Japan is preparing to elect its sixth leader in five years to change unpopular Prime Minister Naoto Kan, under fire for his handling of the reaction to a March tsunami and subsequent radiation crisis at a crippled nuclear energy plant.
The downgrade, while not out of the blue, served as another reminder of the debt burdens that nearly all the world's major advanced economies shoulder. The United States lost its top-tier AAA score from Standard & Poor's earlier this month, and Moody's warned in June it may downgrade Italy.
"Over the past five years, frequent changes in (Japan's) administrations have prevented the federal government from implementing long-term economic and fiscal strategies into effective and durable guidelines, " Moody's said.
Moody's had warned in May that it might downgrade Japan's Aa2 rating because of heightened concerns about faltering growth prospects and a weak policy response in order to rein in bulging public debt, already twice the size of its $5 trillion economic climate.
Finance Minister Yoshihiko Noda, a fiscal conservative who has joined the race to achieve success Kan, said he wanted to refrain from direct comment on Moody's downgrade.
However he added: "Recent JGB auctions have met favourable demand and I do not see any change in market confidence in JGBs. "
Analysts said the downgrade was hardly a surprise and also the bond market reaction should be muted.
"I had expected that the rating cut might have taken place after the election for the leadership of the (ruling) Democratic Celebration of Japan. But looking at the candidates, there seems to be nobody included in this who would seriously tackle financial reform, so that's why Moody's went forward and cut the rating, " said Yuuki Sakurai, CEO and president associated with Fukoku Capital Management Inc.
"Moody's probably took the view that Japan's financial situation will continue worsening. "
Japan's next leader has a mountain of problems ahead, from battling a soaring yen and forging a post-nuclear crisis energy policy to rebuilding in the tsunami and reining in public debt while paying for reconstruction and the bulging costs of the ageing society.
Noda's chances of winning an Aug. 29 ruling party leadership race to choose Kan's successor dimmed this week after former Foreign Minister Seiji Maehara, who says beating deflation ought to be the top priority, reversed course and decided to run.
TAX HIKES AND TIMING
The majority of the seven DPJ candidates eyeing the top job agree Japan must eventually raise its 5% sales tax to assist fund the ballooning social welfare costs of its fast-ageing society. Only Noda, nevertheless, favours raising other taxes soon to fund reconstruction of Japan's tsunami-devastated northeast area, and even he has been toning down that stance lately.
"We have major developments about the political front, and while most people in the market believe Maehara is extremely likely to win the election, a swift policy response on debt problems is unlikely in the future out soon, " said Norihiro Fujito, senior investment strategist at Mitsubishi UFJ Morgan Stanley Investments in Tokyo.
The yen barely moved on the downgrade news, trading from around 76. 7 to the dollar.
"Several factors make it difficult for Japan to slow the growth of debt-to-GDP and therefore drive this rating action, " Moody's said in a statement, adding how the March 11 earthquake and nuclear crisis had exacerbated Japan's problems.
Still the actual ratings agency said the outlook was now stable given the "undiminished house bias of Japanese investors and their preference for government bonds, which allows the government's fiscal deficits to become funded at the lowest nominal rates globally".
The downgrade brings Moody's score for Japan into line with rival agency Standard & Poor's, which reduce Japan's rating in January to AA minus, the fourth-highest on its size.
Moody's downgrade of Japan was its first since 2002, when it decreased the rating to A2, six notches from the top. It had upgraded Japan 3 times since then, with the last upgrade as recent as May 2009.
Persistent deflation and slow growth has shackled Japan's economy for a long time, reducing tax revenues available to the government, which has grown to depend on debt issuance to finance a large part of its budget.