Standard & Poor's cut Japan's credit rating on Thursday for the first time since 2002, saying Tokyo had no plan to deal with its mounting debt, a warning that could rattle other heavily indebted rich countries.
The agency cut Japan's long-term sovereign debt rating by a notch to AA-minus, its fourth highest rating. It said an aging population, persistent deflation and the government's loss of its upper house majority compounded the fiscal challenge.
Politicians and ratings agencies have warned for years that Japan must cut its public debt, which is double the size of its $5 trillion economy -- by far the worst among rich nations.
Other developed countries are also struggling with high debt burdens. Outstanding U.S. public debt has ballooned to more than 60 percent of total output since the financial crisis, and with a record $1.5 trillion budget deficit expected this year, is set to grow further.
Emergency rescues for Ireland and Greece, meanwhile, have left some investors to reconsider whether it's always a safe bet to lend to rich governments.
If Japan fails to get its fiscal house in order, further downgrades will surely follow, said Julian Jessop, chief international economist at Capital Economics in London.
Given the size of Japan's economy and the current sensitivity of global financial markets to sovereign debt concerns, the impact would be felt worldwide, he added. It supports our fear that 2011 could be the year when Japan's dire fiscal position finally impacts markets both at home and internationally.
Japanese Prime Minister Naoto Kan has made tax and social security reform top priorities and the S&P downgrade adds pressure on him to galvanize a divided parliament.
The yen and Japanese government bond prices fell and the cost of insuring Japanese debt against default rose after the announcement.
S&P's rating for Japan is now one notch below both Fitch's and Moody's. It is on a par with S&P's ratings for China and Saudi Arabia and one notch below Spain's.
Fitch on Thursday said its rating was based on Japan's ability to fund itself, although a failure to reduce the country's fiscal burden could put pressure on its rating.
Moody's Investors Service reaffirmed its rating on Thursday. Both agencies have a stable outlook on Japan.
So far, fear of a Japanese default has been muted. Unlike the United States, which relies primarily on foreigners to finance its debt, Japan can draw on domestic savings. At some 1,400 trillion yen, household assets amount to three times the size of total output, more than enough to fund borrowing.
But Japanese society is aging quickly, and social welfare costs will take up an increasing proportion of the budget in the absence of reforms, a trend that S&P said reduces Japan's already weak fiscal flexibility.
The downgrade reflects our appraisal that Japan's government debt ratios -- already among the highest for rated sovereigns -- will continue to rise further than we envisaged before the global economic recession hit the country and will peak only in the mid-2020s, S&P said in a statement.
Japanese yields rose only slightly, with the 10-year note up 2 basis points to 1.250 percent.
But that could change.
Japan's finances have steadily worsened since the last downgrade, one trader said. Yields look to go up going forward, not down.
Tim Condon, head of research in Asia for ING Financial Markets, said the long-term risk comes from Japan's death-spiral demographics, adding the downgrade could be bad news for U.S. and European sovereign debt because it spotlights their weak public finances.
Japan's debt started to swell in the 1990s as the country tried to revive its economy after a property bubble burst. Other developed countries have added to their public debt to help their economies get through the global financial crisis.
Doubts about the solvency of some euro zone governments led investors to punish Greek and Irish government debt last year, ultimately forcing an emergency rescue from the European Union. That crisis raised doubts about the future of the euro and fears that Portugal and possibly even Spain may need help as well.
Spanish, Irish and Italian bonds yields were higher on Thursday. S&P's move on Japan also pushed credit default swaps on triple-A rated debt higher, with the spread on German credit default swaps hitting the highest level since March 2009 at 63 basis points.
The United States holds a coveted top triple-A credit rating from all three agencies, though Moody's warned last month that a swelling budget deficit could move it a step closer to a downgrade in the coming two years.
The U.S. Congressional Budget Office said this week the budget gap would hit $1.48 trillion in fiscal 2011 and outstanding public debt swell to 70 percent of output.
Alan Wilde, who helps manage $50 billion at Baring Asset Management, said S&P's downgrade reinforces his instinct to steer clear of most developed country sovereign debt.
We have been underweight Japanese government bonds for several years because of the high debt burden and glacial pace of fiscal reform, he said. But the outlook is hardly better anywhere else.
High-yield, hard-currency corporate debt is a more attractive investment, he said, adding those who must buy sovereign debt should focus on fiscally healthy countries such as Canada, Australia, Singapore and Malaysia.
Japan's outstanding long-term government debt is set to reach 869 trillion yen ($10.57 trillion) at the end of March this year, or 181 percent of total output, Japan's Ministry of Finance says.
If short-term debt is added, Japan's liabilities will hit 204 percent of output this year, compared to 137 percent for Greece and 113 percent for Ireland, according to figures from the Organization for Economic Cooperation and Development.
The government plans to issue a record 144.9 trillion yen in bonds in the fiscal year that starts on April 1, which would exceed tax revenue for the second year in a row.
This month, Economics Minister Kaoru Yosano warned that Japan faced a fiscal dead end. He said on Thursday the S&P move was regrettable.
Prime Minister Kan is pushing for a debate on increasing the national sales tax as a way to pay for welfare costs. At 5 percent, the tax is among the lowest in major economies.
The chairman of Nomura Holdings, Junichi Ujiie, said the downgrade offered Kan's government an opportunity.
It will make it easier for Yosano to push through laws on fiscal reform, Ujiie said on the sidelines of the World Economic Forum in Davos. Foreign investors might short-sell but they don't hold very much -- only around 5 percent. I don't expect turmoil in markets.
(Reporting by Tokyo bureau: Additional reporting by Steven C. Johnson in New York; Writing by Alex Richardson and Neil Fullick; Editing by Leslie Adler)