At about 180% of GDP, Japan's government debt is by far the highest of any rated sovereign. "Fitch believes that current economic conditions will preclude any improvement in the fiscal balance in the short term, and the lack of political will to address the country's fiscal problems will hinder medium-term progress as well," said James McCormack, the agency's Head of Asia Sovereigns. The agency expresses doubt that the government will meet its objective of achieving a primary balance (the overall balance excluding interest payments) for the combined central and local governments by 2011. "In our view, policy initiatives to increase tax revenue are required if a primary balance is to be realised, but this is unlikely to happen in an election year when the economy is slowing," Mr. McCormack added. According to Fitch, Japan's government debt dynamics will remain unfavourable until at least 2010.
Fitch notes two important considerations in regard to Japan's international economic and financial integration, both of which partially mitigate concerns over the country's exposure to distressed market conditions elsewhere. First, although Japan's trade balance is deteriorating - consistent with the slowing of the global economy and the effects of the appreciating yen - the current account surplus continues to be supported by sizeable income inflows generated by extremely large external asset holdings. On a net basis, therefore, Japan retains the capacity to be a potential supplier of capital to the rest of the world, and benefits from a distinct advantage in terms of financial stability when the availability of short-term external funding is uncertain, as it has been lately.
Second, it is clear that Japanese credit markets and bank funding conditions have not been under the same stress as those in many other advanced economies. The Bank of Japan is committed to providing additional liquidity to the market, but it is not faced with the urgent need to restore interbank credit flows.
Fitch points out, however, that reasonable liquidity conditions and the lack of an external funding requirement may not necessarily rule out the need for an injection of public funds to support banks' capital positions. With large equity holdings, major banks are exposed to the sharp correction in Japanese equity markets, while smaller regional banks may face asset quality problems associated with more pronounced economic downturns outside the large urban centres. A government plan to set aside JPY2 trillion to recapitalise banks if needed is currently working its way through parliament.
