Chapter 2 2.9

Sovereign Credit Ratings

Understanding how rating agencies assess sovereign creditworthiness and why Japan maintains A+ ratings despite 264% debt-to-GDP

What Are Sovereign Credit Ratings?

Sovereign credit ratings are independent assessments of a government's creditworthiness—its ability and willingness to repay debt on time. The three major global rating agencies—Standard & Poor's (S&P), Moody's, and Fitch Ratings—evaluate countries based on economic strength, fiscal policy, governance, and external finances.

These ratings matter because they:

  • Influence borrowing costs: Higher ratings = lower yields governments must pay on bonds
  • Affect investor demand: Many institutional investors have mandates requiring investment-grade ratings (BBB-/Baa3 or higher)
  • Signal financial stability: Downgrades can trigger capital flight and currency weakness
  • Shape market perceptions: Ratings provide a standardized framework for comparing sovereign risk globally

Understanding the Rating Scale

Investment Grade: AAA/Aaa (highest) → AA → A → BBB/Baa (lowest investment grade)

Speculative/Junk: BB/Ba → B → CCC/Caa → CC/Ca → C/C (default imminent)

Note: S&P and Fitch use letter-based scales; Moody's uses alphanumeric (e.g., Aa1, Baa3)

G7 Sovereign Credit Ratings (2025)

As of October 2025, credit ratings across the G7 diverge significantly, reflecting different fiscal trajectories and political risks:

Country S&P Moody's Fitch Debt-to-GDP Recent Changes
Germany AAA (Stable) Aaa (Stable) AAA (Stable) ~65% Maintained AAA across all agencies. Model of fiscal discipline and economic strength
Canada AAA (Stable) Aaa (Stable) AA+ (Stable) ~107% Holds AAA from S&P and Moody's. Fitch downgraded from AAA to AA+ in 2020 (COVID impact)
United States AA+ (Stable) Aa1 (Stable) AA+ (Stable) ~123% Lost last AAA rating in May 2025 when Moody's downgraded from Aaa → Aa1. S&P downgraded in 2011, Fitch in 2023
United Kingdom AA (Stable) Aa3 (Stable) AA- (Stable) ~101% Stable ratings across agencies. Brexit and fiscal challenges limit upward mobility
France AA- (Stable) Aa3 (Negative) A+ (Stable) ~112% Fitch downgraded to A+ in Sept 2025 (lowest on record) due to political crisis and ballooning debt. Moody's outlook negative
Japan A+ (Stable) A1 (Stable) A (Stable) ~264% Ratings stable since 2015. Fitch affirmed A rating January 2025 with stable outlook
Italy BBB+ (Stable) Baa3 (Positive) BBB+ (Stable) ~137% Upgraded by S&P (Apr 2025) and Fitch (Sept 2025) to BBB+ from BBB. Improved fiscal performance under Meloni government

The Paradox: Why Japan Ranks Lower Despite Structural Advantages

At first glance, Japan's ratings appear inconsistent with its economic fundamentals. Consider the comparison with the United States:

Metric United States (AA+/Aa1) Japan (A+/A1/A) Advantage
Debt-to-GDP 123% 264% 🇺🇸 US (lower debt)
Domestic Ownership ~70% ~88% 🇯🇵 Japan (less foreign risk)
Net International Position -$23.7 trillion (debtor) +$3.3 trillion (creditor)* 🇯🇵 Japan (external strength)
Debt Service (% of GDP) ~3.1% ~1.7% 🇯🇵 Japan (lower burden)
Fiscal Governance Risk High (debt ceiling, shutdowns) Low (no debt ceiling) 🇯🇵 Japan (stable process)
Currency Status Global reserve currency Regional currency 🇺🇸 US (exorbitant privilege)

* Note: Japan lost its position as the world's largest creditor nation to Germany in 2025 for the first time in 34 years, but remains a major creditor

Why Japan is Rated A+/A1/A Despite 264% Debt-to-GDP

Rating agencies acknowledge Japan's massive debt but weigh several mitigating factors that prevent lower ratings:

1. Domestic Ownership Eliminates Foreign Rollover Risk

88.1% of JGBs held domestically (as of December 2024):
• Bank of Japan: 46.3%
• Domestic insurance companies: 15.6%
• Domestic banks: 14.5%
• Other domestic investors: 9.7%

This insulates Japan from sudden foreign capital flight that triggered crises in Greece (2010), Argentina (2018), and Turkey (2018). Japan borrows in yen from Japanese savers—no currency mismatch, no external vulnerability.

