Japan and the United States faced new pressure to confront their swollen budget deficits as the IMF and rating agencies demanded more evidence they can bring their public debts under control.
The International Monetary Fund said the G7's two biggest economies needed to spell out credible deficit-cutting plans before the markets lose patience and dump their bonds.
On Friday, Japan's Prime Minister Naoto Kan vowed to push ahead with tax reforms aimed at curbing the country's debt, but an uncooperative opposition and divisions within his own party on policy make the chances of success slim.
The important thing is to maintain fiscal discipline and ensure market confidence in Japan's public finances, Kan, who took over in June as Japan's fifth premier since 2006, told parliament's upper house.
Ratings agency Standard & Poor's cut Japan's long-term debt rating on Thursday for the first time since 2002, and hours later Moody's Investors Service warned the risk of the United States losing its top AAA rating, although small, was rising.
Bond markets reacted calmly, but the latest warnings about the colossal liabilities piled up by the two countries raised fears of rising borrowing costs that could hamper attempts to restore fiscal discipline and consolidate a fragile recovery.
In advanced economies where fiscal sustainability has not been a market concern, credible plans going well beyond 2011 need to be put in place urgently to lock in benevolent market sentiment, the IMF said in its Fiscal Monitor report.
The 2007/08 financial crisis prompted a dramatic rise in developed world debt, as governments spent billions of dollars propping up sinking economies and bailing out stricken banks.
In the United States, outstanding 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.
Japan is in an even worse position. Its debt has been growing for years as it tried to revive the economy from a huge asset bubble burst in the 1990s and outstanding long-term government debt now stands at around 180 percent of GDP.
Kan has made tax and social security reform, including a future rise in the 5 percent sales tax, a priority given the rising costs of Japan's fast-aging society and a public debt that is the biggest among advanced nations.
In Europe, where Greece and Ireland have been driven by bond market pressure to take bailouts, many governments have adopted austerity measures to cut their deficits.
But the IMF said new tax cuts in the United States and increased spending in Japan had set back progress in rich nations more generally. Ratings agencies fretted that politics is making reining in the deficit harder for both countries.
Moody's worried that a U.S. Congress where the Republican now control the House of Representatives might fail to consider and pass some of the deficit-reducing measures proposed by a panel mandated by Democratic President Barack Obama.
S&P, which cut Japan's long-term sovereign rating to AA minus, voiced similar concerns about Tokyo.
In our opinion, the Democratic Party of Japan-led government lacks a coherent strategy to address these negative aspects of the country's debt dynamics, in part due to the coalition having lost its majority in the upper house of parliament last summer, the agency said.
The debt fears hanging over much of the developed world underlined the two-speed recovery from the financial crisis, which has seen emerging economies rebound strongly, especially in Asia, while the traditional powers struggle.
People are realizing that emerging markets are not as dangerous as other places, in light of what has happened, Mark Mobius, chairman of Franklin Templeton's Emerging Markets Group, told Reuters in Singapore.
Emerging markets are still cheaper than developed markets despite the run up, and we see continuing flows into emerging markets.
NO CRISIS YET
The reaction of bond markets indicated there is no immediate crisis on the horizon for the United States or Japan, with the former protected for now by its status as issuer of the global reserve currency, while Japan is sheltered by the fact its sovereign debt stock is overwhelmingly held by domestic investors with ample savings.
Japanese government bonds gained on Friday, recovering from a dip after the S&P downgrade, although the Nikkei share average fell 1 percent.
The immediate impact of the downgrade is negligible. It has long been accepted that Japan is in an unenviable fiscal situation, said Nobuto Yamazaki, an executive fund manager at DIAM Asset Management.
But the downgrade highlighted the fact that the government's ability to follow through with its policies is being questioned. This could be a negative factor waiting to kick in if the government starts running into trouble trying to push through budget-related issues.
U.S. Treasuries were little changed in Asian trade, with the benchmark 10-year note up 1/32 in price to yield 3.41 percent, down a basis point from late U.S. trade.
I don't think there is any risk that U.S. Treasuries will have difficulty finding a home and at a reasonable price at the moment. Particularly ... when the Fed is basically giving out money for free right now, said Roland Randall, senior strategist at TD Securities in Singapore.
There is a bigger picture of a slow decline in the perception that people have of whether the U.S. is a safe store of wealth or not. But that's a big long-term picture.
(Additional reporting by Kevin Lim in Singapore and Ian Chua in Sydney; Writing by Alex Richardson; Editing by Neil Fullick)