The massive earthquake and tsunami that hit northeastern Japan on March 11, and the continued destructive threat posed by the worsening failures at the Fukushima nuclear power plant, have provoked a cautious response from the three leading credit rating agencies.
Standard & Poor’s says it is too early to judge the implications for Japan’s AA- sovereign credit rating. Much will depend on the “overall macroeconomic impact of the earthquake, the pace and duration of reconstruction, and the impact on fiscal deficits”, said S&P’s credit analyst Takahira Ogawa on March 15. The greatest uncertainty relates to the country’s safe shutdown of its nuclear reactors and its future energy supply.
Ogawa pointed out that the 1995 Kobe disaster cost Japan ¥16.3 trillion ($159 billion) from 1995 to 2000 and the bill this time will be “significantly higher”. The country’s rating could possibly come under threat if the debt burden were to turn out “materially above our pre-earthquake expectations”.
The reaction of credit markets has been less circumspect. Japan’s sovereign credit default swap (CDS) spread widened from 79 basis points before the earthquake, to a record 125bp on March 15. The Markit iTraxx Japan index, representing the cost of insuring the debt of 50 Japanese investment-grade borrowers, surged 30 basis points to a record 144bp on March 15, before falling back yesterday.
Nevertheless, S&P says that the markets should be able to absorb extra central government debt without a big increase in risk premiums. But, a question mark hovers over the ability of the government to push ahead with its earlier fiscal and economic reforms on the back of recovery once it has tackled the immediate challenges of the disaster.
Moody’s Investors Service, which rates Japan Aa2 and changed its outlook to negative from stable less than a month ago, agrees that a fiscal crisis isn’t imminent. For the time being, at least, the country’s deep and liquid government debt market has room to fund government deficits at an “exceptionally low cost”. Indeed, “reconstruction spending will likely prove to be a very effective and justifiable fiscal stimulus”.
Meanwhile, the Bank of Japan is supplying liquidity to the financial sector ($345 billion so far this week), and in Moody’s opinion, large, wealthy economies (and Japan has a $6 trillion economy) demonstrate a capacity to absorb localised natural disasters. In addition, “the country has the largest stock of net international assets, equal to 59% of GDP , of any large, advanced economy, to help as well”.
The agencies also seem sanguine about the ratings outlook for corporate Japan.
For the vast majority of its rated companies, Moody’s says that “the impact will primarily involve a short-term interruption to operations due to power constraints, or more severe disruptions to operations in the most-affected prefectures”. So, it expects few ratings implications for most large companies and banks.
S&P’s initial assessment was similar. It said in a March 15 report that events during the past week are “unlikely to have a direct impact on the ratings on most Japanese corporations”. The exception (so far) is Tokyo Electric Power (Tepco), whose outlook on its AA- is now negative.
S&P, like Moody’s and Fitch Ratings, doesn’t assign ratings to any Japanese companies with headquarters in the three worst-hit prefectures (Fukushima, Iwate and Miyagi). And of those companies it does rate, none has an especially high business dependence on these areas, as many have increased local procurement in the overseas markets into which they have expanded.
Nevertheless, it warned that credit quality could still deteriorate for companies that escaped direct earthquake damage if electricity shortages and other infrastructure challenges are prolonged.
None of S&P’s rated manufacturing companies has suffered catastrophic damage, such as the destruction of main factories. Even for those that have suffered direct hits, it says that “the damage is limited relative to their overall size”, and improved operational and financing performances means that they should be able to absorb the costs caused by the earthquake.
However, there are vulnerable sectors. In a March 14 report, Moody’s identified four sectors it expects “will likely include the bulk of the small number of possible ratings actions”. In descending order of exposure they are: insurance and power utilities in the country as a whole, and regional banks and transport providers with substantial operations in the prefectures most affected.
