Downgrade is no insult to Japan

JAPAN'S Finance Minister is angry with Moody's. The credit ratings agency has again downgraded the country's government debt. Japan now ranks below Botswana, and Masajuro Shiokawa thinks his country has been insulted.

He is wrong. Investing in Japanese government bonds is very dangerous and Moody's would be at fault if it did not say so. But this does not mean there is a risk of default.

The bonds are issued in yen and the government owns the printing press. It can thus always repay maturing bonds, even if no one will lend it any more money. All it has to do is print some more of its smart 10,000 yen (£55) notes and exchange the money for bonds. No one can then claim a default has occurred.

Nonetheless, lending money to Japan is risky. The risk is inflation, not default, and it is a big risk because inflation is badly needed. Long-term government bonds normally give a real return of about 3.5%. We know this by looking at the yields on bonds, which are protected against the ravages of inflation. This is done by having their interest and redemption payments linked to indices of inflation, such as Britain's retail price index.

Several countries have issued this type of bond and all of them, with the interesting exception of Britain, are currently giving such returns. We also know these yields are not just today's rates, but long-term average ones. Professor Jeremy Siegel has shown that US bonds have given a 'real' 3.5% return, after inflation, over the past 200 years.

Today, the nominal return on 10-year Japanese bonds is 1.3%. This implies investors are expecting inflation to be minus 2% a year for a decade. One thing at least is clear. Either Moody's is foolish to be worried about inflation in Japan, or investors are about to lose an awful lot of money. Oddly enough, we should hope Moody's, rather than the bond market, is the better judge. If Japanese inflation proves to be minus 2% over that time scale, the chances of the country prospering are extremely slim.

In the past, countries have occasionally managed to flourish despite deflation but not when they have debt mountains, as Japan does today. Both the government and companies have huge liabilities. The national debt is now 140% of gross domestic product and the average Japanese company finances itself 75% with debt and 25% with equity. The underlying position is even worse, as companies own so much of each other's equity.

Many companies which show profits in their accounts are really making losses since the value of their assets is falling. Unless prices stop falling, more of them will go bankrupt and stop the economy from recovering. The government should not attack Moody's. It should be trying to prove the agency right, particularly since Friday's GDP data were a disappointment.

www.smithers.co.uk