abenomics

MOODYS.COM

27 AUGUST 2013

Abenomics Success Prospects Constrained By Fundamental Macroeconomic Challenges, Risks Aggravating Credit Challenges If Growth Remains Elusive “Abenomics”—the popular colloquialism referring to the Japan Revitalization Strategy of the government led by Prime Minister Shinzo Abe—aims to push the economy into a new era of growth and rejuvenation after more than two decades of stagnation. The first two ‘arrows’ of the Revitalization Strategy, aggressive monetary easing and fiscal stimulus, have provided a temporary boost. But achieving long term growth hinges on the success of structural reforms to boost the economy’s potential growth rate.

Prospects for success are constrained by the country’s fundamental macroeconomic challenges. Spurring growth and ending deflation would be credit positive for Japan’s issuers, but the stimulatory policies risk aggravating the credit challenges facing Japan’s corporates, financial institutions and various levels of government if growth remains elusive.

This compendium of research examines the potential cross-sector credit ramifications if the Japan Revitalisation Strategy is successful in stimulating growth, versus the credit challenges Japan’s issuers face if the country suffers a third decade of economic stagnation. A copy of the cross-sector presentation and associated teleconference replay is available here.

MACROECONOMIC BACKDROP » Prospects of Success for Abenomics Constrained by Japan’s

Fundamental Macroeconomic Challenges 2

SOVEREIGN » Higher Growth Essential to Reduce Japan’s Large Government

Debt Burden 8

SUB-SOVEREIGN » Return to Growth Would Benefit Japan's Heavily Indebted

Regional and Local Governments 11

INSURANCE » Japanese Insurers Would Benefit From Growth, Normalization

in Domestic Interest Rates 13

BANKING » Japan's Banks Would Benefit From Sustainable Growth and an

End to Deflation 16

CORPORATES » Economic Growth Would Boost Japan’s Corporate Earnings but

Immediate Effects Varied 19

STRUCTURED FINANCE » Higher Property Prices, Increased Bank Lending Would Benefit

Japan’s Commercial Real Estate Structured Finance Sectors 22

» Growth in GDP and Employment Would Benefit Japan’s RMBS and ABS

24

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SOVEREIGN

2 ABENOMICS: CROSS-SECTOR IMPACT 27 AUGUST 2013

Prospects of Success for Abenomics Constrained by Japan’s Fundamental Macroeconomic Challenges

Raising Japan’s potential growth rate, generating inflation expectations and encouraging bank lending will be challenging in an economy that has stagnated for more than two decades “Abenomics” - the popular colloquialism referring to the Japan Revitalization Strategy of the government led by Prime Minister Shinzo Abe - aims to push the economy into a new era of growth and rejuvenation.

» The first two ‘arrows’ of the Revitalization Strategy - aggressive monetary easing and fiscal stimulus -

have provided a temporary boost. But achieving durable growth over the longer term hinges on the success of structural reforms to boost the economy’s potential growth rate.

- Generating robust GDP growth would be overall credit positive for Japan’s issuers; however, the prospects for success are constrained by the country’s fundamental macroeconomic challenges.

- Raising Japan’s potential growth rate, ratcheting up investment, generating inflation expectations and encouraging bank lending will be challenging in an economy that has experienced two decades of anemic growth and more than a decade of deflation.

- Senior government officials fear that the scheduled consumption tax increase - a key element of reforming Japan’s fiscal situation - will repeat the 1997 experience, wherein a rise contributed to the economy contracting the following year.

- Maintaining a weak yen will be difficult in an environment where Japan’s safe-haven currency status often leads to exchange rate appreciation at times of global economic uncertainty.

- Durable asset price appreciation would be a significant deviation from Japan’s seemingly relentless decline in asset prices over the past two decades.

» If growth remains elusive, the government’s stimulatory policies risk aggravating the credit challenges already posed by the low growth/low return environment. Incomplete progress on fiscal and structural reforms would weigh on confidence and undermine the success of the new policy framework, ultimately causing growth to eventually fall below the pre-Abenomics baseline.

Thomas J. Byrne Senior Vice President - Manager +65.6398.8308 [email protected]

Matthew Robinson Director of Sovereign Research +44.20.7772.5635 [email protected]

Bart Oosterveld Managing Director - Sovereign Risk +1.212.553.7914 [email protected]

SOVEREIGN


EXHIBIT 1

Macroeconomic Challenges to Ending to Japan’s Economic Stagnation

Robust GDP growth Ending deflation

Increasing productivity

Proceeding with consumption tax increase

Higher interest rates

Increased bank lending JPY depreciation

Asset price appreciation

Japan has recorded a mere 0.2% average for annual growth since 1991.

Chronic deflation has persisted ever since the asset bubble burst in the early 1990s.

A declining labor force and aging demographics continue to pressure Japan’s potential growth rate.

The economy went into recession the last time the consumption tax was raised (to 5% from 3% in 1997).

Implies mark-to-market losses for banks’ JGB holdings, increased debt servicing costs for governments and corporations, and higher default rates on loan-backed securities.

Companies are cash rich and households are reluctant to borrow. Bank lending remains 25% below its 1997 peak, with new loans contracting in 11 of the past 16 years.

Despite recent depreciation, the yen remains 20% stronger on a trade-weighted basis when compared to 2007.

Residential property prices have declined 30% below their early-1990s peak, while commercial land values are 60% lower.

Initial measures have provided only a temporary fillip Two of the three pillars of Abenomics were implemented earlier this year: the government’s announcement of a JPY10.3 trillion (2% of GDP) supplementary budget stimulus program in January1 and the Bank of Japan (BOJ) enacting aggressive monetary easing in April.2

Monetary easing in particular had immediate, credit positive effects across most sectors. The weakening of the yen has boosted export competitiveness and the increase inyen-denominated foreign-sourced earnings has boosted corporate profits. Japanese stock prices have risen, albeit with considerable volatility in recent months,3 and business and consumer confidence has firmed.

However, after initial and sometimes strong gains in a variety of asset classes, financial market enthusiasm seems to have cooled, and businesses have become more circumspect in their assessments of the prospects for Abenomics. Second-quarter GDP results undershot expectations,4 with private, non-residential investment contracting for a sixth consecutive quarter and housing investment decreasing for the first time in five quarters despite the promise of further stimulus and growth-enhancing structural reforms.

Stimulating private investment is the key to sustained growth Permanently ending Japan’s two-decade-long period of economic stagnation through generating sustained growth - and accordingly, defining the success of Abenomics - is contingent on stimulating private capital formation. During the past 20 years, Japan’s economy has generally only grown when companies have expanded their capital expenditure, increased workforces and raised wages.

There are nascent signs that spending by private corporations is firming: machinery orders from Japanese manufacturers rose through the first half of the year - a precursor to capital expenditure. Yet this trend has so far not translated into higher employment and wages, which will be necessary for the growth improvement to become self-sustaining.

