TOKYO (AFX-ASIA) - The move by Moody's to place Japan's domestic sovereign rating on review for possible downgrade had been largely anticipated by financial markets, HSBC Securities Japan senior economist Peter Morgan said. The agency said it may downgrade the Aa3 rating by as much as two notches, adding that deflation is exacerbating the government's serious debt problem. "The longer it takes for the government to fashion an effective policy response to deflation, the more complicated solving other economic problems becomes," Moody's said. However, HSBC's Morgan said the review has long been expected, with bond yields rising sharply in recent weeks on reported or rumoured downgrades. The Nikkei Financial Daily said this morning that Standard and Poor's could in principle downgrade Japan's sovereign rating at an earlier stage than previously assumed, but the markets largely ignored the news. "I think that this was expected at this stage," Morgan said, adding that an eventual downgrade by both S&P and Moody's has, "in absence of any reason not to," been accepted by the markets. The expected downgrade by Moody's is most significant for bonds as it would take Japan to single-A status, forcing some foreign banks to sell bonds ahead of the launch of new Bank for International Settlements risk-management rules. Single-A rated bonds will carry a 20-pct risk weighting, increasing the level of reserves banks need to hold as cover for these assets. The new rules will be introduced in 2004 but banks are expected to prepare their balance sheets ahead of this deadline. "Some would have to cut bond holdings ... though foreigners have already been selling JGBs," Morgan said, adding that combined foreign holdings may have reached a mere 4 pct of all issues. The relatively small level of foreign-held bonds also provides protection for the Japanese government bond market, as local investors are unlikely to sharply offload their holdings, given a lack of investment alternatives. Domestic investors are also expected to be exempt from the new BIS rules, which do not apply to institutions' holdings of bonds from their own country, as money can always be printed to pay off domestic bondholders. "We are looking for yields to rise to around 1.6 pct this year," from 1.5 pct currently, Morgan said, noting that huge holdings by domestic players, including government institutions, will prevent a sharp spike in rates. Morgan also questioned what he considers aggressive downgrades by rating agencies, adding that they may be hoping to push the government on structural reform more than considering the real possibility of a default. "Basically, there are huge savings and Japan is still the world's largest creditor nation. Do they mean there is a likelihood of default? "They have been very much focused on reforms. If they believe there is some effect on that, it may be some motivation," he said, but added: "I'm not sure it does have any effect."