The end of Japan's negative interest rate policy could stabilize sovereign credit support, if further monetary policy tightening progresses smoothly. The benefits are clear. Higher interest rates and consistently positive inflation could boost banks' financial performances and fiscal revenue. The Bank of Japan (BOJ) also regains short-term interest rates as a policy tool after years of relying on less conventional monetary instruments. This could improve confidence in its ability to manage economic and financial volatility.

In this scenario, the stability of the sovereign ratings on Japan (A+/Stable/A-1) could benefit from consistent economic support. External and monetary assessments, already-strong rating factors, could strengthen further. And there's an increased likelihood of successful fiscal consolidation, resulting in an improvement in budgetary performances.

The journey to higher interest rates has some risks, however. Government revenue growth may not keep up with increased interest payments. Weak business borrowers may not be able to cope with higher debt servicing. And yen-funded foreign investments may unwind abruptly to hurt economic and financial stability.

Consequently, S&P Global Ratings believes the credit impact of the long-awaited monetary tightening in Japan is still dependent on how the BOJ manages it and on a more-or-less favorable external environment.

Positive Policy Rate Equals Positive Credit Implications?

The March policy rate increase is a major milestone for the Japanese economy. It marks the first time since the late 1990s that the central bank no longer considers deflation a serious threat. Instead, it believes that stable inflation--at rates close to its 2% target--is achievable by the fiscal year ending March 2026.

This could help government revenue grow more consistently. Largely owing to weak price trends, Japanese tax revenue did not consistently return to the level in fiscal 1997 until fiscal 2014 (see chart 1). This was when the sales tax rate rose to 8% from 5%. Tax revenue showed another significant pickup, to 10%, in fiscal 2021, after a further tax rate hike in late 2019. If inflation stays persistently at about 2%, it could help revenue grow even without further tax rate increases. This helps reduce Japanese fiscal deficits from the elevated levels of recent years.

Chart 1

Monetary policy tightening could also lift banks' profitability and increase their willingness to fund businesses. Persistently low interest rates and large amounts of excess reserves on banks' balance sheets dragged on the financial performances of Japanese banks. Most are ranked among the least profitable banks in Asia-Pacific (see chart 2).

Weak profit margins could have constrained banks' appetite for risk, given their limited capacity to absorb the losses of defaults. The progressive reversal of monetary easing should lead to higher lending rates and a decline in excess reserves.

Chart 2

Higher policy interest rates should also afford the central bank more policy flexibility. By our assessment, the BOJ enjoys strong policy credibility. However, it ranks below other central banks--including those of the U.S. and U.K.--that issue what we regard as reserve currencies. An important reason is the prolonged period of weak price trends in Japan. This limits the bank's ability to employ short-term interest rates as a policy tool.

With interest rates at (or below) zero percent, the BOJ had to rely heavily on non-conventional monetary instruments. Over time, as the uncollateralized overnight rate returns as the main monetary policy instrument, it could improve monetary support for the Japanese sovereign ratings.

If the yen exchange rate rebounds with higher interest rates, economic support for the ratings could also be better anchored. In recent years, Japan has slipped in the relative ranking of per capita GDP (measured in U.S. dollars) due to the depreciating yen. This has not affected the sovereign ratings because we expect the exchange rate to recover as global interest rates return to lower levels.

Nevertheless, if Japan's average income doesn't recover over time, it could signal a structural loss of international competitiveness that would weaken sovereign credit support. A sustained recovery of the yen exchange rate would dispel such risks.

Much Depends On What It Does To The Budget…

But higher policy interest rates also come with credit risks. An important one is the increased interest payments that the government must pay on its very high heavy debts. Years of negative short-term interest rates in Japan meant that, in many recent years, budgetary interest costs have fallen even as the government borrowed more (see chart 3).

Chart 3

This upside is no longer possible now that yields across the Japanese Government Bond (JGB) yield curve are positive. For fiscal 2024, the Japanese government has budgeted for interest payments to be ¥9.7 trillion. This is more than a third higher than the ¥7.1 trillion actually paid in fiscal 2022.

The Ministry of Finance also estimated that, if Japan achieves average nominal GDP growth of 3% annually, interest payments in fiscal 2033 will rise to nearly 2.5x that in fiscal 2024.

How negatively this development affects sovereign credit metrics depends on future revenue growth and interest rate changes. The very weak fiscal performance in Japan should improve in the next few years as the economy continues its recovery and extraordinary government measures to help households mitigate rising costs come to an end. However, such improvements may be offset by pressures posed by disappointing revenue growth or unexpectedly large increases in JGB yields.

…And To Businesses Used To Low Borrowing Rates

The uncertainty over how well non-government borrowers adjust to rising interest rates also poses risks to sovereign credit support. As of June 2024, more than 70% of Japanese bank lending paid interest at rates of below 1% (see chart 4). Lifting the bar a little higher, more than 90% of bank debtors enjoyed interest rates of below 1.75%.

Chart 4

Even before the policy rate increase in March, banks were paring down loans with the lowest interest rates. Since then, they have also been cutting down loans in the next higher interest rate category (see chart 5). Lending rates, long on a declining trend for most borrowers, will continue to rise as banks reset interest rates amid expectations of further monetary tightening.

Chart 5

Many businesses may face cash flow difficulties if borrowing rates increase much more. Bank loans to small enterprises account for around 40%of total loans and two-thirds of business loans. Most of these enterprises likely service the domestic economy that has been growing slowly over much of the past two decades. If many of them fail as their interest payments escalate in the future, the social repercussions may mean that the government will have to delay fiscal consolidation again.

Deft Adjustments From The BOJ Also Help

The market volatility of early August highlights another risk of further monetary tightening in Japan. The higher interest rates in other advanced economies since 2022 have sparked significant outflows of Japanese funds. It is likely that some investors have borrowed yen to finance their investments elsewhere, since borrowing rates are low.

Another sharp reversal could cause financial volatility that brings wider negative impact on the Japanese economy. While some of the more leveraged investment positions have reportedly been unwound during the August market turmoil, risks could build again if the current market calm persists. In an environment of monetary easing in most other major economies, such leveraged investment positions complicate the BOJ's future monetary tightening further.

If the central bank's communication is misunderstood, further interest rate hikes could create pressures on economic and fiscal metrics.

Recent Research

• Japan's Long Wait For Sustained Inflation Is Likely Ending, April 17, 2024
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• Asia-Pacific Sovereign Rating Trends Midyear 2024: Fiscal Strains Rise, July 25, 2024
• Japan 'A+/A-1' Ratings Affirmed; Outlook Stable, March 28, 2024
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