1 See Japan’s New Policy Stance Provides Temporary Fillip for Economy, 1 February 2013 2 See Japan’s Monetary Easing, 8 April 2013 3 See Japan’s Abenomics: Three-Part Solution Meets a 7% Market Hesitation (Capital Markets Research), 28 May 2013 4 See Weaker Growth in Japan Jeopardizes Economic Revitalization, 15 August 2013

http://www.moodys.com/viewresearchdoc.aspx?docid=PBC_149661




SOVEREIGN


Without an improvement in private capital investment, the government’s willingness to expand its deficit and attempt to inflate the economy into a recovery will be of limited effect, and will instead merely add to the government’s already very high debt stock. The Cabinet Office recently announced that the central government’s debt alone had breached the JPY1 quadrillion mark in June, more than 200% of GDP, by far the highest among industrialized economies.

Structural and efficiency reforms pivotal in determining success of Abenomics in generating growth It is the third element of the Revitalization Strategy - targeting industrial restructuring and regulatory reform to increase productivity and generate efficiencies to complement and eventually supplant the monetary stimulus already in place and fiscal easing taken - which will determine the success or otherwise in stimulating private investment and generating sustainable long-term growth.

On this front, the government’s plans remain largely nebulous: a work in progress, as Abe and his Cabinet continue to formulate details. The government has outlined a broad growth and fiscal strategy, but specific measures and a concrete timetable remain outstanding.

Some supply-side measures that have been identified include:

[1] Entering the Trans-Pacific Partnership (TPP), a free trade agreement among 12 countries and including the US, Canada and Australia, would expand Japan’s international trade and boost its GDP by about JPY3.2 trillion (or 0.66%) annually5

[2] Corporate tax breaks aimed at encouraging spending and spurring investment (although as currently envisaged these would be selective and temporary, and thus would not provide a long-term boost)

[3] Electrical power market liberalization aimed at spurring growth through fostering competition and reducing energy costs, though full implementation is not scheduled until 2018.

By their very nature, the full benefits from measures aimed at boosting the supply side of the economic-growth equation would only accrue several years on.

Abenomics success would be credit positive for Japan’s issuers, but prospects constrained by fundamental macroeconomic challenges Success in generating robust GDP growth would be generally credit positive for Japan’s issuers. An end to deflation, increased labor productivity, a favorable exchange rate, and increased bank lending would be conducive to government revenues, corporate profitability, employment, the health of the banking system, and the performance of structured finance securities.

Some sectors are more exposed to others in terms of unintended or unavoidable consequences of higher growth and inflation (such as a likely modest increase in market interest rates), but we would expect the challenges posed by increased debt-servicing costs to be offset by growth-induced benefits.

However, the prospects for success of the Abenomics plan are constrained by fundamental macroeconomic challenges:

5 See Japan’s Official Participation in Trans-Pacific Partnership Talks Is Credit Positive, 29 July 2013


SOVEREIGN


» Achieving the Japan Revitalisation Strategy targets of annual average real GDP growth of 2% and nominal growth of 3% over the next decade would be no small feat for an economy that has recorded a mere 0.2% average annual nominal growth rate since the bubble burst in 1991. Although our 2013 forecast is for real GDP to expand by 2%, we see growth ebbing in 2014 (forecast of between 1% and 2%)6 owing to a dissipation of the initial effects of monetary easing and exchange rate depreciation, the ongoing weakness in external demand from Europe and China, and the dampening effects on domestic demand of the planned raising of the consumption tax.

» Although productivity growth in Japan has been comparable to that in other countries, the decline in the labor force due to aging demographics continues to pressure the country’s potential growth rate. The IMF estimates that this rate has fallen to less than 1%,7 underscoring the challenge the government will face in raising labour productivity growth to the targeted 2% per year.

» Similarly, generating expectations regarding future inflation will not be easy, given that chronic, albeit mild, deflation has persisted since the late 1990s. Deflation pressures corporate margins and amplifies government debt reduction challenges by increasing the real value of debt outstanding.

» Senior government officials and advisers to the prime minister are debating the merits of delaying the scheduled consumption tax increase out of concern that it may extinguish the nascent recovery in economic growth. The economy contracted in the year following the last consumption tax increase (to 5% from 3% in 1997), and which also coincided with the onset of chronic deflation. Various unique domestic and external were also at play at the time - Japan’s first post-war financial crisis and the Asian financial crisis. Therefore, the present does show some strong differences from the past. Japan’s economy is fundamentally sounder now than in 1997, the Asia Pacific overall is healthier, Japan’s private sector has deleveraged, and the country’s financial sector has undergone a restructuring and is no longer in crisis. Nevertheless, containing the upward debt trajectory is contingent on the consumption tax increase; the government’s commitment to halve the 2010 fiscal deficit by 2015 and its capacity to finance social welfare expenditure over the longer term are predicated on the revenues expected from the consumption tax increases scheduled for April 2014 and October 2015.

» While a normalization in interest rates would be positive for banks’ loan-deposit spreads and resolve insurers’ twin problems of negative spreads and heightened reinvestment risk, higher rates also imply mark-to-market losses for banks’ JGB holdings, increased debt-servicing costs for governments and corporations, and higher default rates on loans backing structured securities’ loan pools. If Abenomics can boost and build a foundation for sustainable growth, we would expect yields on JGBs to move towards where they settled during the final years of the Koizumi administration (2001-2006), when real GDP growth peaked at 2.5% in 2006 and inflation moved, but barely, into positive territory on an annual average basis. During 2006 and 2007, the average yield on 10-year JGBs was around 1.7%, compared to the current level of around 0.8%.

» Encouraging bank lending will be difficult. Large corporations are cash rich and households are reluctant to borrow; banks are reluctant to lend in a low rate/deflationary environment that constrains their ability to appropriately price credit risk. Annual growth in credit to the private sector has averaged virtually zero over the past decade: bank lending remains 25% below its 1997 peak, with new loans contracting in 11 of the past 16 years.

» Keeping the yen weak will be difficult in an environment where Japan’s safe-haven currency status often leads to currency appreciation at times of global economic uncertainty. While the yen has depreciated 20% against the US dollar since Abe’s election in December 2012, the currency had appreciated nearly 35% in the four years to mid-2011.

6 See Update to Global Macro Outlook 2013-14: Loss of Momentum, 13 May 2013 7 See Japan: Selected Issues (IMF Country Report No. 12/209), August 2012

https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_153268

http://www.imf.org/external/pubs/ft/scr/2012/cr12209.pdf

SOVEREIGN


» Durable asset price appreciation would be a significant deviation from Japan’s seemingly relentless decline in asset prices: residential property prices remain almost 30% below their early-1990s peak, while commercial land values are 60% down from their peak two decades ago.

In the absence of growth, Japan’s credit challenges will be amplified If growth remains elusive, the government’s stimulatory policies risk becoming self-defeating, aggravating the numerous credit challenges already facing Japan’s national, regional and local governments, corporations and financial institutions.

