The decision by

Moody's Investors Service

to place Japan's sovereign debt

on watch for another possible downgrade is bemusing many market observers. How can a country, which records a significant current account surplus every year and with reserves of almost $300 billion and very little foreign-currency-denominated debt, be a credit risk?

Moody's has already shown itself to be more skeptical of developments in Japan than the other leading credit-rating agency

Standard & Poor's

. Moody's downgraded Japan's sovereign rating to Aa1, its second-highest rating, in November 1998. S&P, on the other hand, has maintained a triple-A rating on Japan since 1975. In recent weeks, rumors have been circulating in the foreign-exchange market that Moody's was preparing to downgrade Japan's sovereign rating. Most observers expect a decision in the second quarter.

After the dollar's recent struggles to move above the 110-yen level, Moody's news provided the sufficient impetus, and by the end of the week, the dollar was trading near the 111 area. The 111.50-to-112.00 area may be a difficult barrier for the dollar, even though talk suggests managers of leveraged funds have been buying short-dated dollar calls struck near 113 yen. Japanese bonds, unsurprisingly, sold off sharply in response to Moody's announcement.

The actual decision to lower Japan's credit rating won't be made for a couple of months. The head of Moody's sovereign risk unit in New York was quoted on

Bloomberg News

saying: "Japan, under almost all circumstances, is a 'double-A' credit." This suggests the risk that Japan's credit rating could be cut as much as two notches.

A cut of one notch in Japan's credit rating would put it at the same level as Spain and Portugal and one notch below Canada and Belgium. What's going on?

Moody's said the problem was that the government's effort to spend its way out of the country's stew of recession and slow growth has proven costly and ineffective. The sequence of growth in Japan over the most recent quarters was a string of five quarters of contraction and two quarters of expansion, and then it looks like two quarters of contraction in the second half of 1999.

The government has spent an estimated 120 trillion yen ($1.1 trillion) since 1992 on packages aimed at reflating the economy. Its gross public debt is likely to reach 115% to 120% of GDP this year. Japan's

Ministry of Finance

estimates that it will have to sell 30 trillion yen (about $280 billion) in new bonds a year for the next five years to pay its interest bill and fund current spending.

This pace of fiscal spending and debt accumulation cannot continue much longer. Moody's warns that stabilizing the public debt position may not be possible without slowing the economy.

Many market participants have a blind spot, if I can be so frank. They seem to think that one can have too much of anything but capital. And yet this is precisely Japan's problem: a surplus of capital. Even some of the most astute market observers understand Japan's problem in terms of classic Keynesian insufficient demand.

Insufficient demand in Japan is really a reflection of the surplus capital rather than the other way around. Last year, Japan's private sector saved 28% of GDP. This is above the average savings rate since 1985. Last year, the private sector invested 17% of GDP. To put this in perspective, the U.S. invested about 16% of GDP in 1999.

This large gap between savings and investment is the source of the surplus capital. The law of supply and demand dictates that when a good or a factor of production is in relatively greater supply, its price/return will fall. One recent investment house study found that the return on capital in Japan is about half of that of the U.S. Similarly a good or factor with excess supply encourages its inefficient use. Sure enough, a number of studies suggest the productivity of Japan's capital is below that in the U.S.

In essence, Japan has tried to absorb its surplus capital through wasteful government spending and inefficient private investment. The government spending is reaching political and economic limits. The inefficient private investment prong is meeting resistance by shareholders and corporate reform efforts.

To reduce the deficit and public-sector debt, the government will have to raise taxes. The news that has rattled bank shares in Japan is a proposal by the local Tokyo government to tax the operating profits of the large Japanese banks based within its jurisdiction. There is also recurring talk that the ruling

Liberal Democratic Party

is considering raising the retail sales tax. Reducing Japan's debt position risks not only slowing the economy, as Moody's correctly points out, but would exacerbate the surplus capital problem I have identified. Private-sector savings would rise. Increasing the efficiency of private investment in Japan would also exacerbate the surplus capital problem.

There is no clear solution for Japan's surplus capital problem short of a major revamp of the Japanese political economy: Policymakers cannot or will not think outside the box. The Japanese society is at an important juncture at which bolder vision and more radical policies need to be considered. The potential downgrade of Japan's sovereign credit rating is a useful reminder of Japan's policy dilemma and the serious limitations of traditional medicine.

Marc Chandler is the chief currency strategist for Mellon Bank. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

chandler.m@mellon.com.