While Japanese markets seem fully able to resist any near-term sell-off due to the nation's debt problem, economists warn that Tokyo can't sit still in the face of a rapidly aging population.
Moody's Investors Service said earlier Tuesday that it had lowered the outlook on Japan's Aa2 sovereign debt rating to negative from stable, citing the surging public deficit and slow policy response.
"The rating action was prompted by heightened concern that economic and fiscal policies may not prove strong enough to achieve the government's deficit reduction target and contain the inexorable rise in debt, which already is well above levels in other advanced economies," Moody's said in a statement.
"Although a JGB funding crisis is unlikely in the near- to medium-term, pressures could build up over the longer term which should be taken into account in the rating, even at this high end of the scale," it said.
The action by Moody's came after Standard & Poor's last month cut Japan's sovereign debt rating to AA-, the fourth-highest level, citing the government's lack of a "coherent strategy" to deal with a debt burden approaching 200% of gross domestic product.
Thomas Byrne, senior vice president of Moody's Investors Service, said recently that any policy drift or friction that prevents passage of tax reform bills in parliament would be a credit-negative development.
Japanese analysts do not share Moody's negative sentiment about the domestic bond market, at least in the near term.
"The market was right in ignoring the warning," said Akio Yoshino, chief economist at Amundi Japan Co.
"Unless the investment and savings balance drastically changes in Japan, the latest warning from the rating agency won't pose a serious downside risk to the Japanese government bond market," he said.
In fact, Japanese government bonds extended their gains further after Moody's announcement. The yield on 10-year JGBs fell 3.5 basis points to 1.275%, after falling to as low as 1.2600% at one point.
The yen also quickly trimmed its losses, after temporarily weakening to Y83.50 in immediate reaction to the announcement. The currency was quoted around Y83.32 in late Asian afternoon trading.
The Nikkei 225 Stock Average closed down 192.83 points, or 1.78% at 10,664.70 on Tuesday but today's losses were driven by the growing civil unrest in the Middle East and North Africa.
"If the JGB market stands firm despite the news on the rating (outlook), it's unlikely to cause a major downturn in the yen or (Japanese) stocks," Yoshino added.
Junko Nishioka, chief economist at RBS Securities, agreed with Yoshino on the short-term impact of the credit warning on financial markets.
"Given the likelihood that the debt holding structure of Japanese government bonds will remain intact and that Japan can continue to maintain a current account surplus in a stable manner, it is highly unlikely that Japan will face a Greece-like deficit problem in the foreseeable future," Nishioka said.
"Therefore, it is difficult to see a sharp and sustained spike in yields on Japanese government bonds stemming from rising risk premiums for holding JGBs," she added.
Still, some economists warn that Japan is gradually running out of time to put its fiscal house in order in light of the aging population and political instability -- Kan is the fifth prime minister in the past five years and his popular support has fallen to an historically low.
Public expectations were high in 2009, when the Democratic Party of Japan took power away from the Liberal Democratic Party with a full plate of policy reform promises.
But the DPJ's first prime minister, Yukio Hatoyama, barely stayed in office for 10 months, having failed to cut the deficit by simply slashing "wasteful" spending.
"The government of Japan has a poor ability to control its purse; most housewives are much more capable than that," said Mitsuru Saito, chief economist at Tokai Tokyo Securities.
"If you keep spending twice as much as what you are making, it would not be a surprise if you went under eventually," he added.
By the end of March 2012, the level of outstanding Japanese government bonds will total Y668 trillion, 138% of projected gross domestic product, according to an estimate by the Ministry of Finance.
Japan's total outstanding long-term debt, including JGBs and municipal bonds, is estimated to total Y891 trillion, 184% of projected GDP.
As a result, Japan will remain the most heavily indebted industrialized nation, dwarfing gross public debt held by Greece.
Japan, hypothetically, needs to make interest payment on its government bonds of Y27.2 billion each day during the year to March 31, 2012, with the annual interest bill expected to reach Y9.9 trillion in the current term.
The warning from the credit rating agencies also came as the public approval ratings for the cabinet of Kan tumbled after the minor cabinet reshuffling last month failed to boost confidence in the government's ability to push key budget and tax bills through the hung parliament, with the upper house controlled by the opposition.
The approval rating for the cabinet dropped to 19% in a weekend poll conducted on Feb. 19 and 20 by the Mainichi Shimbun newspaper, down from 29% in its January survey.
The reading was the lowest since the Democratic Party of Japan took power away from the Liberal Democratic Party in September 2009 and it also fell below the key 20% mark which often resulted in the resignation of past prime ministers.
Kan took office in June last year after Hatoyama resigned, with his public support slumping to the 20% threshold after he failed to secure the relocation of a controversial U.S. air base on the southern island of Okinawa, one of several broken promises.
The Mainichi poll also found that the disapproval rating for Kan's cabinet rose 11 percentage points to 60% in the wake of the reshuffling of the cabinet last month and that some 60% of respondents said Kan should call a snap election.
"Apparently, Japanese citizens are losing confidence in the DPJ's ability to make changes to Japan's administration system and prospects for the nation's economy," Saito said.
"And as they are losing their trust in Kan, they can't possibly accept any proposal for hiking the sales tax rate from the current 5%, which is the ultimate measure to fix the budget problem," he added.
Kan last month called for cross-party discussion on tax reforms, which include a possible increase in the sales tax rate, but none of the opposition parties has so far accepted.
The opposition New Komeito party has decided to vote against legislation needed to issue deficit-financing bonds to pay for the child care subsidy in the fiscal 2011 budget even if Prime Minister Kan agrees to step down as part of the bargain, the Nikkei newspaper reported today.
New Komeito decision came after the main opposition Liberal Democratic Party and Your Party decided to reject the government's budget-related bills, leaving little room for the bills to get through the opposition-controlled upper house.
The Social Democratic Party is also expected to formally announce its opposition to the budget legislation.
"Unless Japanese financial markets went berserk in a way that can spook politicians, they won't make any constructive compromise on a drastic tax reform," RBS's Nishioka predicted.
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