The bond rating agencies are yet again considering a move to downgrade
Japanese sovereign debt. It is no secret that the Japanese economy remains
moribund, facing its third recession in a decade and with rising unemployment,
price deflation, and persistently stagnant growth. And in spite of near-zero
interest rates, large fiscal deficits, and a series of economic reforms, the
prospects for recovery remain dim. However, anyone who understands the nature
of sovereign debt knows that none of these factors should play any role in
assessment of default risk on local currency denominated sovereign debt of any
nation with a floating exchange rate.
Moody's Investors Service last downgraded Japan's yen-denominated bond rating
to Aa3 from Aa2 in December, 2001. At the time, the rating agency justified
its move on the basis of "fiscal strains that will likely persist owing to the
country's on-going economic weakness and the elusiveness of effective policy
remedies." It also hinted that if the country's economic outlook remained
negative, it would consider further downgrading-which it now seems to be
prepared to undertake.
What is the logic used in downgrading sovereign debt? As a report from Mizuho
Securities says, "Moody's and other prominent foreign credit agencies have
used historical default ratings for corporate entities.... On the other hand,
regarding sovereigns (particularly highly rated OECD countries) there is a
lack of data which would provide a statistically (sic) explanation as it does
for the corporate sector."
(www.mizuho-sc.com
/english/ebond/reports/mi010910.html) John A. Bohn, president of Moody's,
explained that a "rating is at bottom an opinion. At Moody's Investors
service.... This opinion is defined as the future ability and legal obligation
of an issuer of debt to make timely payments of principal and interest on a
specific fixed-income security. Our rating measures the probability that the
issuer will default on the security over its life...." (Bohn 1995,
www.cipe.org/ert/e15/across.php3) He went on to argue that the likelihood of
default for an Aa2-rated debt should be the same across issuers, without
regard to "a borrower's country, industry, or type of fixed-income
obligation". Hence, it is clear that the primary consideration used in
determining whether to downgrade sovereign debt-or any other debt--must be an
assessment that risk of default has increased. And Japan's default risk has
supposedly risen because its persistent government deficit has increased
"fiscal strains" by raising debt-to-GDP ratios.
However, a sovereign nation that issues government debt denominated in the
home currency will never experience difficulty in "making timely payments" so
long as it lets its currency float. All such sovereign nations spend by
crediting banking system reserves. Hence, the large Japanese fiscal deficits
resulting from government purchases and interest payments lead to large
reserve credits for the banking system. If nothing further were done, these
credits would just sit in the banking system as excess reserve holdings.
However, most of the created excess reserves are actually drained from the
banking system through treasury sales of new JGBs. The result of such sales is
to provide banks with an interest-earning alternative to non-interest-earning
bank reserves. (It is telling that in spite of the largest budget deficits
among OECD nations, Japan's overnight interest rate is the lowest. It
accomplishes this by leaving some excess reserves in the banking system.) The
government could at any time stop issuing new sovereign debt and simply leave
more excess reserves in the system. This would also reduce the government's
net interest payments. Given the state of the Japanese economy and the lack of
safe domestic assets that earn a positive return, such a policy would likely
depress growth further. Nor is it likely that the government would ever need
to pursue such a policy, for the banking system would almost assuredly prefer
earning assets over non-earning excess reserves. But in any case, the
government will always be able to pay interest (and roll-over principal)
simply by crediting bank reserves.
Note that one can think of sovereign debt as nothing more complicated than
reserves that pay interest. In all modern nations that operate with a domestic
currency and a floating exchange rate, governments spend by issuing reserves
without promising to convert those reserves to anything. This is quite
different from a nation that operates on a gold standard, with a currency
board, or on a fixed exchange rate, in which case the government essentially
promises to exchange reserves for gold or a foreign currency at a fixed
exchange rate. Such a nation faces the possibility that it will run out of the
required gold or foreign currency reserves-in which case it will be forced to
default on its promise to convert. However, countries like the US or Japan do
not promise to convert reserves of dollars or yen (respectively) to anything
at a fixed exchange rate. Hence, there is no possibility of default on
reserves. And because sovereign debt issued by a US or a Japan is really
nothing more than reserves that pay interest, there is no greater possibility
of default on sovereign debt than on reserves. It makes as much sense to rate
Japanese government home currency debt as it would to rate the Bank of Japan
reserves held by the Japanese banking system. Indeed, could one imagine that
a ratings agency would downgrade Japan's banking system reserves if the BOJ
decided to pay interest on excess reserve holdings? Yet, such a policy would
eliminate the Treasury's need to issue JGBs to soak up excess reserve
holdings.
This should make it clear that Japan's "deteriorating" fiscal deficit and
rising government debt ratios are not relevant to the probability of
involuntary default. Unlike a corporation, which must (eventually) obtain
revenues to service its debt, the issuer of a currency does not need revenue
to credit interest or roll-over principal. The Japanese government will be
able to service its debt regardless of fiscal deficits or debt ratios. Note
that by this we do not mean to imply that a sovereign nation should run large
deficits in all circumstances, nor do we deny that there might be negative
consequences of large fiscal deficits (such as inflation, although that is
highly unlikely for Japan in the foreseeable future). What we do deny,
however, is that ability to service debt is in any way compromised by the size
or persistence of Japanese government deficits. According to Moody's own
reports, it uses assessments of "future ability and legal obligation" to make
payments when it decides to downgrade sovereign debt. By this standard, credit
agencies have already erred in downgrading Japan's debt in the past, and there
is no reason for further downgrades.
Finally, it should be clear that this analysis does not apply to private
sector debt; the ratings agencies have accumulated an immense amount of data
on private defaults and we do not question their logic in rating nonsovereign
debt. In addition, there is no doubt that foreign holders of Japanese
sovereign debt face currency risk, and it is possible that fiscal deficits
might be related in some complicated way to currency values. However, by their
own admission, the ratings agencies are rating default risk, not currency
risk. Fluctuation of the foreign exchange value of the yen cannot affect
default risk on home currency denominated sovereign debt. Thus, currency risk
should be included in assessments only of foreign currency denominated
sovereign debt-such as dollar denominated Argentinian sovereign debt. Finally,
one might distinguish between ability to pay and willingness to pay. It is
conceivable that a sovereign issuer that has the ability to service its debt
might instead choose to default-perhaps for political reasons-as Russia did.
We believe it is inconceivable that any major OECD nation would voluntarily
choose to default on sovereign debt. If Moody's and other rating agencies
believe that Japan has become more likely to voluntarily default on home
currency sovereign debt, they should present some argument in justification
for this belief.
In conclusion, we believe that ratings agencies have seriously erred in their
assessment of home currency denominated debt issued by sovereign governments
that operate with floating exchange rates. All such debt should receive the
highest rating, if the ratings agencies follow their own guidelines for
generating ratings, for the simple reason that involuntary default is not
possible. We urge ratings agencies to be consistent in applying their ratings
criteria for sovereign debt denominated in domestic currency. 
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