In its recent Article IV report8 estimating the potential effects of Abenomics on growth, inflation and debt, the International Monetary Fund’s (IMF) simulations illustrate that the government’s 2% inflation target and higher growth will only be achieved in a speedy and sustained manner under a full package of structural reforms aimed at raising labor supply, deregulating protected domestic sectors, creating new growth sectors (e.g. energy, environment, health care services), establishing a more growth-supporting financial sector, and integrating further with Asia.9

In contrast, the IMF posits that incomplete progress on fiscal and structural reforms would weigh on confidence and undermine the success of the new policy framework. The IMF study concludes: in the absence of ambitious structural reforms, the requisite medium-term fiscal adjustment necessary to remedy government finances and a rising risk premium (given the need to tap foreign investors as financing requirements remain high amid declining private savings) will cause growth to eventually fall below the pre-Abenomics baseline. This development would compound credit challenges already posed by the low growth/low return environment.

EXHIBIT 2

IMF Scenario Analysis Shows Incomplete Abenomics Strategy Undermining Growth in the Medium Term

Source: International Monetary Fund

This scenario underscores the potential downside risks associated with the Japan Revitalization Strategy in

8 See Japan: 2013 Article IV Consultation (IMF Country Report No. 13/253), 5 August 2013 (page 9) 9 See Japan: Selected Issues (IMF Country Report No. 12/209), August 2012



SOVEREIGN


the absence of a return to sustainable growth. The government’s willingness to expand its deficit and attempt to inflate the economy into a recovery will be of limited effect in the absence of an improvement in private capital investment, instead merely adding to the government’s already very high debt stock. Similarly, regional and local government finances would remain strained under their existing heavy debt burden in the absence of growth.

Meanwhile, if the government’s own rising debt burden erodes confidence in the JGB market, this would threaten the stability of the banking and insurance sectors, impede bank lending to the detriment of corporate investment and structured finance loan rollovers, and potentially lead to a financial crisis.

SOVEREIGN


Higher Growth Essential To Reduce Japan's Large Government Debt Burden

Spurring growth, ending deflation would support the sovereign’s credit profile, however a tipping point looms if growth remains elusive Generating growth is an essential element of a credible long-term fiscal adjustment policy, a necessary (but not sufficient) condition for reducing Japan’s (Aa3 stable) heavy level of government indebtedness. Long-term government debt exceeds 200% of GDP and annual debt-refinancing needs are the highest among mature economies.

Spurring growth, ending deflation would support the sovereign’s credit profile Ending Japan’s economic stagnation of two decades is contingent on stimulating private capital formation. During the past 20 years, the economy has only grown and the budget deficit only declined when global conditions were buoyant and companies responded by expanding capital expenditure, increasing workforces, raising wages, and paying more taxes.

The lacklustre outlook for the global economy over the next two or three years exerts pressure on the government to devise a stronger domestic policy response to spur sustainable economic growth. Achieving the revitalization strategy’s objectives of annual average real GDP growth of 2% and nominal growth of 3% over the next decade would be credit positive, given that it would increase government revenues and improve key credit metrics. Currency weakness, increased bank lending and higher productivity would also be conducive to growth, employment and company profitability, as well as increasing corporate, personal and consumption tax revenues.

Tax reform and containment of social security expenditure would further reduce the government’s budget deficit and enhance its debt-servicing capacity.

Ending deflation and achieving stronger nominal GDP growth would also help reduce the government’s large gross financing requirements and relieve the burden on fiscal austerity, helping in turn to free up savings for more productive private sector investment. A revived economy and smaller fiscal deficit would stabilize and eventually reverse the current upward trajectory in debt through simultaneous improvements in the numerator and denominator of the country’s debt-to-GDP ratio.

Thomas J. Byrne Senior Vice President - Manager +65.6398.8308 [email protected]

Matthew Robinson Director of Sovereign Research +44.20.7772.5635 [email protected]

Bart Oosterveld Managing Director - Sovereign Risk +1.212.553.7914 [email protected]

SOVEREIGN


EXHIBIT 1

Sovereign Credit Implications of an End to Japan’s Economic Stagnation

Sovereign Robust GDP growth

Ending deflation






Positive Increased tax revenues; improves debt-GDP denominator

Positive Diminishes real value of debt outstanding

Positive Conducive to growth, corporate profitability and employment, improving tax revenues/ reducing social welfare expenditure

Positive Increased revenue, broadening/ securing revenue base

Negative Higher debt-servicing costs, but likely to be offset by increased revenues

Positive Conducive to growth

Positive Supports export-oriented manufacturers, conducive to growth and profitability, thereby improving tax revenues

Potentially negative Potential for stimulatory policy to merely generate destabilizing asset price bubble

credit positive

credit negative

Growth would also provide sufficient headroom for the government to proceed with reforming Japan’s sales tax system, thereby further improving government revenues. The consumption tax is currently scheduled to increase to 8% in April 2014 from 5% currently, and ultimately to 10% in October 2015, although this is predicated on favorable growth conditions, which were not explicitly defined. Recently, senior government officials and advisers to the prime minister have debated the merits of the government delaying this schedule out of concern that a tax increase at this time would extinguish the nascent recovery in economic growth.

Government finances are under increasing strain from social welfare expenditure due to Japan’s declining and aging population. Curbing social welfare expenditure has not so far been part of the policy debate, amplifying the urgency of boosting revenues through stronger economic growth or through tax reform, or both.

Rising interest rates accompanying sustainable growth would increase government debt-servicing costs. However, the rise in tax revenues related to improving economic growth rates, especially from corporations, would offset the rise in debt-servicing costs associated with increasing Japanese Government Bond (JGB) yields. Currency weakness has no impact on debt-servicing costs, given that Japan has no outstanding foreign currency denominated debt.

A tipping point looms if growth remains elusive In contrast, if the revitalization strategy does not generate sustainable growth, the government’s stimulatory policies risk aggravating Japan’s existing credit challenges. Without an improvement in private capital investment, the government’s willingness to expand its deficit and attempt to inflate the economy into a recovery will be of limited effect, instead merely adding to the government’s already very high debt stock.

SOVEREIGN


EXHIBIT 2

Rising Debt Trajectory: Japan’s Increase in Government Debt Relative to Other G-7 Countries

Source: Moody’s

In the event of a third decade of economic stagnation, the government’s debt would continue to rise through 2020 by as much as 30 percentage points of GDP from its already elevated ratio in excess of 200% of GDP for long-term debt and 245% for total debt.10 Its gross deficit and debt-refinancing needs are the highest among mature economies, and they will increase to more than 59% of GDP, according to the International Monetary Fund’s projections for 2013; or 35% according to Japan’s own Ministry of Finance (which excludes short-term debt financed by foreign exchange special accounts).

These levels are far higher than even the most indebted governments globally and could eventually overwhelm the exceptional home bias of the JGB market. The government is currently able to fund its deficit at low cost because of the strong appetite for JGBs of Japanese financial institutions, including banks and insurers backed by huge deposit bases.

At some point, these investors may demand a premium for funding Japan’s growing debt. This could happen if Abenomics does not generate sustainable growth, leaving government finances even more strained. Such a development could threaten to undermine sovereign creditworthiness and erode confidence in the JGB market, potentially destabilizing the financial system, including banks and insurance companies, the largest holders of JGBs.

