Moody's, which has been reviewing Japan's economic situation since July, cut the country's sovereign ratings and currency ceilings by one notch from the top rank "AAA" to "AA1", warning the outlook was negative.

Its rating comes just a day after prime minister Keizo Obuchi unveiled the largest stimulus spending package in Japan's history, worth more than $ 189 billion. Obuchi pledged Japan would return to growth next year, although economists doubted his promise.

Japan's economic slump since the collapse of the bubble economy in the early 1990s has brought structural weakness, Moody's said. The country is now in the grip of its worst post-war recession.

"Measures taken in recent years have not restored domestic confidence, suggesting that more extraordinary macro-economic and reform policies may be required for Japan toovercome its economic malaise," the agency said.

It will be difficult for the Japanese government to revive growth and rebuild its finance industry while at the same time cutting back the country's huge fiscal deficit, Moody's said.

Japan's combined central and local government deficit is now worth more than 10 per cent of its gross domestic product.

"Regardless of measures taken now and in the future government debt will rise even higher over medium term to levels not compatible with an "AAA" rating," the agency said.

Moody's criticised Tokyo's continual resort to huge stimulus packages, which it noted have not brought sustained economic growth and instead have driven domestic debt higher.

Meanwhile, analysts say the decision by US credit rating agency Moody's on Tuesday to downgrade Japan's credit ratings may exacerbate yen and dollar fund-raising costs for Japanese corporations in the medium term, market analysts say.

"Market reaction to the news was calm. But, market players will be concernedhow much of a premium will be placed on Japanese corporations in the wake of Moody's decision," said Naomi Hasegawa, senior manager of the investment strategy division at Tokyo-Mitsubishi Securities Co Ltd.

Moody's Investor Services on Tuesday lowered Japan's top-notch rating on its debt and foreign currency ceiling. It also said the outlook for the ratings as negative.

Although widely anticipated, Moody's action will likely mean credit risk fears will remain for some time, analysts said. "Credit risk fears stemming from Moody's decision may cancel out the positive effects of the BOJ's recently announced steps" to counter a credit crunch, Tokyo-Mitsubishi's Hasegawa said.

The Bank of Japan announced last Friday a series of steps to facilitate firms' fund-raising by expanding credit to financial institutions through its money market operations.

Meanwhile, the spread between Japanese government bonds and low-rated corporate bonds will likely widen in the wake of Moody's action, said Masuhisa Kobayashi,a bond strategist at Merrill Lynch Japan.

But, others said the market impact from Moody's decision will likely be limited even in the longer term. "I think people were prepared (for the downgrade). Many people now take Moody's as one opinion among many, and not as an absolute," said Hiroyuki Miki, deputy general manager of the corporate treasury department at Sumitomo Bank. "The premium that Japanese corporations face is basically factored in, and may be too high in some instances," he said.

The impact on Japanese firms' dollar fund-raising will likely be subdued, as the perception among market players is that most Japanese banks have basically raised enough funds to cover year-end needs, currency dealers said.

The Japan premium, the extra cost charged to Japanese banks in the euro interbank markets, was little changed as Tuesday's downgrade on Japan's top-notch status by Moody's was largely expected, bankers in Tokyo said.

But some weaker Japanese banks will likely face difficulties, as Japanesecorporations with high credit ratings have been funnelling dollar funds to those banks, dealers said.

"When companies like Nippon Telegraph and Telephone (NTT), which is very popular overseas and can raise funds cheaply, see their funding costs rise, it may have a gradual impact on fund-raising costs overall," Tokyo-Mitsubishi's Hasegawa said. Top-tier Japanese firms, including NTT and power firms such as Tokyo Electric Power Corp, saw their ratings cut on Tuesday as no entity can have a higher rating than the government.