Moody’s pointed out that insurers, both in Japan and around the world, will sustain heavy losses, and this has negative credit implications. The scale of individual losses will depend on the overall size of claims, the types of coverage provided, the amount of reinsurance purchased and the structure of reinsurance schemes. For instance, residential earthquake risks are covered by a government reinsurance programme, while commercial risks aren’t always absorbed.
Three groups, MS&AD Insurance, Tokio Marine, and NKSJ dominate the non-life sector in Japan, accounting for nearly 90% of the domestic market, and Japan Earthquake Reinsurance, jointly owned by private insurance companies, assumes residential earthquake exposure from domestic insurers, including the big three groups. It provides up to ¥5.5 trillion ($66.9 billion) in claims-paying capacity, but losses above ¥115 billion are shared with domestic insurers and the Japanese government.
However, Moody’s reckons that a significant amount of losses will flow to the global reinsurance industry, as catastrophe reinsurance covering Japanese earthquakes is a large market. It’s too early to tell just how large the claims on those top domestic insurers will be, but their credit ratings will be under scrutiny. Yesterday, S&P revised its outlook for the non-life sector to negative from stable.
In the power utility sector, clearly Tepco is the most exposed, as it battles against the problems at its Fukushima Daiichi nuclear power plant, 240 kilometres north of Tokyo. Moody’s says it expects large write-downs and high costs for decommissioning, unit replacement and for accessing interim replacement power for its customers. Even with partial expense recovery due to regulatory arrangements, Moody’s says the impact on Tepco will probably be “material and prolonged”.
The agency is also reassessing its ratings throughout the nuclear power industry in Japan, because of the increased business risks in a sector that typically operates with quite high levels of leverage. On the other hand, strong regulatory and banking system support is likely to be maintained to ensure electricity supplies.
In the two sectors highlighted that have significant businesses within the affected area, Moody’s expects a material impact on the eight regional banks operating in the three prefectures, but none of them is rated by the leading agencies. Importantly, national banks do not have significant direct exposure there.
Railroad and expressway operators such as East Japan Railway, East Nippon Expressway, and Japan Expressway Holding and Debt Repayment Agency all had substantial operations in the most affected areas, and of course, no one knows when they can restart.
However, Fitch is less optimistic. In a report published on March 15, it said that there could be short-term negative implications for the six Japanese technology companies it rates — Hitachi, NEC, Panasonic, Sharp, Sony, and Toshiba.
The six companies’ sales exposure to the domestic economy ranges between 30% (Sony) and 85% (NEC), so “in addition to the cost of repairing damaged manufacturing and distribution facilities, Fitch needs to assess how each company will cope with a likely fall in local spending on electronic products, and possible constraints on export production levels due to a combination of factors including damaged facilities, power outages and logistic delays to sourcing key components”, said Matt Jamieson, head of Fitch’s Asia-Pacific telecom, media and technology team.
Export sales could also drop if manufacturing facilities have to run at lower speed, but that could be alleviated by a reversal of the strong yen that has been dampening earnings since late 2008.
Fitch also warned that the production and shipment activities of Japanese automakers and steelmakers might suffer — although it’s too early to make any judgment on long-term credit ratings. A few, such as Toyota, Nissan and Honda had factories in the affected areas, but the most important and hard to calculate impact is due to disruption in supply chains, logistics and electricity supply.
S&P also highlighted the fact that many suppliers of automotive parts and electronic components do have production facilities in earthquake-stricken areas — so a slow recovery would hurt large manufacturers. In addition, a return to normal production might be impeded if customers and vendors’ businesses don’t recover quickly.
Depressed consumer confidence as a result of electricity shortages could slow recovery in sectors with a high exposure to the domestic market, such as retail and property, but the “effect is likely to be particularly marginal on major real estate companies and J-Reits because their portfolios mainly comprise properties in the Tokyo metropolitan area”.
However, all the credit rating agencies warn that it is too early to make a final prognosis. It is hard to believe that some adjustments to individual ratings won’t take place eventually.