Japan has long had the highest debt-to-GDP ratio in the developed world, at approximately 200 percent of GDP. (The U.S. is around 60 percent.) Today, Standard & Poor’s, the bond-rating agency, downgraded Japanese sovereign debt from AA to AA-. Here is what S&P had to say (h/t ZeroHedge):

The downgrade reflects our appraisal that Japan’s government debt ratios–already among the highest for rated sovereigns–will continue to rise further than we envisaged before the global economic recession hit the country and will peak only in the mid-2020s. Specifically, we expect general government fiscal deficits to fall only modestly from an estimated 9.1% of GDP in fiscal 2010 (ending March 31, 2011) to 8.0% in fiscal 2013. In the medium term, we do not forecast the government achieving a primary balance before 2020 unless a significant fiscal consolidation program is implemented beforehand.

Japan’s debt dynamics are further depressed by persistent deflation. Falling prices have matched Japan’s growth in aggregate output since 1992, meaning the size of the economy is unchanged in nominal terms. In addition, Japan’s fast-aging population challenges both its fiscal and economic outlooks. The nation’s total social security related expenses now make up 31% of the government’s fiscal 2011 budget, and this ratio will rise absent reforms beyond those enacted in 2004. An aging and shrinking labor force contributes to our modest medium-term growth estimate of around 1%.

In our opinion, the Democratic Party of Japan-led government lacks a coherent strategy to address these negative aspects of the country’s debt dynamics, in part due to the coalition having lost its majority in the upper house of parliament last summer. We think there is a low chance that the government’s announced 2011 reviews of the nation’s social security and consumption tax systems will lead to material improvements to the intertemporal solvency of the state. We even see a risk that the Diet might not approve budget-related bills for fiscal 2011, including government financing authorization. Thus, notwithstanding the still strong domestic demand for government debt and corresponding low real interest rates, we expect Japan’s fiscal flexibility to diminish.

One thing that most Americans have yet to consider is what would happen if the bond rating agencies ever downgraded U.S. Treasury debt. Moody’s has indicated that U.S. debt could be downgraded later this decade. If this were to happen, interest rates would rise, further destabilizing our fiscal position and raising borrowing costs for ordinary Americans, and there would be a risk of significant instability in the financial markets.

— Avik Roy is an equity research analyst at Monness, Crespi, Hardt & Co. in New York City. He blogs on health-care issues at The Apothecary.