Jan. 27 (Bloomberg) -- The cut to Japan’s debt rating outlook by Standard & Poor’s escalated pressure on Prime Minister Yukio Hatoyama to rein in spending and consider raising taxes to reduce the nation’s borrowing.

S&P yesterday lowered the outlook on Japan’s AA sovereign credit rating to “negative” because of diminishing “flexibility” to cope with the world’s largest public debt and concern about the lack of a plan to rein in budget deficits.

The move highlights concern that the shrinking Japanese population and stagnating economy will erode a savings pool that has kept yields on benchmark 10-year bonds below 2 percent for 11 years. At the same time, because domestic investors hold more than 90 percent of Japan’s debt, there may be little risk of an immediate increase in borrowing costs that would force Hatoyama and Finance Minister Naoto Kan to act more quickly.

“There is no way Japan can keep bleeding deficits like this without drawing a roadmap to restore its fiscal health,” said Shuichi Obata, senior economist at Nomura Securities Co. in Tokyo. “Japan’s already a lit bomb, but no one knows the length of the fuse. The key is to defuse the bomb at some point before it explodes.”

Ten-year bond yields rose half a basis point to 1.325 percent at 9:56 a.m. in Tokyo. Credit-default swaps showed an increase in Japanese bond risk yesterday, with the cost of protecting from default for five years climbing to 88 basis points, the highest since April 2009, according to CMA DataVision.

‘Wake-Up Call’

National Strategy Minister Yoshito Sengoku said the government needs to consider S&P’s warning as a “wake-up call.” Kan said it’s “extremely important to maintain fiscal discipline and pursue fiscal health.”

The two ministers are working to formulate a “medium- term fiscal framework” by June. Sengoku chairs a panel that first met this week to begin drafting the plan.

Kan has been asking the central bank to support the economy, saying in parliament yesterday that it has more options available to fight deflation. Hours later, the Bank of Japan left its policy unchanged and kept benchmark interest rates at 0.1 percent.

Since their Democratic Party of Japan took power in September, Hatoyama and Kan have argued that stimulus to support households is needed to cement the recovery from Japan’s worst postwar recession. The premier has deferred debate on reducing the public debt as his approval ratings tumble ahead of an upper house election scheduled for July.

Election Looms

S&P wouldn’t have issued its debt warning “if Japan’s government had published its mid-term fiscal consolidation plan earlier,” said Junko Nishioka, chief economist at RBS Securities Japan Ltd. in Tokyo. “As a national election approaches, the government will stick to the economic policy of providing aid for households and assisting employment.”

Hatoyama’s approval rating fell to 45 percent from 56 percent earlier this month, according to a Yomiuri newspaper survey published on Jan. 18.

Kaoru Yosano, who was finance minister in the previous administration, said last week that Japan is on the verge of an “uncontrollable rise” in bond yields as the difference between public debt and net household savings narrows. The DPJ “doesn’t have a sense of crisis about this,” he said.

Roubini ‘Worried’

Nouriel Roubini, the New York University professor who predicted the global financial crisis, said he was “worried” about the Japanese economy as its debt mounts, deflation returns and population ages. While Japan can currently finance itself thanks to domestic savers, at some point they may “flee the yen,” pushing up borrowing costs and crippling the economy, he said in an interview on Bloomberg Radio.

Japanese have funded state spending through their more than 1,400 trillion yen in savings.

The outlook downgrade came a day after the government said public debt will probably spiral to 973 trillion yen in the year starting April 1, almost double gross domestic product and the equivalent of 7.7 million yen for each citizen.

Japan lacks a “credible” strategy to fix its finances, Andrew Colquhoun, a member of the sovereign rankings group for Asia and the Pacific at Fitch Ratings, said on Bloomberg Television today.

“The government needs to act now,” said Masamichi Adachi, senior economist at JPMorgan Chase & Co. in Tokyo, who used to work at the Bank of Japan. “We need reforms the size of the Meiji Restoration.”

Broken Promises

Hatoyama has been forced to break campaign promises to secure revenue. He kept a gasoline tax that he had pledged to abolish after the Finance Ministry projected that tax revenue will fall below bond sales for the first time in 63 years.

Other promises remain intact. Hatoyama said this month that the country’s sales tax won’t be raised from the current 5 percent for four years.

Kan repeated yesterday that cutting costs remains the government’s top priority, and he won’t debate changes to the tax code until all “wasteful” spending has been eliminated.

“There will come a time when we need to discuss reforming the tax structure,” Kan told lawmakers in parliament. “But it is only after we make a strident effort to eliminate wasteful and inappropriate spending that we can start to do that.”

Adachi at JPMorgan said there’s no room for delaying an increase in the sales tax and the current government is “way too populist” to commit to restoring Japan’s fiscal health. “The sooner Japan takes on the pain, the better.”

To contact the reporters on this story: Aki Ito in Tokyo at aito16@bloomberg.net; Mayumi Otsuma in Tokyo at motsuma@bloomberg.net

Last Updated: January 26, 2010 20:02 EST

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