Moreover, if the level of government debt exceeds gross national savings - a risk that could develop over the next five years - the process of re-intermediating Japan’s massive savings into JGBs could become difficult, generating so far non-existent rollover risk. And if Abenomics does not spur private investment, the liquidity generated by the government’s and BOJ’s stimulatory policies will threaten to manifest itself in asset bubbles domestically and abroad, with negative consequences for systemic stability.

10 Based on the Cabinet Office’s previous growth strategy long-term scenario analyzes.

0

50

100

150

200

250

300

2005 2006 2007 2008 2009 2010 2011 2012 2013F 2014F

% o

f GD

P

Japan G-7 ex-Japan

SUB-SOVEREIGN


Return to Growth Would Benefit Japan’s Heavily Indebted Regional and Local Governments Since Japan’s regional and local governments’ (RLGs) debt burdens are amongst the highest of local governments globally, success in stimulating growth would translate into increased own-source revenues and central government transfers, alleviating pressure on local government budgets. In the absence of growth however, RLGs finances would remain strained under their existing heavy debt burden.

Growth, increased revenues would benefit Japan’s regional and local governments With the main revenue sources for Japan’s prefectures coming from corporate and personal income taxes, higher growth rates would ease pressures on these regional and local governments’ financial performance. Currency weakness, increased bank lending and improving productivity would also be conducive to growth, enhancing RLGs revenue generation capacity. An end to deflation and stronger nominal GDP growth would also diminish the real value of RLGs debt outstanding, improving debt-service capacity. Meanwhile, proceeding with the proposed hikes in the consumption tax in 2014 and 2015 would boost RLGs’ income, given the central government’s commitment to sharing a portion of the increase with them (1.2 percentage points).

In addition, to the extent that the central government’s own-tax intake rises at a faster pace than inflation, the current pressures on local allocation tax (LAT) revenue-sharing transfers - a primary source of RLGs’ operating income - should ease. In recent years, LAT transfers have been increasingly replaced by the RLGs’ issuance of government-supported rinzai-sai debt. To the extent that the central government can directly cash fund LAT transfers, it will curb this source of indebtedness. Similarly, as increased local taxes help to build operating surpluses, reliance on both rinzai-sai and other debt may slow.

Rising interest rates accompanying sustainable growth would increase RLGs debt servicing costs. However, the rise in tax revenues associated with improving economic growth rates and transfers from the central government would offset the rise in debt-servicing costs.

EXHIBIT 1

RLGs Credit Implications of an End to Japan’s Economic Stagnation

RLGs Robust GDP growth Ending deflation





Positive Increased tax revenues; reduces pressures on LAT revenue-sharing transfers

Positive Diminishes real value of debt outstanding

Positive Conducive to growth, corporate profitability and employment, improving tax revenues

Positive Given central govt. commitment to share 1.2pp with RLGs

Negative Higher debt-servicing costs, but likely offset by increased revenues

Positive Conducive to growth and revenue generation

Positive Conducive to growth and revenue generation

credit positive

credit negative

Yuka Tamba Vice President - Senior Analyst +81.3.5408.4216 [email protected]

Debra Roane Vice President - Senior Credit Officer +612.9270.8145 [email protected]

https://www.moodys.com/credit-ratings/Japan-Government-of-credit-rating-423746

SUB-SOVEREIGN


In the absence of growth, RLGs finances strained under heavy debt burden In contrast, if growth remains elusive, a third decade of economic stagnation would leave the finances of local governments strained. Revenues that the RLGs generate themselves have been declining since the global financial crisis, and would continue their downward slide. The recent reliance on issuance of government-supported rinzai-sai debt along with other borrowing has led to RLGs debt burdens rising to a high 41% of GDP, amongst the highest of local governments globally. Meanwhile, the need to increase welfare, health, and nursing services will continue as the population ages, further reducing the RLGs’ financial flexibility.

EXHIBIT 2

Japan’s RLGs Debt Burden Amongst the Highest of Local Governments Globally Net Direct and Indirect Debt/Total Revenue in 2011

Source: Moody’s

270%

205%

157%

102%79%

59%

0%

50%

100%

150%

200%

250%

300%

Prefectures Moody's rates

Quebec, Province of Baden-Wuerttemberg, Land of

Madrid, Comunidad Autonoma de

Lazio, Region of New SouthWales (State of) Australia

INSURANCE


Japanese Insurers Would Benefit From Growth, Normalization in Domestic Interest Rates

The credit profiles of insurers would be supported by gradual increases in interest rates, accompanying the rise in economic growth, but would be negatively impacted if government debt continues to climb. Japan’s life insurers would be among the biggest beneficiaries of a more normal interest environment if Abenomics is successful in ending deflation and achieving stronger nominal GDP growth. However, if growth remains elusive, Japan’s insurers would continue to face the persistent credit challenges associated with a low interest rate/low return environment.

Life insurers among the biggest beneficiaries of a more normal interest rate environment Ending deflation and achieving stronger nominal GDP growth would cause an increase in the risk-free rate which would, in turn, be credit positive for Japan’s domestic insurance sector. Insurers, in particular life insurers, have been one of the major losers from Japan’s extended period of low interest rates. Accordingly, life insurers will be among the biggest beneficiaries of a more normal interest rate environment.

Market expectations of sustainable average real GDP growth of 2% - 3% and positive inflation will cause a steepening of the yield curve. A steeper yield curve will help resolve the twin problems of negative spreads and heightened reinvestment risk that are characteristics of the life industry in a low interest rate environment.

Higher investment returns are essential to resolve the problem of negative spreads. Life insurers typically earn a margin, or spread, between their investment results and their average payouts to policyholders. In Japan, for many life insurers, this spread is currently negative because investment returns are lower than the guaranteed rate of returns to policyholders.

EXHIBIT 1

Negative Spread Has Been Narrowing, But Still Exists

Source: Company disclosures Average is simple average ( – adding up the negative spread of the eight insurers and divided by eight)

Further, if returns on long duration assets rise, then the pace at which life insurers accumulate long duration assets should increase. This trend would help reduce duration mismatch, that is the difference between the

-3.00%

-2.50%

-2.00%

-1.50%

-1.00%

-0.50%

0.00%

-0.70%-0.60%-0.50%-0.40%-0.30%-0.20%-0.10%0.00%0.10%0.20%0.30%

2009/3 2010/3 2011/3 2012/3 2013/3

Nippon Dai-ichi Meiji Yasuda Sumitomo Fukoku

Taiyo Sony Average Mitsui(Right axis)

Kenji Kawada Vice President - Senior Analyst +81.3.5408.4056 [email protected]

Graeme Knowd Associate Managing Director +81.3.5408.4149 [email protected]

INSURANCE


average term of life insurance policies and the term of insurers’ investments. Given that life insurers must invest in long-term assets to match the long duration of their liabilities, their investment returns will rise as the yield curve steepens.

Among the likely effects of a successful implementation of Abenomics, increased economic growth and a return to inflation would have the most lasting credit-positive effects on the insurance sector. Even so, the difficult transition from a deflationary to an inflationary environment will challenge the asset/liability management capabilities of all insurers, and not all will rise to the challenge equally.

