Asia: Moody’s downgrade infuriates the government, which had protested the action.

The world’s second-largest economy suffered a deep psychological blow Friday when its credit rating was slashed two notches by Moody’s Investors Service, which said Japan’s debt levels are approaching “uncharted territory.”

The country’s yen-denominated government bonds, in theory, now are less credit-worthy than those of Botswana, Chile and the Czech Republic, and on par with Poland and Cyprus.

It was the latest economic embarrassment for Japan, which little more than a decade ago seemed invincible, its corporate titans snapping up Hollywood studios and prime U.S. real estate at premium prices.

These days, the dominant headlines are about rising unemployment, bankruptcies, bad loans and politicians too weak-willed to do anything to correct the course.

Nevertheless, Japan’s financial markets largely took the expected news in stride. The Nikkei-225 stock index eased less than 0.1%. The yen, which has been surging against the dollar in recent weeks, was little changed until the Bank of Japan stepped in again to try and weaken the currency. It fell in New York trading to 124.38 per dollar from 123.05 Thursday.

The Moody’s downgrade took Japan’s yen-denominated securities to A2 from Aa3, affecting $5.4 trillion of debt. Moody’s left Japan’s foreign-currency bonds rated Aa1.

The move by the U.S.-based rating firm infuriated the Japanese government--which had taken the rare step of protesting the anticipated action before it happened Friday. It was Moody’s second downgrade of Japanese securities in six months.

The Finance Ministry blasted Moody’s. “They’re only concerned about the direction of a country, but the purpose of the rating is to measure default risk, and if you consider that, the rating’s not appropriate,” said spokesman Masaki Omura.

Prime Minister Junichiro Koizumi blamed Moody’s for causing Japanese “to begin to lose confidence in themselves.” He contended that the rating shows only part of the picture, neglecting Japan’s “staying power” and economic fundamentals.

“If you look at the ratings given by those same ratings agencies to Latin American countries and African countries--the same countries that Japan is providing assistance to--Japan’s rating has gone below the ratings for some of these countries,” Koizumi recently told reporters. “How is that possible?”

Indeed, the rating does seem somewhat ironic. Japan remains by far the largest net creditor country in the world, whereas the U.S. is a net debtor. And Japan still sits on the world’s largest pile of savings.

Moreover, most economists think the possibility of default--which is what the credit rating is supposed to grade--is minute.

“The likelihood of Japan missing a debt payment is virtually nil,” said Robert Feldman, economist at Morgan Stanley Dean Witter.

Even Moody’s said it “assigns a very low probability” to a default. Japan’s large pool of household savings, the ability of the banking system to absorb substantially higher levels of government debt, and the small scale of the government’s exposure to foreign creditors should avert any such possibility, Moody’s said. All but about 5% of Japanese bonds are held by domestic investors, versus one-quarter to one-third of bonds in countries such as the U.S.

But Moody’s was taking aim at Japan’s broad economic direction. “Japan’s general government indebtedness, however measured, will approach levels unprecedented in the postwar era in the developed world, and that as such Japan will be entering ‘unchartered territory,’” it said in a statement.

Japan’s debt stands at about 140% of its output, or gross domestic product.

In theory, at least, the lower credit rating should mean that prices of government bonds should drop and, correspondingly, interest rates rise. But Japan often doesn’t function like a normal market economy. Despite the comparatively low credit ratings, its interest rates are among the lowest in the world.

Moreover, domestic investors have few attractive options about where to invest: The stock market is one-third of its value 10 years ago, real estate values have plunged, and investing overseas presents substantial foreign-exchange risk.

Hence, investors stick with government bonds. “The fact that the economy offers such bad alternatives to government bonds only indicates how broken the system is,” said economist Feldman.