2. Exceptionally Low Debt Service Burden

Despite 264% debt-to-GDP, Japan pays only 1.7% of GDP in annual interest costs—lower than the US (3.1%), UK (3.4%), and Italy (4.0%). Three decades of ZIRP/NIRP/YCC have locked in ultra-low rates:
• Average JGB coupon: ~0.8%
• Weighted average maturity: 9.2 years
• Even with BOJ normalization to 1.5% by 2027, debt service would remain manageable at ~2.5% of GDP

3. Strong Net Asset Position: Understanding Gross vs Net Debt

Japan's often-cited 215.9% gross debt-to-GDP ratio is misleading because it ignores the government's substantial financial assets. When accounting for these assets, Japan's net debt is 106.7% of GDP (MOF estimate) or 125.6% (IMF estimate)—a critical distinction that explains why Japan hasn't faced a debt crisis.

The Math:
Item Amount (¥T) % of GDP
Gross Debt ¥1332.2T 215.9%
Government Financial Assets ¥660.7T 105.0%
Net Debt (MOF) ¥671.5T 106.7%
Net Debt (IMF) ¥790.3T 125.6%

Data as of: Gross debt (2025-06-01), Assets (2025 (estimated)). Calculated: October 26, 2025

Breakdown of Government Financial Assets (¥660.7T total):
  1. Government Pension Investment Fund (GPIF): ¥282.5T (44.9% of GDP)
    • World's largest pension fund
    • JGB holdings: ¥74.3T
    • Domestic equities: ¥69.1T
    • Foreign equities: ¥70.9T
    • Foreign bonds: ¥68.3T
    • Legally separate from general government but counted as government asset (as of 2025-09-30)
  2. Foreign Exchange Reserves: ¥201.2T (32.0% of GDP)
    • Managed by MOF through Foreign Exchange Fund Special Account
    • Primarily US Treasuries (~$1.05T) earning 4-5% yields
    • Generates positive carry: earning 4-5% on USD while JGB funding costs ~0.5-1%
    • See Section 3.2: Japan's FX Reserves for full breakdown
  3. Social Insurance Funds: ¥77.0T (12.2% of GDP)
    • Separate from GPIF, includes various pension/insurance reserves
    • Majority held in JGBs
  4. Government-Owned Enterprises: ¥50.0T (7.9% of GDP)
    • Japan Post Holdings: ¥20.0T (postal/banking services)
    • JR companies: ¥15.0T (railways)
    • NTT stake: ¥15.0T (telecommunications - government retains 1/3 ownership)
  5. Fiscal Loan Program Assets: ¥50.0T (7.9% of GDP)
    • Loans to local governments and public corporations
Why This Matters:
  • No liquidity crisis risk: Government can tap FX reserves or facilitate GPIF rebalancing during market stress
  • Positive carry from FX reserves: Earning ¥8-10T annually (4-5% on $1.32T reserves) while paying ~0.5-1% on JGB funding
  • Crisis buffer: Unlike Greece (no significant assets) or Italy (minimal reserves), Japan has ¥660.7T cushion
The Controversy: Why Two Different Net Debt Numbers?

Net debt calculations are debated because:

  • MOF approach (106.7%): Conservative asset valuation. MOF gross debt (¥1,332T as of June 30, 2025, 211.7% of GDP) minus estimated total government assets (¥660.7T, 105.0% of GDP). Note: MOF does not publish an official net debt figure.
  • IMF approach (125.6%): IMF General Government Gross Debt (2025 projection: ¥1,451T, 229.57% GDP) minus estimated General Government Financial Assets (¥660.7T, 105% GDP). IMF 2025 net debt not yet officially published.
  • Asset liquidity debate: GPIF assets are earmarked for future pensions (not freely spendable); Enterprise stakes are illiquid (selling NTT would crash stock price)
  • However: In crisis, these assets ARE accessible (Greece had no such option in 2010)
International Comparison (Net Debt):
Country Gross Debt Net Debt Assessment
United States 123% ~97% Better net position than gross suggests
Japan 215.9% 106.7-125.6% Comparable to France/Italy on net basis
Italy 137% ~125% Similar net debt to Japan (IMF basis)
France 112% ~95% Better net position due to lower gross debt
Germany 65% ~45% Strongest fiscal position in G7