Although a steeper yield curve is a long-term positive for the insurance sector, a steepening would initially reduce the value of the insurance sector’s JGB portfolios, an unavoidable consequence of a successful shift to stronger economic growth and inflation.

Higher long-term rates would cause mark-to-market losses on those JGBs reported as available for sale. Unrealized losses negatively impact accounting capital, although insurers can mitigate unrealized losses by increasing their portions of policy reserve-matching bonds and by reducing their available-for-sale bonds.

An increase in JGB yields also has a positive impact on economic value and economic capital because of the duration mismatch between assets and liabilities. The reason is that a higher risk-free rate (which reflects JGB yields) would lead to higher discount rates for insurance liabilities, which would in turn diminish their present (or economic) value.

Credit positive effects on the insurance sector from BOJ monetary easing Although the prospects for the success of Abenomics remain uncertain, monetary easing by the BOJ has already had several credit-positive effects on the insurance sector. The most direct effect has come from rising asset prices, particularly domestic equities, a trend which benefits the large investment portfolios of insurers.

Meanwhile, the weakening yen has increased the attractiveness of assets denominated in other currencies. In general, higher asset prices are a positive for insurers, which have been starved of investment opportunities under deflation. However, they will need to manage asset allocation and associated risks carefully. The rise in the value of domestic equities and investments denominated in currencies other than yen has also had a positive effect on capital.

INSURANCE


EXHIBIT 2

Life Insurers: Credit Implications of an End to Japan’s Economic Stagnation

Insurance

Robust GDP growth Nom GDP >3% Real GDP > 2%

Ending deflation Inflation > 2%

Improved labor productivity Productivity growth > 2%

Consumption tax increase proceeds

Higher interest rates (JGBs, bank rates)



Positive Healthier corporate and retail balance sheets, and therefore increasing opportunities for premium growth.

Positive Emergence of inflation, leading to an environment where investment assets increase in value.

No impact Negative Consumers may cut back on discretionary insurance or chose cheaper polices.

Negative Losses emerge on carry.

No impact Positive Interest income earned abroad translates into a greater amount of yen, and therefore supporting profitability.

Positive Increases in unrealized gains. Positive

Better investment returns, and therefore reducing negative spread.

credit positive

credit negative

In the absence of growth, pressure on insurers’ creditworthiness would persist In contrast, if the revitalization strategy does not generate sustainable growth, a third decade of economic stagnation would see the current credit challenges faced by the insurance sector persist. Negative spreads and heightened reinvestment risk are characteristics of the life insurance industry in a low interest rate, low return environment.

Worse still, if the government’s rising debt burden erodes confidence in the JGB market, the consequences would be negative for insurers. Currently, private sector savings are largely recycled via the banking and insurance sectors into the JGB market.

Any loss of confidence -- that saw a reluctance by the private sector to hold its savings in the domestic financial sector -- would make it difficult for insurers and banks to keep funding the government deficit. Under this scenario, stock prices are also likely to decline, potentially causing losses on insurers’ equity portfolios. Such a scenario, which is not our central expectation but a plausible downside risk, would destabilize both the JGB market and the banking and insurance sectors, potentially leading to a financial crisis.

BANKING


Japan’s Banks Would Benefit From Sustainable Growth and an End to Deflation Sustainable growth, an end to deflation and an improved corporate lending environment would be credit positive for Japan’s banks. However, if growth remains elusive, Japan’s banks would continue to face the persistent credit challenges associated with intense competition and depressed deposit-loan spreads in a deflationary environment.

Banks Would Benefit from Sustainable Economic Growth and an End to Deflation Ending deflation and achieving sustainable nominal GDP growth would be credit positive for Japan’s domestic banking sector. One of the keys to revitalizing growth is increased private sector capital formation, which in turn should invigorate financial intermediation between savers and borrowers, the core function of the banking sector. The result would be an increase in lending.

Loan demand would be further strengthened by a return to inflation which increases the incentives for investors to finance fixed capital formation through greater borrowings rather than cash on hand. In mature economies, such as Japan, loan growth and nominal GDP growth are approximately equal over multi-year periods. Another positive impact of revitalized growth would be that it would create profit opportunities for companies, improving the financial health and credit profiles of the banks’ corporate clients.

EXHIBIT 1

Loan Growth in Japan Tracks Nominal Japanese GDP Growth

Source: Bank of Japan, Cabinet Office

Among the likely effects of a successful implementation of Abenomics, increased economic growth and a return to inflation would have the most lasting credit-positive effects on the banking sector. The positive effects would include the aforementioned increase in loan growth and higher earnings from widening deposit-loan spreads. Such spreads are currently depressed by the deflationary environment and intense competition among banks for creditworthy customers.

In contrast, these positive effects would be offset by the likely steepening of the yield curve. A steeper yield curve would reduce the value of the banks’ JGB portfolios, leading to mark-to-market losses, an unavoidable consequence of a successful shift to sustainable economic growth and inflation. However, although mark-to-market losses generate accounting losses, under an improved economic scenario, the risk associated with JGBs will decline and revenue streams from their holdings of JGBs will not change. Under such a scenario, banks face a choice of either realizing their losses and investing in higher yielding JGBs, thereby improving

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%Loan growth Nominal GDP growth

Graeme Knowd Associate Managing DirectorAnalyst +81.3.5408.4149 [email protected]

Tetsuya Yamamoto Vice President - Senior Analyst +81.3.5408.4053 [email protected]

BANKING


future returns; or of holding onto their portfolios to maturity, thereby enjoying the associated carry, and at the same time reporting unrealized losses and lower investment returns.

In our view, the longer-term benefits of a return to growth in the banking sector would outweigh the short-term credit-negative effect of mark-to-market losses. For most banks, a gradual rise in rates associated with market expectations that Abenomics will succeed would be manageable, although institutions less skilled at interest rate risk management (which would likely and primarily include smaller institutions) could see large unrealized losses during the transition.

Although the prospects for the success of Abenomics remain uncertain, monetary easing by the Bank of Japan (BOJ) has already had several credit-positive effects on the banking sector. The most direct effect has come from rising asset prices, particularly domestic equities. Share prices are currently mostly higher than the value at which the banks acquired their portfolios, leading to unrealized gains.

Domestic banks hold large equity portfolios, which result from the practice of Japanese banks purchasing the equity of some of their largest corporate clients as a sign of support and as part of the accepted nature of bank-client relationships in Japan. Over the last decade and more, such holdings have suffered huge losses, becoming a burden for the banks. The current buoyant stock market provides an ideal opportunity for the banks to make progress towards their stated goals of reducing their equity exposures and at the same time realize profits on some of their equity holdings, which would in turn improve their capital positions. The overall result would be a reduction in their risk exposure.

EXHIBIT 2

Banks: Credit Implications of an End to Japan’s Economic Stagnation



Improved labour productivity Productivity growth > 2%





Banks Positive Increases in loan growth as loans generally grow in line with nominal GDP and financially stronger borrowers.

