Japan has become the latest country to suffer a credit downgrade, with Moody’s dropping the country’s credit rating to Aa3 in response to its mounting debt problems.

In a note explaining the reasoning behind the move, Moody’s said the downgrade was prompted by Japan’s large budget deficits, and the build up in government debt since the 2009 recession.

Further, the aftermath of the catastrophic earthquake and tsunami which struck the country in early March has delayed recovery and “aggravated inflationary conditions”, Moody’s said.

The outlook for the country remains stable, a view supported by the “undiminished home bias” of Japanese investors and their preference for government bonds.

“We believe that this funding cost advantage will be sustained by considerable institutional and structural strengths, which will prevail even with large budget deficits in 2011 and 2012,” Moody’s said.

The agency also stressed that this downgrade does not affect the Aaa country and bank deposit ceilings, the outlooks for which remain stable.

Moody’s also outlined a range of factors which could trigger a positive rating outlook, and potential upgrade in future.

Namely, well established progress in achieving fiscal consolidation targets and a “robust and sustainable” recovery from recession could improve views on the country.

On the other hand, a delay in implementing Japan’s tax and social security reforms, ongoing inability to recover from the lingering effects of the recession and March earthquake, or a diminished home bias in the country’s bond markets could prompt negative action.

Head of fixed income, Asia Pacific, at Aberdeen Asset Management Anthony Michael said the move was not surprising given Japan’s fiscal position.

However, coming as it does after Standard & Poors’ unprecedented downgrade of the United States and ongoing concerns over the sovereign debt situation in the Eurozone, the credit action is likely to continue to add to investor concerns over the state of the developed world's sovereign finances.

“Indeed this downgrade is unlikely to be the last among so-called developed market countries, the majority of which to varying degrees are suffering from huge deficits. In contrast the credit worthiness of many of Japan's neighbours in the Asia Pacific region are likely to continue to improve over the coming years.”

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