Sources: Ministry of Finance Balance Sheet - https://www.mof.go.jp/english/policy/budget/topics/situation/, Government Pension Investment Fund Quarterly Reports - https://www.gpif.go.jp/en/, IMF Article IV Consultation Reports - https://www.imf.org/en/Countries/JPN

4. Creditor Nation Status (Recently Lost)

Until 2025, Japan held the title of world's largest net creditor for 34 consecutive years. Even after Germany overtook Japan in 2025, Japan maintains +$3.3 trillion in net international investment position:
• Japanese institutions own $4.2T in foreign assets
• Foreigners own $0.9T in Japanese assets
• Net creditor position = ability to import without borrowing

The US, by contrast, is the world's largest debtor (-$23.7T). In a crisis, Japan can repatriate foreign assets; the US must attract foreign capital to finance deficits.

5. Abundant Domestic Savings and Home Bias

Japan's household savings rate remains positive (2.5% as of 2025, down from 10% in 1990s) and financial assets total ¥2,100 trillion ($14 trillion at ¥150/$):
• 54% in bank deposits
• 10% in JGBs and government-backed bonds
• Strong "home bias"—Japanese savers prefer domestic assets

This deep domestic savings pool allows the MOF to absorb massive JGB issuance (¥190T annually) without relying on foreign buyers. As long as domestic savings exceed deficits, Japan can sustain high debt.

6. No History of Default or Political Brinkmanship

Unlike the US (which faces recurring debt ceiling crises and government shutdowns) or France (facing political gridlock in 2025), Japan's parliamentary system ensures smooth fiscal operations:
• No debt ceiling mechanism (borrowing authority embedded in annual budget)
• Lower House supremacy prevents budget deadlocks (Article 60 of Constitution)
• Never missed a debt payment in modern history
• Strong institutional credibility and policy continuity

What Limits Japan’s Rating: The Weaknesses

Despite these strengths, rating agencies cite structural concerns that cap Japan at A+/A1/A:

  1. Demographic Time Bomb: Population aging reduces workforce (working-age population -0.8% annually) and increases social security spending. By 2040, retirees will outnumber workers 2:3, straining fiscal sustainability
  2. Persistent Primary Deficits: Japan has run primary deficits for 30 consecutive years (except 2018-2019 surplus). Without primary balance, debt/GDP ratio is projected to rise to 300%+ by 2035
  3. Weak Medium-Term Growth: Real GDP growth averages 0.8% (2010-2025), below peers. Low productivity gains, rigid labor markets, and demographic drag limit fiscal space
  4. Depleting Savings Pool: As boomers retire and draw down savings, the domestic funding cushion shrinks. Household financial asset growth has slowed from 5% (1990s) to 2% (2020s)
  5. BOJ's Balance Sheet: BOJ holds 46% of JGBs (¥580T outstanding). When BOJ eventually unwinds QE, who will absorb bonds? This "exit risk" worries rating agencies
  6. Political Will for Reform: Successive governments have failed to enact structural reforms (consumption tax increases, entitlement cuts) needed for long-term sustainability

Rating Agencies' View: Slow-Moving Crisis

From Fitch's January 2025 report: "The 'A' ratings balance the strengths of an advanced, wealthy economy with correspondingly robust governance standards and public institutions, against weak medium-term growth prospects and very high public debt."

Translation: Japan won't face a sudden crisis (like Greece) due to domestic funding, but the debt burden is unsustainable long-term without reforms. The A+ rating reflects this "stable but unresolved" equilibrium.