Negative Reduces real value of JGB portfolios.

No impact Negative Increases the banks costs, and potentially reduces demand for mortgages and other large ticket items that might be funded by borrowings, leading to lower profitability.

Positive Interest spreads should improve as rates on interest-earning assets increase, leading to greater profitability.

Positive Improved loan growth = greater profitability.

Positive Interest income earned abroad translates into a greater amount of yen, therefore supporting profitability.

Positive Unrealized gains on equity, making it easier to sell equity holdings, and include in CET1 under Basel III rules.

Positive Inflation, coupled with sustainable growth, can encourage borrowing, as inflation helps erode the value of debt, leading to greater profitability.

Negative Large mark-to-market losses on JGBs.

credit positive

credit negative

BANKING


A challenging environment for banks persists if growth remains elusive In contrast, if the revitalization strategy does not generate sustainable growth, a third decade of economic stagnation would see the current credit challenges faced by the banking sector persist. Depressed deposit-loan spreads due to the deflationary environment and intense competition among banks for creditworthy customers will continue to weigh on loan growth and earnings.

Worse still, if the government’s rising debt burden erodes confidence in the JGB market, the consequences would be negative for banks. Currently, private sector savings are largely invested in domestic bank deposits, which the banks, in turn, invest into the JGB market.

Any loss of confidence -- that saw a reluctance by the private sector to hold its savings in the banking sector -- would make it difficult for banks to keep funding the government deficit. Such a scenario, which is not our central expectation but a plausible downside risk, would destabilize both the JGB market and the banking sector, potentially leading to a financial crisis.

CORPORATES


Economic Growth Would Boost Japan’s Corporate Earnings but Immediate Effects Varied If the economic revitalization plan is effective, the country’s non-financial companies should see their earnings and cash flow increase amid renewed GDP growth. However, if economic stagnation continues, smaller and less diversified companies by product and geographic markets will continue to be hardest hit.

Long-Term Economic Growth Hinges on Corporate Investment in Japan The key to long-term economic growth, the core objective of Abenomics, is a revitalization of the domestic economy. For this to occur, corporates must see the benefits of investing domestically, which hinges on the government’s ability to push through with structural reform.

Structural issues that may increase Japanese corporates’ willingness to invest domestically include a reduction in energy costs, which are heightened by the nuclear issues and the current yen weakness, increased labor market flexibility and reform of the corporate tax system.

Immediate Prospects for Corporates Show Considerable Differences on a Sector Basis However, for now, in the aftermath of the Abe administration’s implementation of some of its more immediate measures, the benefits for each of corporate sector vary, considerably in some cases.

For example, the weakness in the yen – a by-product of recent policies – has given a near-term fillip to exporters, but for energy companies has boosted their costs. And while the hotel and domestic tourism sector stands to benefit from more international tourists, who seek to take advantage of the weaker yen, those companies focused mainly on the domestic market could face higher import-related costs or pressure from the government’s plan to raise the consumption tax.

The impact of both increased interest rates and debt-servicing costs – two other expected effects of Abenomics – will be another, although modest, credit-negative development for all Japanese companies. Rated companies in Japan are typically large and financially healthy with average debt maturity profiles of several years and substantial cash balances. Accordingly, the full impact of increased interest rates will be felt over time rather than immediately.

Most rated companies also have good access to low-cost funding and the cushion of high EBIT to interest ratios. Companies with shorter average debt maturities would, however, face more stress if interest rates rise quickly and the capital markets become less liquid. These companies are typically relatively small and unrated.

Exporters and Corporates With Overseas Operations Benefit from the Weak Yen Many Moody’s-rated Japanese corporates are exporters and/or have significant businesses abroad and benefit directly from the weakening in the yen, which is a result of the Revitalization Strategy. The current softness in the currency is making Japanese products less expensive abroad, boosting profits for exporters such as automotive and consumer electronics companies.

However, the magnitude of such a benefit varies by company, and depends on several factors, including the percentage of profits or losses generated by their offshore subsidiaries, their percentage of exports from Japan and their percentage of debt denominated in foreign currencies.

Mariko Semetko Assistant Vice President - Analyst +81.3.5408.4209 [email protected]

Kazusada Hirose Vice President - Senior Credit Officer +81.3.5408.4175 [email protected]

Richard Bittenbender Associate Managing Director +81.3.5408.4025 [email protected]

CORPORATES


So far, the automotive and consumer electronics sectors have gained the most from Abenomics but, as indicated, to varying degrees. And these gains are primarily because of the weak yen. For example, within the automotive sector, Toyota Motor Corporation (Aa3 stable), with its larger Japanese export base, has benefitted proportionately more than Nissan Motor Co., Ltd. (A3 stable) and Honda Motor Co., Ltd. (A1 stable), which have smaller domestic export levels. Toyota, Honda and Nissan see foreign exchange as a significant operating-profit contributor in the 2013 fiscal year, which ends in March 2014. For example, Honda projects that its fiscal 2013 net increase in operating profit will be JPY235 billion year-over-year, of which JPY248 billion will be from foreign exchange gains.

Meanwhile, the shipping, steel and chemicals sectors face difficult regional and global operating environments, including overcapacity. For example, in the shipping sector, in the cases of Nippon Yusen Kabushiki Kaisha (Baa2 negative) and Mitsui O.S.K. Lines, Ltd. (Baa3 negative), industry-wide overcapacity will offset the benefits from the weak yen and cost efficiencies.11 And the steel industry, which includes Nippon Steel & Sumitomo Metal Corporation (A3 negative) and JFE Holdings, Inc. (Baa1 negative), also continues to struggle with regional and global overcapacity.12 We expect Asian steelmakers’ profits, as measured by EBITDA per tonne, will remain at a historically low level during the next 12 months, given persistent overcapacity.

Domestic-Focused Companies Will Need Sustained Domestic Growth The prospects for companies deriving most of their earnings from domestic consumers will remain overwhelmingly dependent on GDP expansion reaching the government’s targets of 3% nominal growth and 2% real growth. And while growth has shown some recovery in the last few months, the key question is sustainability.

Rated companies directly affected by the state of the economy include utilities Okinawa Electric Power Company, Incorporated (Aa3 stable) and Tokyo Gas Co., Ltd. (Aa3 stable) and passenger railroads Central Japan Railway Company (Aa3 stable) and East Japan Railway Company (Aa2 stable). And the utilities continue to struggle with higher imported energy costs following the weaker yen.

Moreover, the consumption-tax increase scheduled to take effect in April 2014 will prove credit negative because it is expected to depress consumer spending, at least temporarily and, as a result, corporate earnings.

The impact of the tax rise should be limited if the economy is, as the government intends, expanding. But the effect on consumer spending and related corporates could prove substantial if the hike takes effect in the absence of economic growth.

A summary of the credit implications of a successful Abenomics policy on the corporate sector in Japan may be found below. See exhibit 1.

