Fiscal missteps must be avoided

Fitch Ratings has cut Japan’s long-term foreign currency rating by two notches from AA to A+ with a negative outlook, bringing it on par with that of Korea, which it upgraded in 2006 and revised to a positive outlook last year. This is the first time Korea has held a stronger sovereign credit profile than its neighbor. The agency cited growing credit risks due to Japan’s rising public debt ratio and lack of political will to tackle the problem.

The downgrade, which follows similar moves by Moody’s and S&P last year, reflects growing concern for Japan’s snowballing public debt, which is twice the size of its GDP. The government proposed reducing its debt burden and swelling social security costs by raising the sales tax, but has made little progress due to strong resistance from the opposition as well as the ruling party.

Rating agencies, as demonstrated by their harsh rating cuts in highly-indebted European countries, value fiscal and financial stability above economic performance in evaluating sovereign economies and their potential. The latest downgrade won’t likely deal a lasting blow to Japan because of the strong status of the yen and the country’s large holdings of other countries’ sovereign debt. Moreover, 95 percent of Japan’s government debt is held by domestic investors.

Public debt takes up 34 percent of Korea’s GDP. The economy has been growing more than 3 percent on-year despite the global economic slump, and foreign exchange reserves are sufficiently well stocked. But risks remain. Public companies hold debt of more than 800 trillion won ($678.8 billion), and this is, strictly speaking, national debt. Welfare costs are also likely to rise as a result of this year’s parliamentary and presidential elections, while consumer borrowing has surpassed 900 trillion won, posing a threat to the financial sector.

Agency representatives have warned Korea that its rating may be compromised by fiscal mismanagement in an aging society unless the government can guarantee the debt of both state companies and consumers. In response, Seoul has pledged to maintain fiscal integrity in the face of political populism on welfare issues, while the financial supervisory authorities have promised to clean up mutual savings banks.

But the central bank has not done enough to rein in household debt. As such, the government must take precautionary and preemptive steps to shore up the health of public finance. Korea may have lessons to learn from Japan, but fiscal control is not among them.