TOKYO (AFX-ASIA) - Standard & Poor's Corp decided to downgrade Japan's long-term sovereign ratings by only one notch, rather than the two or three that had been feared, leaving markets largely stable, dealers said. Standard & Poor's said it cut its long-term local and foreign currency sovereign credit ratings on Japan to AA from AA+, adding that the outlook for the ratings remains negative. It attributed the downgrade to the slow progress in the reforms of the administration of Prime Minister Junichiro Koizumi. "Although marginal progress may be achieved, Standard & Poor's expects further significant weakening of both the Japanese economy and the government's fiscal position before more radical action is taken," it said. The agency said it affirmed the short-term local and foreign-currency sovereign ratings at A-1+. S&P also said it will place several large Japanese private-sector financial institutions on CreditWatch with negative implications. Spokesman Kyoto Narimatsu said 12 banks will be placed on CreditWatch negative and these are Fuji Bank, Industrial Bank of Japan, Dai-ichi Kangyo Bank, Sumitomo Mitsui Banking Corp, Sanwa Bank and Bank of Tokyo Mitsubishi. The others are Tokai Bank, Toyo Trust, Yasuda Trust, Mitsubishi Trust, Sumitomo Trust and Norin Chukin Bank. UBS Warburg senior credit analyst Graeme Knowd said the move was not as bad as many had anticipated so the reaction in the markets was positive. "It was nothing, one notch, people were expecting two, so it is less than expected, so it is positive. The market had already priced in two notches," Knowd said. "One notch is seen as positive. I don't think it will impact on banks although they do have more fixed than floating-rate securities. "The bond holding is more actively managed than equity and the bond market is a source of profits for the banks," he said. "I think it points out the same things as Fitch. One notch brings S&P to the same level as Moody's and Moody's is expected to downgrade again, which would make it the lowest," he said. "In Japan people watch the lowest one." However, Knowd noted the reference to "institutional dysfunction" in the report, making clear that Japan faces deep-seated structural hurdles to turning itself around. "The new point is the institutional dysfunction. No one has spelt this out before," he said. S&P noted in its statement announcing the downgrade the disproportionate political influence of the agricultural, construction and retail sectors, none of which will benefit from structural reform. "The natural conservative nature of a bureaucracy also mitigates against reform," the agency added. Nikko Salomon Smith Barney chief economist Jeffrey Young said "dynamics in Japan are very troubling" but said the ratings move was no big surprise. "They have fiscal deficits and more important, nominal GDP is going down so the debt to GDP ratio will keep going up, so it is not a surprise," he said. "Rating agencies will not look more favourably at Japan until there are credible prospects of a return of growth." BNP Paribas banking analyst Naoto Odagiri was perplexed by the decision to place 12 of Japan's major banks on CreditWatch negative. "I don't know if the recent (earnings) announcements of the banks accelerated their decision because the amount of bad loans was huge," he said. "My personal view is different. I feel the recent announcements have rather a positive impact. Although the losses are big, the banks are absorbing them," Odagiri said, adding that management is at least recognising the problem. The impact of any future downgrade in credit ratings would be indirect as the banks are not major issuers of bonds, he said. "It will have some psychological impact ... but we know the support from the government is pretty strong," he said. The financial markets saw little major impact from the downgrade, with the yen and government bonds rebounding from kneejerk losses on the news. Banking stocks were lower ahead of the announcement. "The S&P downgrade hardly had an impact on the dollar/yen. Market players were not surprised by the announcement as they had expected S&P to downgrade Japanese ratings anyway," Fuji Bank dealer Hideyuki Tsukamoto said. Nikko Trust and Banking treasury department deputy general manager Yasuji Yamanaka said any reaction was short-lived as the market was fully prepared for the one-notch downgrade. "Besides, the market has been engulfed by rumours of a possible two-notch downgrade," he added. Mizuho Securities chief market economist Yasunari Ueno said the downgrade will not have a lasting impact on financial markets but admitted that "there may be mild reaction in the foreign exchange market. "As the hyper-liquidity situation is not going to change so quickly and as investors continue to face difficulties in finding alternative assets, the market will be capable of weathering through any rating action," he said. Dresdner Kleinwort Wasserstein Securities chief strategist Masaaki Mizuno noted that Japanese institutions have lost enough in overseas bond markets and so will be cautious in allocating more funds into foreign instruments. "Domestic institutional investors have already suffered enough in offshore bond investments since the start of the second half. Japanese institutional investors will not dare to shift fund allocations to offshore assets in a way that will hurt their domestic portfolio," he said. However, Merrill Lynch chief strategist Masuhisa Kobayashi said if the government officially admits a weak-yen policy at a time when there is the risk of a further sovereign downgrade, there may be massive capital outflows. HSBC senior economist Peter Morgan said sovereign downgrades will only become significant if the sovereign rating reaches single-A status, when foreign investors would have to reconsider their bond holdings. Even then, he noted that the vast majority of bonds are held domestically. "As in the case of the Fitch downgrade on Monday, we have argued that the impact will be significant only when and if the rating falls another two notches to single A status," Morgan said. "The new BIS rules, which take effect in 2004, specify that single A government bonds will have a capital risk rating of 20 pct rather than zero currently," he said. "This would force many banks to reconsider their bond holdings," he said. "However, there is a major loophole, as governments have the right to override the 20 pct weighting rule for banks in their own country, and keep the risk weighting at zero. "The idea is that governments can always monetise their own debt in their own currencies, so there shouldn't be any risk of bankruptcy of government debt denominated in its own currency. "This is good news for Japan, since only 4 pct of government debt is held by foreigners. Therefore, foreigners would significantly reduce holdings of JGBs following a downgrade to single-A status, but there would be no need for Japanese banks to do so," he said. "As long as Japanese banks have no other attractive asset to put money in, they will continue to buy JGBs," Morgan added.