11 Please see Global Shipping Industry: Sustained Oversupply Keeps Outlook Negative, 13 June 2013 12 Please see Asian Steel Industry: Destocking, Weak Demand and Excess Supply Depress Steel Manufacturers’ Profits, 7 August

2013



CORPORATES


EXHIBIT 1

Corporate Credit Implications of an End to Japan’s Economic Stagnation

Corporates



Improved labor productivity Productivity growth > 2%



Increased bank lending

JPY depreciation


Positive Boosts companies’ earnings and cash flows, particularly for exporters and those companies with large and profitable offshore subsidiaries; somewhat negative for importers.

Positive If it leads to wage rises, which would then lead to higher demand.

Positive Reduces relative input costs and helps export competitiveness.

Negative Depresses consumer spending, although the effect will be limited if the economy is expanding.

Negative Increases debt-servicing costs, but likely to be offset by sales growth and pricing power.

No impact Japanese corporates already have good access to bank lending. Increased lending would improve liquidity and is conducive to growth, but would also potentially raise leverage.

Positive Boosts export competitiveness, tourism and level of foreign-currency revenue.

Positive Facilitates equity raisings; may have indirect benefits for balance-sheet leverage as the denominator of debt to capitalization will rise more than the numerator; eases access to bank credit.

credit positive

credit negative

Continued Economic Stagnation Would Hurt Smaller and Less Diversified Companies Most If the revitalization strategy does not generate sustainable growth, a third decade of economic stagnation would prolong the credit challenges facing Japanese companies.

Overall, the financial health of all rated corporates in Japan depends on the strength of the domestic economy, regardless of the scale of their overseas operations and dependence on overseas markets. Toyota, for example, made 26% of its sales in Japan in the fiscal year which ended in March 2013. At the same time, the effects of continued economic stagnation would be varied throughout the corporate sector.

Moody’s-rated Japanese corporates are typically larger and more diversified by product and geographic markets than generally smaller and unrated companies, and would therefore be more insulated from the effects of continued tepid growth. So, in the absence of domestic growth, companies without a global presence would be most negatively affected. In such an environment, they would need to renew their cost cutting.

STRUCTURED FINANCE CMBS/REIT


Higher Property Prices, Increased Bank Lending Would Benefit Japan’s Commercial Real Estate Structured Finance Sectors If Japan’s Revitalisation Strategy were to succeed in generating growth, commercial mortgage backed securities (CMBS) and Japanese real estate investment trusts (J-REITs) would benefit from higher property prices and increased bank lending. Those backed by hotels would also benefit from a depreciated yen. However, in the absence of growth, default rates would rise.

CMBS would benefit from higher property prices and a weaker currency Higher property prices would facilitate the refinancing of CMBS loans to pay back investors and improve recovery rates for defaulted loans.13 Although normalized interest rates higher than today’s rates would be a negative for refinancings, refinancing risk for the underlying loans of CMBS deals would be unlikely to increase substantially from current levels because of higher property prices.14

In addition, a weakening JPY, associated with monetary easing, would lead to an increase in the numbers of overseas visitors to Japan, which would be credit positive for CMBS backed by hotels: As demand rose, hotels would be able to raise room rates above the inflation rate.15 Hotels in Tokyo, Kyoto and Osaka would be the biggest beneficiaries because of their popularity with tourists and, in the case of Tokyo and Osaka, business travelers.

J-REITs would also benefit from higher property prices and increased bank lending Higher property prices would also make J-REITs more attractive to equity investors, allowing the property trusts to expand their portfolios by tapping the equity markets to fund purchases. J-REITs sponsored by major developers, such as those with strong pipelines of newly built properties, would benefit the most because of their ability to purchase new buildings below market prices from sponsors. Exhibit 1 maps out the specific impact of the different aspects of Abenomics on CMBS and J-REITs.

13 See Japan Real Estate Sector Outlook Stable, 4 July 2013. 14 See Japanese RMBS, ABS and CMBS: 2013 Outlook, 15 January 2013. 15 See Lower JPY and Rise in Overseas Tourists Are Credit Positive for J-CMBS Backed by Hotels, 29 May 2013.

Takahiro Okubo Vice President - Senior Analyst +81.3.5408.4167 [email protected]

Yusuke Seki Associate Managing Director +81.3.5408.4279 [email protected]

Kei Kitayama Managing Director - Asia Pacific Structured Finance +81.3.5408.4161 [email protected]

Arthur Karabatsos Vice President - Senior Analyst +612.9270.8160 [email protected]


http://www.moodys.com/viewresearchdoc.aspx?docid=PBS_SF314004


STRUCTURED FINANCE CMBS/REIT


EXHIBIT 1

CMBS/J-REITs: Credit Implications of an End to Japan’s Economic Stagnation



Consumption tax increase




CMBS and J-REITs

Positive Demand for commercial property would rise, and prices and rents would therefore rise.

Positive Inflation expectations would fuel property price increases.

Positive Increase in productivity would help increase demand for commercial property.

Marginally Negative A rise in the consumption tax would reduce disposable income and dampen demand for goods and services, and thus weaken demand for commercial property.

Marginally Negative CMBS borrowers would find refinancing their loans more difficult, which higher property prices would mitigate. The J-REIT sector has historically relied heavily on bank funding.

Positive CMBS borrowers would find refinancing easier. The J-REIT sector has historically relied heavily on bank funding.

Positive A weakening JPY would fuel tourism and benefit CMBS and J-REITS with hotel properties.

Positive Higher asset prices would support refinancing and recovery rates.

credit positive

credit negative

Source: Moody’s Investors Service

In the absence of growth, CMBS and J-REIT securities will continue to face challenges If the revitalization strategy does not generate sustainable growth, a third decade of economic stagnation will perpetuate challenges for the CMBS and J-REITS markets. Both the CMBS and J-REIT markets still rely heavily on bank funding, and if the real estate market remains lackluster, bank lenders will remain reluctant to refinance loans in those markets. As a result, loans with relatively high loan-to-value (LTV) ratios will continue to default, and losses on CMBS junior notes with initial ratings of A or lower will continue to increase.

Any erosion in the Japanese government bond (JGB) market resulting from the government’s rising debt burden would negatively affect CMBS and J-REITs. Because the sector still relies heavily on bank funding, any decline in bank lending resulting from mark-to-market losses on JGBs because of a rise in interest rates above normalized rates would lead to even higher default rates on loans in the CMBS J-REIT markets.16 This scenario is not our central expectation but remains a downside risk.

16 See Debt Maturities and Tenors Differentiate the Credit Profiles of J-REITs, 31 July 2013.


STRUCTURED FINANCE RMBS/ABS


Growth in GDP and Employment Would Benefit Japan’s RMBS and ABS The performance of residential mortgage-backed securities (RMBS) and consumer loan asset-backed securities (ABS) would benefit if Abenomics were to succeed in generating employment growth and higher incomes. In the absence of growth, however, weaker employment and salaries would translate into higher default rates.

RMBS would benefit from growth in property prices and employment The impact of a growing Japanese economy on RMBS would be credit positive because of rising property prices and employment prospects. The negative effects of rising interest rates on RMBS deals would be modest for deals with existing floating-rate mortgages.