Recent Developments: The US Loses Its Last AAA (May 2025)

For JGB investors, the most significant recent development is Moody's May 2025 downgrade of the United States from Aaa to Aa1—the last of the three major agencies to cut the US below AAA:

Date Agency Action Rationale
Aug 5, 2011 S&P AAA → AA+ Debt ceiling crisis revealed political dysfunction. US lost AAA for first time in history
Aug 1, 2023 Fitch AAA → AA+ Repeated debt ceiling standoffs, fiscal deterioration, governance concerns
May 16, 2025 Moody's Aaa → Aa1 "Increase over more than a decade in government debt and interest payment ratios to levels significantly higher than similarly rated sovereigns"

Moody's specifically cited:

  • Federal deficit widening to 9% of GDP by 2035 if 2017 Tax Cuts extended
  • $4 trillion added to fiscal primary deficit over next decade
  • Interest costs rising from 3.1% of GDP (2025) to 4.5%+ by 2035
  • Successive administrations failing to reverse trend of large annual deficits

Market Impact: Minimal (For Now)

Unlike 2011 (when S&P's downgrade triggered -17% stock market drop and Treasury yield spike), the 2025 Moody's downgrade had muted market impact:
• 10-year Treasury yields rose ~15bp but stabilized within days
• Dollar weakened 2% vs yen/euro but recovered
• No flight from Treasuries—still viewed as "least dirty shirt" in global markets

Why? Markets had priced in the downgrade risk for months. More importantly, the US benefits from "exorbitant privilege"—Treasuries remain the global safe haven regardless of rating. No alternative market has the depth ($26T outstanding) and liquidity of US Treasuries.

France’s 2025 Downgrade: A Cautionary Tale

France's September 2025 downgrade by Fitch (from AA- to A+, lowest on record) illustrates how political instability can accelerate rating deterioration:

What Went Wrong:

  • Parliamentary fragmentation after 2024 elections left government unable to pass budgets
  • Debt/GDP ratio rose from 110% (2023) to 112% (2025) with no consolidation plan
  • Deficit widened to 6.1% of GDP (2025), far above EU's 3% ceiling
  • Moody's downgraded outlook to "negative" in October 2025

Lesson for Japan: While Japan faces long-term fiscal challenges, its stable governance (no debt ceiling drama, parliamentary efficiency) prevents the kind of sudden political risk premium that hit France. Japan's A+ rating reflects chronic issues, not acute crises.

Italy’s 2025 Upgrades: The Flipside

In contrast, Italy received upgrades from both Fitch (BBB → BBB+, September 2025) and S&P (BBB → BBB+, April 2025), demonstrating that even high-debt countries can improve ratings through credible reform:

What Italy Did Right:

  • Primary surplus of 1.2% of GDP (2024), first sustained surplus since 2018
  • Debt/GDP ratio declined from 144% (2023) to 137% (2025)
  • Political stability under Meloni government (no early elections, coalition intact)
  • Successful implementation of EU Recovery Fund investments (€65B deployed)

Lesson for Japan: Concrete fiscal consolidation (achieving primary balance) and structural reforms can shift rating trajectories even when starting from weak positions. Japan's stable A+ could become A if reforms materialize, or AA- if it achieves sustained primary surplus.

What This Means for JGB Investors

Sovereign credit ratings directly impact JGB yields and portfolio positioning:

1. Spread to Treasuries

Japan's lower rating (A+ vs US AA+) theoretically should mean higher yields. In practice, the opposite occurs:

  • 10-year JGB yield: ~1.0% (October 2025)
  • 10-year UST yield: ~4.2% (October 2025)
  • Spread: -320bp (JGBs yield less than Treasuries)

Why? Yields reflect supply/demand dynamics, monetary policy, and inflation expectations more than credit ratings. Japan's structural deflation/low inflation (2.5% CPI) and BOJ's massive holdings dominate over rating-implied credit risk.

2. Regulatory Capital Treatment

Under Basel III banking regulations, higher-rated sovereigns receive preferential risk weights:

  • AAA-AA: 0% risk weight (banks hold with zero capital charge)
  • A: 20% risk weight (banks must hold capital against exposure)

This means Japanese banks holding JGBs face higher capital requirements than US/German banks holding their government bonds—a subtle disadvantage for domestic absorption.

