is preparing to elect its sixth leader in five years to replace unpopular Prime Minister Naoto Kan
, under fire for his handling of the response to a March tsunami and subsequent radiation crisis at a crippled nuclear power plant.
The downgrade, while not out of the blue, served as another reminder of the debt burdens that nearly all of the world's major advanced economies shoulder. The United States lost its top-tier AAA rating from Standard & Poor's earlier this month, and Moody's
warned in June that it may downgrade Italy as Europe's sovereign debt crisis festers.
"Over the past five years, frequent changes in (Japan's) administrations have prevented the government from implementing long-term economic and fiscal strategies into effective and durable policies," Moody's said.
Moody's had warned in May that it might downgrade Japan's Aa2 rating due to heightened concerns about faltering growth prospects and a weak policy response to rein in bulging public debt, already twice the size of its $5 trillion economy.
Finance Minister Yoshihiko Noda, a fiscal conservative who has joined the race to succeed Kan, said he wanted to refrain from direct comment on Moody's downgrade.
But he added: "Recent JGB auctions have met favourable demand and I don't see any change in market confidence in JGBs."
Analysts said the downgrade was hardly a surprise and the bond market reaction should be muted.
"I had expected that the rating cut would have taken place after the election for the leadership of the (ruling) Democratic Party of Japan. But looking at the candidates, there seems to be nobody among them who would seriously tackle financial reform, so that's why Moody's went ahead and cut the rating," said Yuuki Sakurai, CEO and president of Fukoku Capital Management Inc.
"Moody's probably took the view that Japan's finances will continue worsening."
Japan's next leader has a mountain of challenges ahead, from battling a soaring yen and forging a post-nuclear crisis energy policy to rebuilding from the tsunami and reining in public debt, while paying for reconstruction and the bulging costs of an ageing society.
The government on Thursday unveiled steps to help firms cope with the yen's recent rise to record highs, including a $100 billion emergency credit facility aimed at making it easier for Japanese companies to buy foreign firms.
It also said it would ask major financial firms to report on dealers' currency positions for the period to the end of September, an apparent attempt to curb speculation.
"We are watching more carefully than before whether there is any speculative activity in the market. We won't exclude any options and will take decisive action when necessary," Noda told a news conference to announce the government measures. Noda's chances of winning an Aug. 29 ruling party leadership race to pick Kan's successor dimmed this week after former Foreign Minister Seiji Maehara, who says beating deflation should be the top priority, reversed course and decided to run.
TAX HIKES AND TIMING
Most of the seven DPJ candidates eyeing the top job agree Japan must eventually raise its 5 percent sales tax to help fund the ballooning social welfare costs of its fast-ageing society. Only Noda, however, favours raising other taxes soon to fund reconstruction of Japan's tsunami-devastated northeast region, and even he has been toning down that stance lately.
"We have major developments on the political front, and while most people in the market believe Maehara is very likely to win the election, a swift policy response on debt problems is unlikely to come out soon," said Norihiro Fujito, senior investment strategist at Mitsubishi UFJ Morgan Stanley Securities in Tokyo.
"Several factors make it difficult for Japan to slow the growth of debt-to-GDP and thus drive this rating action," Moody's said in a statement, adding that the March 11 earthquake and nuclear crisis had exacerbated Japan's problems.
The yen barely moved on the downgrade news, trading at around 76.7 to the dollar, while 10-year JGB futures 2JGBv1 were up 0.08 point at 142.63 at the end of the morning session after initially dipping into negative territory. Japanese stocks eased.
Moody's said the outlook for Japan's credit rating was now stable given the "undiminished home bias of Japanese investors and their preference for government bonds, which allows the government's fiscal deficits to be funded at the lowest nominal rates globally".
The downgrade brings Moody's rating for Japan into line with rival agency Standard & Poor's, which cut Japan's rating in January to AA minus, the fourth-highest on its scale.
Moody's downgrade of Japan was its first since 2002, when it reduced the rating to A2, six notches from the top. It had upgraded Japan three times since then, with the last upgrade as recent as May 2009.
Persistent deflation and slow growth has shackled Japan's economy for years, reducing tax revenues available to the government, which has grown to rely on debt issuance to finance a large part of its budget.