Recent Japan downgrade ‘no surprise’ but yen fears persist

Moody’s downgrade of Japan’s credit rating last week came as no shock to markets, while economists warned the appreciation of the yen is a more crucial issue for the country.

Moody’s said one reason for the downgrade was the inconsistency of the Japan’s political backdrop and the lack of a clear fiscal strategy, which was vindicated late last week when Prime Minster Naoto Kan resigned, paving the way for the nation’s sixth premier in five years.

Kan had come under fierce criticism for his response to the tsunami and nuclear crisis and barely survived a no-confidence vote in June, but kept his pledge to step down as soon as a new budget bill was passed.

Several commentators said although the downgrade will probably have a minor impact on investments in the country, the yen will remain under upward pressure unless the government intervenes on the currency.

“Japan has seen four downgrades in the past from Moody’s, so it has not been a shock,” said Schroders’ Japan specialist Andrew Rose, manager of the £694m Tokyo fund.

“If sovereign credit is downgraded in the euroland, bond investors would move to Germany or France, but in Japan there is nothing to move to, which explains the lack of reaction in the market.”

Simon Ward, chief economist at Henderson, has criticised the move by Moody’s, arguing Japan should not be rated lower than the US as it is a major holder of US government bonds.

“It does not make sense to rate Japan below the US, given Japan holds foreign exchange reserves of $1.2trn, most of which is invested in US treasuries.

“If Japan faced difficulty financing its budget deficit, it would sell these treasuries, causing yields to surge, transferring the funding crisis to the US,” he said.

Ward added Japan’s economy has “bounced back impressively” from earthquake-related disruption, and industrial production is likely to return to its January level this month.

The main risks to the Japanese economy are external factors such as a eurozone recession or a hard landing in China, he added.

Other economists warned two factors could impact the soaring yen and consequently the Japanese economy. Firstly, any move towards QE3 by US policymakers will affect the dollar/yen exchange rate.

Secondly, Japan’s presidential election will determine whether the country will focus on monetary easing to boost the export-driven economy, or keep to the fairly conservative line of current finance minister Yoshihiko Noda, who is running in the leadership race. 

The yen has continued to appreciate against the dollar, climbing 10% since the beginning of April and reaching a post-war high of 75.95 on 19 August, threatening domestic growth. 

David Rae, a Japan specialist at Capital Economics, said: “Last week’s announcement the government will be issuing $100bn of foreign reserves does show a further intervention into the foreign exchange markets is less likely, which in turns signals a stronger yen.”

Noda’s loan program for corporates investing overseas has seen the country tap its foreign reserves for the third time since 2008, meaning the government may struggle to convince markets on its fiscal strategies.

“It is less likely authorities will act directly on the currency given their efforts have been half hearted in the past. But combining currency intervention with negative forward interest rates would be a more effective policy than acting on rates alone,” said Ignis economist Stuart Thomson.

“The past interventions have carried an implicit expectation to fail, which the markets have punished.”

Schroders’ Rose also pointed to the short-lived effect on the yen of the two past interventions, in autumn last year and after the earthquake in March.

Thomson added although the strength of the yen is largely driven by US and European woes, the Japanese government has a key role in manipulating its own currency: “It can still counteract the weakening of the dollar by making it expensive for investors to hold the yen.

“It should follow the lead of the Swiss national bank by engineering negative forward interest rates, so speculators would take the hit,” he said.