Japan, Taiwan, Korea, and China: Different Ratings, Same Fate?

Standard & Poor's rates both Japan and Taiwan 'AA' (references throughout refer to long-term foreign currency issuer credit ratings). Both ratings have a negative outlook. The Republic of Korea (South Korea, referred to here as Korea) is rated 'BBB+', the People's Republic of China (China), 'BBB'. Both of those ratings have a stable outlook.

The single variable that has the most explanatory power for these ratings is per capita GDP. Even adjusting for purchasing power, Japan and Taiwan's per capita GDP would be several multiples of that of China and still materially exceed that of Korea. Yet, as set out in Standard & Poor's article on sovereign rating methodology, "Sovereign Credit Ratings: A Primer" (available on RatingsDirect and on standardandandpoors.com/ratings, select Resource Center, Ratings Criteria, Sovereigns), per capita wealth is only one aspect of economic structure, which, in turn, is only one factor among 10 considered in each sovereign rating.

Political risk is a key ratings determinate. Japan enjoys stable, predictable political institutions with broad public backing. Since 1955, domestic politics has been dominated by the Liberal Democratic Party (LDP). Although the LDP has maintained a majority in parliament (the Diet) for almost all of the half century, fractiousness within the party has led to 27 governments during this period. Continuity of government, along with a resistance to change, has been assured by a highly trained bureaucracy - notwithstanding frequent changes of cabinets during the short-lived governments. The LDP, in turn, draws its strength from a collection of interest groups (such as farmers, doctors, lawyers, accountants, small retailers, and construction companies) that have benefited directly from its policies of agricultural support, restrictions on trade, and public works.

Although the LDP's internal constituency and the entrenched bureaucracy of the government impede the implementation of policies that would alter the status quo, Japan has all of the characteristics of a mature democracy, comparable in most ways to other Organisation of Economic Cooperation and Development (OECD) nations. In some respects, the strength of the social contract is greater in Japan than its OECD peers, due to the homogeneity of the population and the cultural emphasis on consensus.

Korea and Taiwan are also modern democracies, but differ from Japan in four respects.

In their favour:

Strengthening political checks and balances. Since the late 1990s, power has alternated to the former opposition party.

In their disfavour:

Shorter histories with democracy. Korea held its first democratic presidential election in 1988, Taiwan in 1996.

Serious external military threats. Korea faces a threat from the Democratic People's Republic of Korea (North Korea); Taiwan from China.

Sharp internal differences. In Korea, these run along regional lines; in Taiwan, they pertain to differences between ethnic Chinese who arrived from the Mainland in 1949, ethnic Chinese who have lived in Taiwan for generations, and indigenous peoples who have lived on the island for centuries.

Whereas Japan, Korea, and Taiwan are democracies, China is not. In China, political decision making is concentrated and less open to public scrutiny. Although China's leaders are undertaking structural reforms more aggressively than the leaders of Taiwan or Japan, the needs in China are more pressing and the consequences of reform, should it fail, are more dire.

Although Japan, Korea, Taiwan, and China are at different stages of development, as encapsulated by per capita GDP, the structure of their economies shares certain common features. All have strong export sectors, and high savings and investment rates. Compared with other countries of comparable wealth, all have far improved their indicators for health and education.

They also share certain weaknesses. All grew out of (and still follow, to varying extents) a state-led development policy, which often was effected through the allocation of credit. Whereas this policy raised the level of monetization of the economy, as measured by domestic credit to GDP, the quality of bank lending has been poor; all, therefore, face large contingent liabilities from their financial systems. (In Korea and Japan, some of these liabilities have already been transferred to the public purse; the shoe has yet to drop in China and Taiwan.) Some of this bad lending in all four countries has been undertaken for political reasons, in order to nurture national corporate champions or to promote sectorial or regional development.

These public-policy loans have been extended both by state-owned banks and by privately owned banks under government suasion. Financial repression in these countries has abetted this misallocation of resources.

Growth prospects vary for the four countries. Although Standard & Poor's has questioned the quality of China's economic growth (see "China's Clairvoyant Economic Statistics," available on RatingsDirect and on standardandandpoors.com, select Forum, Ratings Commentary, Sovereigns), China should still post higher real growth figures than Japan, Korea, or Taiwan as it presses ahead with its ambitious reform agenda and continues to attract foreign direct investment (FDI). Much of that FDI is coming from Taiwan, whose own manufacturing sector is losing some of its competitiveness.

As much of the profits from Taiwan's investments in China are either being reinvested on the Mainland or kept offshore - as opposed to being invested in new enterprises in Taiwan - the island's own growth prospects (GDP as opposed to gross national product) have been reduced.

