Japan's central bank offered a bleaker view of the economy and the government warned of worsening business sentiment as exports slumped, adding to evidence of the pain Europe's debt crisis is inflicting on global growth and Japan's recovery prospects.
But in a sign Japan's tattered finances leave it with little room for more fiscal stimulus, Rating and Investment Information Inc (R&I) stripped the country of its AAA status, the first downgrade by a domestic credit ratings agency.
That puts the onus on the Bank of Japan, which kept monetary settings unchanged at a rate review on Wednesday but cut its economic assessment and acknowledged that growth will stagnate at least until spring next year.
BOJ Governor Masaaki Shirakawa said that while Japan's economy was still headed towards a moderate recovery, Europe's sovereign debt crisis and economic stagnation were hurting global growth including Japan.
"A delay in dealing with Europe's crisis may have a severe impact on the global economy. We must prevent this from happening at all cost," he told a news conference.
As widely expected, the BOJ held off on offering additional monetary stimulus after having eased policy two months ago with an increase in asset purchases, in a bid to save its limited options in case the economy faces deeper troubles next year.
"We expect the BOJ to implement additional easing steps in January-March as there is a chance the yen will appreciate further during that period," said Takahide Kiuchi, chief economist at Nomura Securities in Tokyo.
"Another trigger could be a credit rating downgrade for European sovereign debt. If that happens and causes financial market turmoil, coordinated monetary easing with U.S. and European central banks could be a possibility."
Japan's economy rebounded from a recession triggered by the March earthquake and tsunami, but is expected to slow sharply this quarter as the initial spurt driven by companies restoring supply chains and production facilities tails off.
Many in the BOJ are counting on support for growth from fiscal spending for reconstruction from the March disaster, but that may not be enough to offset weakening overseas demand.
"Japan's economy will remain more or less flat for the time being" before resuming a moderate recovery, the BOJ said, sounding slightly more gloomy than last month on the outlook.
The government kept its economic assessment intact in its monthly report issued on Wednesday but cut its view on business sentiment, reflecting worsening confidence among big manufacturers in the BOJ's December tankan survey.
It is also expected to cut its economic forecast for the next fiscal year beginning in April to 2.2 percent growth, a source told Reuters, matching the BOJ's projection but still rosier than private-sector estimates.
The government and Shirakawa both warned that a summit in Europe this month has failed to quell fears about the region's public finances, keeping markets on edge.
"Bond yields in some countries continue to rise (even after the summit) and market tension runs high," Shirakawa said. "The effect is spreading globally via trade and financial channels."
Central banks are flooding markets with cash to support growth. The Federal Reserve has pledged to keep interest rates near zero until mid-2013 and the European Central Bank cut its main interest rate to a record low this month.
The BOJ, too, has kept rates virtually at zero and eased policy in October by topping up its asset buying scheme to ease the pain from sharp yen rises on the export-reliant economy.
It has stood pat since then but expressed its readiness to inject huge amounts of liquidity in market operations and loosen monetary policy to fend off any contagion from Europe as it sees a global credit crunch as a real potential risk.
Shirakawa, however, has warned that easy monetary policy alone cannot fix Japan's structural problems that led to ballooning public debt, such as its rapidly ageing society, low potential growth and delays in tax reforms.
R&I also cited inadequate social security reform and an unclear outlook for economic revitalization as reasons for its ratings cut, which followed a series of cuts by other agencies such as Standard & Poor's and Moody's Investors service.
Japan's bond market has continued to attract investors, mostly risk-shy domestic players, but the clock is ticking for Tokyo to deal with its soaring public debt, which has grown to roughly twice the size of its $5 trillion economy.
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