Property price increases, fuelled by inflationary expectations, would improve recovery rates on defaulted loans. Government measures to evaluate or certify the durability, earthquake-resistance and energy use of existing homes and to encourage the construction of homes with longer life spans would also support recovery rates.17

Higher GDP growth, greater productivity and a depreciating yen would result in rises in employment as well as salaries and, therefore, strengthen obligors’ ability to make repayments. Government initiatives to transition the workforce to growth industries aim to lower unemployment and strengthen obligors’ ability to pay down their mortgages. The decline in the unemployment rate to 3.9% in June 2013 is due partly to the creation of new jobs resulting from the current mix of economic policies.

Normalization of interest rates, which would be likely in a strong growth environment, would not affect the 50% of existing deals backed by fixed-rate mortgages; however, higher rates would be credit negative for new and existing deals backed by floating-rate mortgages, because obligors’ debt-service coverage would decline, which would increase the probability of default.18 Nonetheless, the impact of higher interest rates on existing floating-rate mortgages would be modest: The increased interest would accrue on a much smaller loan balance as a result of amortization, causing the absolute increase in monthly payments to be lower than for new mortgages. The deals we rate have been amortizing for 8.3 years on average, with an average remaining principal amount of about 70% of the initial loan balance.

A consumption tax increase, which the government is currently contemplating, would be a credit negative for RMBS performance because the tax would reduce disposable income and therefore debt-service coverage, although the benefits associated with higher growth, employment and salaries would offset this risk.

Economic growth and employment gains would benefit some ABS more than others Consumer loan ABS would similarly benefit from employment gains and rises in wages. However, credit card ABS would not benefit as much, because consumer loan ABS contain the highest proportion of loans

17 See New Government Measures on Used Homes Is Credit Positive for Japanese RMBS Deals with Predominantly Refinanced

Loans, 26 June 2013. 18 See Abenomics Is Credit Negative for New Mortgages; Existing Mortgages Less Affected, 31 July 2013.

Atsushi Karikomi Vice President - Senior Analyst +81.3.5408.4185 [email protected]

Shinichiro Kan Vice President - Senior Analyst +81.3.5408.4263 [email protected]

Hiroyuki Kato Vice President - Senior Analyst +81.3.5408.4261 [email protected]

Yusuke Seki Associate Managing Director +81.3.5408.4152 [email protected]

Kei Kitayama Managing Director - Asia Pacific Structured Finance +81.3.5408.4161 [email protected]

Arthur Karabatsos Vice President - Senior Analyst +612.9270.8160 [email protected]






to obligors without permanent full-time jobs. Government policies to raise hourly rates for these “irregular” workers would benefit these obligors.19

Any negative effects would be small. Normalization of interest rates on the performance of existing ABS would be unlikely to have a negative impact because the underlying assets in ABS all have fixed interest rates. Additionally, growth, employment and salaries would likely offset the effect of a reduction in discretionary income resulting from consumption tax changes.

Exhibit 1 maps out the specific impact of the different aspects of Abenomics on RMBS and ABS.

EXHIBIT 1

RMBS/ABS: Credit Implications of an End to Japan’s Economic Stagnation



Consumption tax increase




RMBS Positive Robust GDP growth would lead to improved employment prospects and increased salaries.

Negative Higher interest rates following the end of deflation would result in higher defaults, especially on floating-rate mortgages.

Positive Increasing productivity would lead to improved employment prospects and increased salaries.

Marginally Negative Consumption tax increase would reduce disposable income and therefore debt-service coverage.

Negative For new loans, debt-service coverage would decline, leading to higher default rates.

Positive Increased lending would spur property price growth.

Positive RMBS would benefit from improved employment prospects and increased salaries as a result of JPY depreciation.

Positive Higher asset prices would support refinancing and recovery rates.

Less negative For existing deals, the increased interest would accrue on a much smaller loan balance.

ABS

Positive Improved employment prospects and increased salaries led by GDP growth would strengthen obligors’ repayment ability.

Neutral For existing deals.

Positive Improved employment prospects and increased salaries together with increasing productivity would strengthen obligors’ repayment ability.

Marginally Negative Consumption tax increases would reduce obligors’ debt-service coverage because the cost of goods they purchase would increase and disposable income would decline.

Neutral For existing deals, obligor’s repayment obligations would not change because loans bear a fixed interest rate.

Neutral Positive Improved employment prospects and increased salaries as a result of JPY depreciation would strengthen obligors’ repayment ability.

Neutral

Negative Obligors’ repayments would be higher in future deals because of increases in both the cost of goods and interest rates.

credit positive

credit negative

Source: Moody’s Investors Service

19 See Government’s Strategy to Support Job Transitions for Irregular Workers Is Credit Positive for Consumer Loan ABS, 10 July

2013.




Lack of growth will have a negative impact on both RMBS and consumer loan ABS If the revitalization strategy does not generate sustainable growth, a third decade of economic stagnation will increase the credit challenges for RMBS and ABS transactions, leading to higher default rates in an environment of lackluster employment and minimal salary growth. Exhibits 2 and 3 show that RMBS annualized default rates and ABS annualized default rates are currently at all-time lows.

EXHIBIT 2

Japanese RMBS Default Rate Indexes - Annualized

Source: Moody's, servicer/issuer reports

EXHIBIT 3

Japanese ABS Default Rate Indexes - Annualized

Source: Moody's, servicer/issuer reports

Furthermore, erosion of confidence in the Japanese government bond (JGB) market would be negative for RMBS and ABS. This scenario is not our central expectation but a plausible downside risk: Both the JGB market and the banking sector would destabilize, leading to interest rates above the normalized rate, which would lower debt-service coverage in borrowers and result in an increase in delinquencies and defaults.

0.0%

0.2%

0.4%

0.6%

0.8%

1.0%

Jan-

01

Aug-

01

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-02

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-02

May

-03

Dec

-03

Jul-0

4

Feb-

05

Sep-

05

Apr-

06

Nov

-06

Jun-

07

Jan-

08

Aug-

08

Mar

-09

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-09

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-10

Dec

-10

Jul-1

1

Feb-

12

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12

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13

% o

f Out

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ance

Annualized Defaults

0%

5%

10%

15%

20%

25%

Jan-

01

Aug-

01

Mar

-02

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-02

May

-03

Dec

-03

Jul-0

4

Feb-

05

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05

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06

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-06

Jun-

07

Jan-

08

Aug-

08

Mar

-09

Oct

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Jul-1

1

Feb-

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% o

f Out

stan

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ance

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Insurance Kenji Kawada Vice President - Senior Analyst Graeme Knowd Associate Managing Director Structured Finance CMBS/REIT/RMBS/ABS Takahiro Okubo Vice President - Senior Analyst Yusuke Seki Associate Managing Director Kei Kitayama Managing Director - Asia Pacific Structured Finance Arthur Karabatsos Vice President - Senior Analyst Atsushi Karikomi Vice President - Senior Analyst Shinichiro Kan Vice President - Senior Analyst Hiroyuki Kato

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Tim Osborne Senior Vice President - Ratings Communications [email protected]



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