Debt markets focus on Japan after U.S. downgrade

TOKYO Fri Aug 12, 2011 6:09am EDT

TOKYO (Reuters) - Debt markets are wondering which country's rating is next on the chopping block after Standard & Poor's stripped the United States of its top-notch AAA credit rating -- and speculation is growing that Moody's could downgrade heavily indebted Japan as early as this month.

"Investors had bought so called risk-free assets without much thought, but the U.S. credit downgrade awakened them to the possibility that the notion of safe havens may have been a myth," said Akane Enatsu, chief public sector credit analyst at Barclays Capital in Tokyo.

"The meaning of flight to quality is being questioned."

Although Japan's public debt is twice the size of its $5 trillion economy, Japanese government bonds (JGBs) have been recently underpinned by flight to quality amid the debt turmoil in Europe.

But investors are becoming wary that the expected resignation of beleaguered Prime Minister Naoto Kan will push up fiscal risk by opening the door for more reconstruction spending after the devastating earthquake and tsunami in March.

Against this backdrop, the pace of gains in JGBs has been slow relative to U.S. Treasuries and German Bunds, other debt considered safe havens. The benchmark 10-year JGB yield briefly dropped to a nine-month low of 0.975 percent on Tuesday but had pulled back sharply above 1 percent as of Friday, poised to end higher on the week.

By contrast, the U.S. 10-year Treasury note yield is on track to end the week down nearly 30 basis points.

In the credit default swaps (CDS) market, the five-year spread for U.S. sovereign debt had dropped back near 50 basis points as of Thursday from above 60 basis points reached at the end of July.

Japan's five-year CDS spread, on the other hand, has not declined, remaining stuck above 100 basis points.

"After the downgrade of U.S. debt, which is seen as a safe haven, the market is on the lookout for the next one ... one of them is France, because its banks' exposure to Greek debt is large, and the other is debt-ridden Japan," said a fund manager at a Japanese asset management firm.

In January, Standard & Poor's downgraded Japan a notch to AA minus, the fourth highest on its rating scale, from the third-highest AA, and reduced the outlook to negative from stable three months later.

WARNED IN MAY

Citing weak public finances and growth prospects, rival ratings agency Moody's put Japan on review for downgrade in May, saying that a lack of consensus between the government and the main opposition suggests a downgrade is likely after it completes a review over a three months period.

Moody's rates Japan at Aa2, the third highest on its rating scale, along with Italy.

But Japan may have a hard time following through with fiscal reform. Unpopular Prime Minister Kan this week signaled he is ready to resign after parliament made headway on key legislation. Analysts say Kan's successor is likely to face pressure to spend more, left with the task of reconstruction.

Raising taxes to help pay for reconstruction is one way of lessening the government's reliance on debt, although the topic remains a thorny issue as lawmakers could lose voter support if they were to champion the cause.

"The ruling party does not have a common view on the tax topic and neither does the opposition. The new administration could quickly lose public support if it insists on fiscal reform," said the fund manager at the Japanese asset management firm.

"There is also the risk of fiscal reform going out the window if the new administration falters and is forced to call a snap election soon after taking power," the fund manager added.

The yen's threatening to hit a record high against the dollar may also weigh on fiscal restructuring.

"Even a fiscal hawk like finance minister Noda will have his task cut out for him, as economic steps to counter the strong yen's negative impact on industry are likely to be justified easily," said Shunsuke Doi, a market analyst at SMBC Nikko Securities.

Finance Minister Yoshihiko Noda, who has backed Kan's push to cut public debt through fiscal reforms, is considered the top candidate to replace Kan.

(Writing by Shinichi Saoshiro; Editing by Chris Gallagher)

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