depth of the domestic market and high national savings.
But economists and rating agencies have long warned that Japan will have no choice but to reduce its debt burden which, at twice the size of its $5 trillion economy, is the worst among industrialized nations.
"I can't tell whether Moody's will downgrade or not. But there are enough reasons for it to do so as Japan's fiscal condition has been deteriorating every year," said Chotaro Morita, head of Japan fixed income research at Barclays Capital in Tokyo.
Japan is not alone in the scrutiny of its public finances. Euro zone members Greece and Ireland have ratios of debt to gross domestic product above 100 percent. Spain, Portugal, the United States and Britain aren't far behind.
Many countries need to lower debt but still have economic problems that make drastic spending cuts difficult to stomach.
Prime Minister Naoto Kan has staked his career on overhauling the social security system and raising the sales tax, but he faces a divided parliament in which opposition parties threaten to block budget-related bills in an attempt to force Kan to resign or call a snap election.
In May 2009, Moody's cut Japan's foreign currency rating to Aa2 from AAA, but raised the domestic debt rating to Aa2 from Aa3. The outlook in both cases is stable. Moody's last lowered Japan's local currency bond rating in May 2002.
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