Japan: Improved Inflation And Positive Effects For Debt Sustainability Underpin Stable Outlook

The Stable Outlook reflects a balanced view of risks to the rating agency’s assessment for Japan over the next 12-18 months. Japan’s long-term issuer and senior unsecured debt ratings in local and foreign-currency were affirmed at A. The local and foreign currency short-term issuer ratings were affirmed at S-1. The Outlook on short-term ratings remains Stable.

Recent Higher Inflation Appears Increasingly Durable

Japan’s recent inflation appears increasingly durable. Headline and core inflation rose to 2.8% year-on-year as of February 2024 whereas Tokyo inflation, a bellwether of the national index, stayed elevated last month. Annual headline inflation at the national level has stayed above 2.0% since April 2022, evidencing a degree of stickiness after government reflation policies of the past decade under Abenomics were given a significant boost from the global cost-of-living crisis. Inflation in Japan was negative for 12 of the 27 years between 1995 and 2021 and under 2% in all but one of those years (Figure 1).

This record of deflation – so-called Japanification – has represented a core constraint for government debt sustainability and a limitation on the economy’s real output growth. While it is too early to declare any victory over deflation, the phase of higher inflation of the past two years looks increasingly durable. Scope is projecting inflation of 2.2% for 2024 and 2.5% for 2025.

Figure 1. Annual Japanese inflation

1990-2025F, %

The Japanese government has sought to build on the early drivers of inflation during this crisis (including higher commodity prices and yen depreciation) by supporting wage growth and a virtuous cycle of demand-led price gains. The 2024 pay negotiations of Rengo, the largest trade-union group, led to a significant 5.28% wage hike at first aggregated results, the highest in 33 years. This much-higher-than-anticipated gain reinforced the Bank of Japan (BoJ)’s decision last month to end eight years of negative rates.

Elevated wage growth helps sustain reflation. Scope views constructively any continued phase of inflation over-shooting for the present as this supports the central bank’s price-stability mandate. A prolonged phase of above-target inflation is likely compulsory for re-anchoring inflation closer to 2% in the long run, since medium-run inflation risk remains skewed to the downside given structural deflationary dynamics.

Sustained inflation has allowed the central bank very gradually to withdraw some of the exceptional monetary accommodation and relieve associated stresses for banking-system profitability and financial-system stability.

More meaningful wage growth, government subsidies and fresh fiscal programmes should help to buoy aggregate demand and output growth. The government is aiming, rather ambitiously, to achieve real growth of 1%-2% a year. If reflation results in healthier consumption and investment patterns, this may present modest upside for Scope long-run real growth assumption of just 0.4% a year for Japan, the lowest among economies of Scope-rated sovereigns and a core rating constraint.

Stronger Inflation Outlook Constructive For Debt Sustainability

The stronger inflation outlook is constructive for the challenging debt-sustainability outlook. Under Scope’s economic base case, a comparative stabilisation of the government-debt ratio is forecast over 2024-2028. Debt-to-GDP is foreseen at 255% by 2028, roughly unchanged from 253% at end-2023. Elevated nominal growth of 5.8% last year brought about a reduction of the debt ratio from record highs of 260% in 2022, the largest one-year drop on record. Scope Ratings’ debt outlook is anchored by more-constructive nominal growth compared to nominal interest rate differentials than in previous years (Figure 2), driven by higher inflation.

Figure 2. Contributions to annual change in general government debt-to-GDP of Japan

Percentage points

Japan Helped by Cost-of-living Crisis

Japan is among a select number of sovereigns (including Greece) that have been helped significantly from a credit standpoint by the cost-of-living crisis. High inflation has cut elevated debt ratios after many debt-reduction strategies of past decades proved less effective, while low-interest and long-maturity debt structures have aligned with more significant space for higher borrowing rates.

Net interest payments amounted to a low 0.5% of Japan’s government revenue in 2023 and Scope foresees net interest payments rising gradually to a still-modest 2% by 2028 under an assumption of higher rates for longer.

So although Japan holds the highest debt ratio of any sovereign in Scope’s rated universe, it pays among the least interest. The effective interest rate on remains stays near 0% within our forecast horizon to 2028.

Debt sustainability is also supported by the fact that Japan’s debt is predominantly domestically held, denominated entirely in yen, and 48% has been monetised by the Bank of Japan. Because of the latter fact, the amount of rateable debt due to the private sector is much lower than the sovereign’s gross debt ratio. Although the BoJ ended yield-curve control recently, it continues purchasing bonds in secondary markets broadly as before, ensuring further rises of the share of government debt it holds.

Finally, as the world’s largest creditor nation, Japan holds gross government financial assets of around 96.7% of GDP (IMF, 2023), nearly equal in size to gross debt due to the private sector. On this basis, the aggregate debt-sustainability picture is more benign than the sovereign’s very-elevated debt ratio alone might suggest.

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Dennis Shen is Senior Director in Sovereign and Public Sector ratings at Scope Ratings GmbH, and primary analyst on Japan’s sovereign credit rating. Keith Mullin, senior writer at Scope, contributed to drafting this economic comment.