3. Downgrade Risk and Trigger Events

What could cause a downgrade?

  1. Failure to achieve primary balance by 2030 (current MOF target). Another decade of deficits would push debt/GDP to 280%+
  2. Sudden spike in yields (e.g., if BOJ loses control during normalization). Interest costs rising to 3% of GDP would squeeze fiscal space
  3. Demographic shock (e.g., social security trust fund depletion). Pension/healthcare spending exceeding projections
  4. External shock (e.g., major earthquake, war). One-off fiscal costs + growth hit could break stable equilibrium

Conversely, upgrade catalysts include:

  1. Sustained primary surplus (2+ years)
  2. Successful BOJ balance sheet normalization without yield spike
  3. Structural reforms (immigration policy, productivity gains) boosting growth to 1.5%+

Key Takeaways

  1. Japan's A+/A1/A ratings reflect a unique paradox: Massive debt (264% of GDP) offset by domestic ownership (88%), low debt service (1.7% of GDP), and creditor nation status
  2. Ratings don't predict yields: JGBs yield 1.0% vs US Treasuries 4.2% despite lower ratings, due to structural factors (BOJ holdings, inflation differentials)
  3. The US lost its last AAA in May 2025, joining Japan and France in the AA+/A+ tier. Political dysfunction and rising deficits drove downgrades from all three agencies
  4. France's 2025 downgrade shows political risk matters; Italy's upgrade shows fiscal discipline works. Japan's stable governance is an underappreciated rating strength
  5. For JGB investors, the rating matters less than the trajectory: Watch for primary balance progress (2030 target), BOJ normalization success, and demographic/growth surprises

The Bottom Line

Japan's A+ rating is not a crisis warning—it's a recognition that Japan is in a stable but unsustainable equilibrium. The country can service its debt indefinitely thanks to domestic funding and low rates, but cannot grow its way out without structural reforms. For bondholders, this means low yields with minimal default risk, but reinvestment risk if demographics finally break the savings equilibrium. The key question for the next decade: Can Japan achieve primary balance before the domestic savings pool shrinks?

References

Rating Agency Reports

  1. Fitch Ratings. “Fitch Affirms Japan at ‘A’; Outlook Stable.” January 23, 2025. Available at: https://www.fitchratings.com/research/sovereigns/fitch-affirms-japan-at-a-outlook-stable-23-01-2025.

  2. Moody’s Ratings. “2025 United States Sovereign Rating Action.” May 16, 2025. Available at: https://www.moodys.com/web/en/us/about-us/usrating.html.

  3. Fitch Ratings. “Fitch Downgrades France to ‘A+’; Outlook Stable.” September 12, 2025. Available at: https://www.fitchratings.com/research/sovereigns/fitch-downgrades-france-to-a-outlook-stable-12-09-2025.

  4. Fitch Ratings. “Fitch Upgrades Italy to ‘BBB+’; Outlook Stable.” September 19, 2025. Available at: https://www.fitchratings.com/research/sovereigns/fitch-upgrades-italy-to-bbb-outlook-stable-19-09-2025.

Analysis and Context

  1. St. Louis Federal Reserve. “Why Is Japan’s Government Debt So High?” April 2025. Available at: https://www.stlouisfed.org/on-the-economy/2025/apr/what-is-behind-japan-high-government-debt.

  2. Bloomberg. “Germany Ends Japan’s 34-Year Run as World’s Top Creditor Nation.” May 27, 2025. Available at: https://www.bloomberg.com/news/articles/2025-05-27/japan-loses-top-creditor-status-for-first-time-in-34-years.

  3. Peter G. Peterson Foundation. “Moody’s Downgrade of U.S. Credit Rating Highlights Risks of Rising National Debt.” May 2025. Available at: https://www.pgpf.org/article/moodys-lowers-us-credit-rating-to-negative-citing-large-federal-deficits/.

Data Sources

  1. Trading Economics. “Credit Rating - Countries - List.” Available at: https://tradingeconomics.com/country-list/rating.

  2. Wikipedia. “List of countries by credit rating.” Available at: https://en.wikipedia.org/wiki/List_of_countries_by_credit_rating.