Moody's rating move on Japan starts alarm bells ringing in the West

The shot Standard & Poor's put across Britain's bow last week made headlines.

An earlier one by Moody's Investors Service deserves more attention.

The Moody's action didn't involve the UK, but Japan.

On May 18, it stripped Asia's biggest economy of its last AAA rating. Moody's cut Japan's foreign-currency debt grade from Aaa to Aa2. While Japan is a negligible overseas borrower, the symbolism extends to a much bigger point.

With its Japan move, Moody's opened a Pandora's Box for top credits. Three days after Moody's cut Japan, S&P lowered its outlook on Britain to "negative" from "stable". S&P said the nation faced a one-in-three chance of a rating cut as debt approaches 100 per cent of gross domestic product.

Market-shaking government downgrades are now on the table, and Asia would be wise to brace for them.

It raises obvious questions about the US, which relies on Asia's money. Treasury Secretary Timothy Geithner wasted no time last week in reassuring markets that the Obama administration is committed to reducing the federal budget deficit. Forcing him to the microphone was a jump in government-debt yields.

Geithner also is aware of rumblings in Beijing and Tokyo, where politicians have voiced concerns about the safety of their US debt holdings. If Asian central banks begin dumping their trillions of dollars of US debt, the greenback will plunge.

Treasuries, the US dollar and American stocks had a rocky week amid concern about that eventuality. Bill Gross, the co-chief investment officer of Pacific Investment Management, said the US "eventually" would lose its AAA grade.

Japan's downgrade matters less than a US one would, of course. The yen is far from being the world's reserve currency. Nor do Asian central banks hold anywhere near as many Japanese government bonds as they do US debt. Still, Japan's downgrade suggests a new assertiveness on the part of ratings companies. It's fair to ask who cares a lick about what Moody's or S&P say.

They dropped the ball on the 1997 Asian crisis, the dot-com crash a few years later and the current credit-market meltdown. Moody's, S&P and Fitch Ratings all gave Lehman Brothers Holdings bonds at least an A rating - meaning they were a safe investment - right until the day Lehman filed for bankruptcy.

The assertiveness we are seeing may be an exercise in reputation enhancement. Then again, it also is recognition that governments are increasing borrowing at an historic rate. Central banks are pumping unprecedented liquidity into markets. Once global growth returns, all that money is likely to cause inflation. Rising yields will add to public-debt burdens. Downgrading the US will require great courage. You can just imagine the backlash on Capitol Hill when Moody's or S&P pulls the trigger.

The sub-prime-related Congressional investigations that debt graders want to avoid would become a certainty. It's coming, though, as investors point out.

Japan's debt load is huge, and growing. It will spiral to 197 per cent of GDP next year, according to an OECD estimate published before Japan unveiled the most recent of three stimulus packages on April 10. The plan will bring new bond sales to a record 44.1 trillion ($753 billion) in the year ending March.

Even so, few investors would even entertain the thought of betting on a default by savings-rich Japan. Moody's last week said it was unlikely to cut Japan's debt rating over the next year because investors were willing to buy bonds that would fund stimulus measures, and the economy would probably recover.

Part of last week's action by Moody's was to bring Japan's local and foreign-currency debt ratings to the same level, Aa2, to reflect that the repayment risk for each is equal. When Moody's highlights Japan's funding abilities, though, it inadvertently fuels speculation about highly rated countries that have fewer options.

Is the US such a nation? Again, the idea of a Russia-style default by the US is all but unthinkable. Even so, the world's biggest economies are arguably reaching an inflection point where the growth in debt loads is becoming unsustainable.

Recent comments out of Beijing, Brasilia, Moscow, Tokyo and the Gulf states suggest the US has some trust issues to address. Brazilian President Luiz Inacio Lula da Silva and his Chinese counterpart Hu Jintao discussed a plan to settle trade in local currency during Lula's three-day state visit to China last week.

That won't happen anytime soon. Like it or not, our current world financial system was built around the US dollar. Now isn't the time to change things. Two years from now? Perhaps. At a time when economies are in turmoil? Hardly. There is clearly a desire, though, to rely less on the US currency. The reasons are both economic and political.

A downgrade of US credit would accelerate that process. On that score, recent steps by Moody's in Japan could be a global harbinger.

- BLOOMBERG