Korea's medium-term growth prospects depend upon the success of the government's reform agenda, and several key corporate transactions are currently stalled, as the chaebol attempt to delever and to refocus on core competencies. Japan's economy has contracted 3% in nominal terms since 1997. Without more forceful private-sector restructuring - closing down unprofitable business lines in corporations, writing down debt, foreclosing on insolvent companies and banks, removing inept management - Japan's growth prospects will continue to be dismal.

The fiscal positions of the four governments vary. Japan has been running general government deficits in excess of 5% of GDP since 1995. This fiscal stimulus has been ineffective in boosting growth due to the problems in the country's banking system. With gross general government debt to GDP forecasted at 165% at fiscal year-end March 31, 2003, and with the ratio not likely to crest before the end of the decade, Japan has no more scope for additional fiscal easing.

Both China and Taiwan are also running accommodative fiscal stances. In the case of China, general government debt to GDP (not counting likely future required assistance to the banking sector) is low, projected at 27% at year-end 2002, although one can question the effectiveness of government spending.

Korea entered the Asian crisis with a long track record of controlled government expenditure (if rampant quasi-fiscal activity). It was able to pursue a successful counter-cyclical fiscal strategy, which partly accounted for its strong rebound in growth. However, Korea faces a unique contingent fiscal risk: the potential of a sudden collapse of North Korea. The implosion of this autarchic government could cost Korea several times its GDP in unification costs.

Monetary policy is another important rating category. Japan faces the most severe deflationary pressures of all rated sovereigns. Its wholesale price index has recorded price declines since 1991 (excluding the 11-month period up to February 1998 and six months in early 2000), its consumer price index (CPI) since the second quarter of 1998. Part of the pressure stems from productivity gains in the technology sector and benefits from outsourced production, although most of the pressure is more insidious. Delays in private-sector reform have had two negative effects:

They have rendered the credit channel ineffective for multiplying the monetary impulse of near-zero nominal overnight interest rates. Bankers are simply unwilling to increase lending due to capital constraints imposed by their large stock of impaired assets and due to a dearth of viable lending opportunities.

In thwarting asset prices from quickly finding a clearing level policymakers have only engendered a steady deflation of the balloon instead of a pop, weighing on consumer and investor sentiment.

Although neither China nor Taiwan suffered asset price inflation to the same extent as Japan, problems in their own banking systems also blunt the effectiveness of monetary policy.

Another aspect of monetary policy is the flexibility derived from having a key currency. Japan enjoys this flexibility, while the other three governments do not. Although capital account and currency restrictions have been greatly eased in Korea since the Asian crisis, the Korean won is still a shallow foreign currency market.

The New Taiwan dollar is not an international currency, and the Chinese yuan is not convertible.

All four countries boast a very strong external position. All are net external creditors (public- and private-sector combined). Of course, part of this position derives from the competitive export sector in all four countries, but other factors are at work as well. In the case of Japan and Taiwan, their current account surpluses, which have averaged 15% and 5%, respectively, of exports during the past five years, reflect their aging populations (and, hence, the natural propensity of older citizens to save) and falling investment (albeit from high levels), which, in turn, stems from diminishing rates of return.

Balance of payment surpluses in China, and, to a lesser extent, in Taiwan, have been bolstered, in part, by strict capital account controls. Korea has been husbanding reserves, in part to restore an eroded external position after the Asia crisis and in part to staunch a further appreciation of the won. China and Korea (the latter beginning with the Kim Dae-jung Administration) have been recording net FDI inflows. These investments have served as catalysts for economic restructuring, bolstering growth.

The sum of these credit strengths and weaknesses, constraints, and supporting factors is expressed in Standard & Poor's ratings, and prospective credit trends in outlooks. What would it take, then, for these ratings to move?

More than anything else, changes in ratings for these four governments will turn on the results of their reform agendas. Can Japan and Korea press ahead with private-sector reform? Can Taiwan and China reform their banking sectors and modernize their tax systems? Or, more generally, can policymakers in these four governments forge a consensus and a sense of urgency with their populations and then follow through?

The outlooks on the ratings of the four governments reveal Standard & Poor's projections on the medium-term prospects for reform. In the case of Japan and Taiwan, the outlooks are negative; if reform efforts are derailed or delayed, the ratings will fall. In the case of Korea and China, the ratings will not rise without further progress on these structural impediments. The middle ground, the 'A' category, could host both the courageous and the timid in the quest for reform.

Research assistance: Daria Alexeeva, New York, (1) 212 438 7346

Analyst: John Chambers, CFA, New York (1) 212-438-7344; Takahira Ogawa, Singapore (65) 6239-6342; Joydeep Mukherji, New York (1) 212-438-7351; Ping Chew, Singapore (65) 6239-6345

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