Japan May Suffer Drop in a Key Credit Rating

Moody’s Investors Service said Wednesday that it may downgrade Japan’s domestic credit rating by two notches, as pressure rises on the Japanese government to tame deflation and fix its economy.

Moody’s, which last shaved Japan’s debt rating in December, said it may cut the Aa3 rating on Japan’s yen-denominated debt further after a one- to three-month review of the country.

“In this particular case, there is a reasonable possibility that the downgrade might be two notches,” said Vincent Truglia, Moody’s managing director of sovereign ratings.

A one-notch cut by Moody’s to A1 would put the domestic debt rating of the world’s second-largest economy on par with that of the Czech Republic, Hungary and the Bahamas.

A two-notch cut to A2 would put it alongside Poland, South Africa, Cyprus and Latvia.

The news knocked the yen lower against the dollar, after a two-day rally. But the stock market rallied modestly, as investors bet the rating threat could spur true financial reform. The Nikkei 225 index rose 90.36 points, or 0.9%, to 9,968.35. The market sank to 18-year lows last week.

Prime Minister Junichiro Koizumi ordered his top economic advisors Wednesday to devise a deflation-fighting economic recovery plan by the end of the month, taking his first stab at major reform this year.

In particular, Koizumi is seeking a plan to reverse Japan’s continually falling prices, which undercut hope for a turnaround. “We must aggressively implement concrete and effective anti-deflation measures,” he said.

Economics Minister Heizo Takenaka said an outline decided Wednesday will target five policies already being pursued: getting rid of banks’ bad loans, stabilizing the financial system, re-energizing financial markets, helping small and medium-sized firms get loans and loosening monetary policy.

The weak state of the banking system has been a major issue in Japan. Banks are saddled with a huge number of nonperforming loans that they have been reluctant to write off.

Speculation that more government money may be needed to bail out the banks has grown in recent days. Public money was used during the 1997-98 financial crisis and afterward to prevent a banking meltdown.

Koizumi’s decision comes ahead of next week’s visit by President Bush, who is expected to lean on Koizumi to step up the pace of reforms.

Moody’s singled out Japan’s losing battle to stem a three-year fall in consumer prices, warning that deflation was eroding the government’s revenue base and making it harder for policymakers to tackle other economic problems.

“Deflation is the foremost challenge facing Japanese authorities, exacerbating overall credit risks throughout the economy as debt rises in real terms,” Moody’s said.

In addition to the banking system’s woes, unemployment is at a record 5.6%, exports are flagging, and government debt is the highest in the industrialized world, at more than 130% of gross domestic product.

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Reuters and Associated Press were used in compiling this report.