Sliding prices, massive bad loans at banks and mounting government debt continue to threaten Japan's sovereign debt rating, which could be downgraded within two years, Standard and Poor's said yesterday.
At the same time, progress in tackling the nation's economic woes would support the rating at its current level and could lead to an upgrade of Japan's outlook, said S&P credit analyst Takahira Ogawa.
The rating agency affirmed Japan's AA-minus long-term rating -- the weakest of the Group of Seven rich countries -- and A1-plus short-term local currency ratings, with the outlook remaining negative.
"In the short term, it will be very difficult for Japan to deal with its pressing problems: to overcome deflation; to improve banking sector non-performing loans [NPLs]; and to stabilize fiscal deficits and the debt burden," Ogawa said in a statement.
"If deflation is not contained, banking system NPLs and government finances will deteriorate and undermine the ratings on the sovereign," he warned.
The negative outlook means S&P may downgrade Japan's sovereign rating within one or two years "if ... things go on as they are," Ogawa said later by phone from Singapore.
"But if there are good developments in economic policy, if Japan can come out of deflation [the rating] might stay," he said, adding that the outlook could also be raised.
Japan remains the world's second-largest economy with net foreign assets worth a staggering yen1.46 trillion, a strong current account surplus and a widely-traded currency, S&P noted.
Other positive factors include the nation's highly skilled workforce, world-leading manufacturing industry and high savings rate, the agency said.
But deflation, which hurts corporate profits and deters consumer spending as people wait for prices to fall further, has aggravated Japan's fiscal and financial problems since the middle of the 1990s.
Government debt -- which at around 140 percent of GDP is the highest among industrialized nations -- is expected to grow, while Japanese banks remained buried under huge bad loans.
The government has instructed banks to halve the ratio of bad loans on their accounts by March 2005 and re-evaluate other assets -- a move that prompted regional lender Resona Holdings to ask for a government bailout last month.
S&P is wary about whether the banks will return to health.
"Japan still cannot find its way out of deflation, which is exacerbating the banking sector's non-performing loans problem," it said.
"Deflation is also negatively impacting economic growth, which in turn delays fiscal consolidation," it said.
A change in the Bank of Japan governor last March offered a glimmer of hope that monetary policy may be stretched further to provide help, Ogawa said.
"Nevertheless it is rather difficult for only the Bank of Japan and monetary policy to help Japan come out of deflation," he warned.
"You need policy coordination with the government and the Bank of Japan. Unfortunately the government side is less flexible," he said.