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Japan faces risk of ratings downgrade over debt

Fitch Ratings warned Japan to keep to its borrowing target or risk a credit rating downgrade as the finance minister acknowledged the problem and tried to reassure rattled investors by saying spending had to be cut.

Japanese sovereign credit default swaps spreads have nearly doubled in the past week as investors fretted that the government faces a funding crunch over its ballooning public debt, which the International Monetary Fund says will spiral to 227% of gross domestic product next year, by far the worst in the G7.

The fiscal pain is causing public concern in Japan and is building into a major test of the new government, which is trying to reconcile a slump in revenues owing to the global downturn with ambitious spending plans.

The government has said it plans to borrow ¥44 trillion ($490 billion) in the 2010/11 fiscal year starting next April, which would be on top of expected record issuance this fiscal year of more than ¥50 trillion.

But Fitch Ratings said it's hard to see how the 2010/11 goal will be achieved and borrowing much more than ¥44 trillion would spark a ratings review.

“To be frank, at this point it is quite hard to see how they are going to maintain the ¥44 trillion,” David Riley, co-head of global sovereign ratings at Fitch, told Reuters Television in an interview.

“It's not the sole determinant that will drive our assessment but other things being equal, then I think that would prompt us to review Japan's current double AA-minus rating.”

Reflecting investor concerns over the government's budget, yields on benchmark 10-year Japanese government bonds hit a five-month high on Tuesday of 1.485% and the JGB yield curve is its steepest in over three years.

Apart from the sharp move in the CDS market, the interest rate swap curve has hit its steepest level in four years as investors believe bond investors may start to choke on swelling debt issuance by the government.

“The rise in yields likely reflects uncertainty about the budget,” Finance Minister Hirohisa Fujii told reporters after a cabinet meeting.

“I'm concerned about the rise in yields. It is most important that we do not lose the trust of the bond market. We will simply have to cut spending,” he said.

He reiterated that he wanted to limit JGB issuance in the fiscal year starting next April to ¥44 trillion. December 10-year JGB futures rose 0.10 point to 137.48 following his remarks.

“This was the kind of comment the market needed as the authorities had not shown too much concern over the recent rise in rates,” said Katsutoshi Inadome, a fixed-income strategist at Mitsubishi UFJ Securities in Tokyo.

“But the market will need more reassurance as investors await developments in the government's upcoming issuance plans,” Inadome says.

The government is working to cut back on ministry budget request to spend a record ¥95 trillion in 2010/11.

A poll on Tuesday showed that support for the two-month old government had slipped eight points to 63%.

The Yomiuri poll found 85% of voters said they would rather see the government break some campaign promises than let public debt rise further.

Japan's debt burden is the worst among major economies at 170% of gross domestic product. It is currently offset by low interest rates but conditions may not remain so benign, Standard & Poor's analyst Takahira Ogawa said on Monday.

S&P's rating on Japan is AA, two notches below its top rating. The agency noted a lack of detail in the government's plans to make budgetary allocations more efficient and effective.

A ratings downgrade would raise borrowing costs in Japan to reflect the perceived higher risk and threaten a recovery from the country's worst recession in decades.

Still, analysts said the chances of a downgrade were relatively low as about 92% of JGBs are held by Japanese investors.

“Yields are determined by domestic investors and they are a captive market, so the doomsday scenario will likely be avoided,” said Dariusz Kowalczyk, chief investment strategist at SJS Markets Ltd in Hong Kong.

“A downgrade could prompt a rise in yields, but it's probably not the case that yields will rise to a level that reduces investment.”

Kowalczyk added that 10-year JGB yields are still relatively low at around 10 basis points above the average yield over the past 12 months of 1.365%.

The Democrats rode to power in an election in August pledging to pay out household allowances, make high schools free and abolish surcharges on cars and gasoline.

But the new government's spending schemes look increasingly in doubt as its efforts to root out wasteful spending came up with less than half of the funds its said it would need for its policies in the first year of the new administration.

The government is also under pressure to rein in its spending plans as they will likely have to issue a record amount of JGBs this fiscal year to cover a tax revenue shortfall that may be ¥6 trillion yen or more. (Reuters)