Moody's Investors Service cut its rating on Japan's government debt by one notch to AA3 Wednesday, blaming large budget deficits and a buildup of debt since the 2009 global recession.
The ratings agency also warned that frequent changes in Japan's government have hampered its ability to tackle the problem of bulging debt as Tokyo prepares for its sixth leader in five years.
Over the past five years, frequent changes in administrations have prevented the government from implementing long-term economic and fiscal strategies into effective and durable policies, Moody's said.
Unpopular Prime Minister Naoto Kan confirmed Tuesday he would step down as head of the ruling Democratic Party of Japan within the week.
Moody's had warned in May that it might downgrade Japan's Aa2 rating due to heightened concerns about its faltering growth prospects and a weak policy response to deal with bulging public debt, now twice the size of its $5 trillion gross domestic product.
Analysts said the downgrade was hardly a surprise and the bond market reaction should be muted.
I had expected that the rating cut would have taken place after the election for the leadership of the Democratic Party of Japan. But looking at the candidates, there seems to be nobody among them who would seriously tackle financial reform, so that's why Moody's went ahead and cut the rating, said Yuuki Sakurai, CEO and president of Fukoku Capital Management Inc.
Moody's probably took the view that Japan's finances will continue worsening.
The yen barely moved on the news, trading at around 76.7 against the dollar.
Several factors make it difficult for Japan to slow the growth of debt-to-GDP and thus drive this rating action, Moody's said in a statement, adding that the March 11 earthquake and ensuing nuclear crisis had exacerbated Japan's problems.
Still the ratings agency said the outlook was now stable given the undiminished home bias of Japanese investors and their preference for government bonds, which allows the government's fiscal deficits to be funded at the lowest nominal rates globally.
The downgrade brings Moody's rating for Japan in line with rival agency Standard & Poor's, which cut Japan's rating in January to AA, the fourth-highest on its scale.
Moody's downgrade of Japan was its first since 2002, when it reduced the rating to A2, six notches from the top. It had upgraded Japan three times since then, with the last upgrade as recent as May 2009.
Persistent deflation and slow growth has shackled Japan's economy for years, reducing tax revenues available to the government, which has grown to rely on debt issuance to finance a large part of its budget.
(Reporting by Wayne Cole in Sydney and Nathan Layne and Rie Ishiguro in Tokyo; Editing by Ed Davies and Michael Watson)