Japan's debt at risk. Is U.S. next?

NEW YORK (CNNMoney.com) -- Credit rating agency Standard & Poor's raised the prospect of a downgrade in Japan's sovereign debt rating Tuesday. That's reigniting fears that the U.S. could be next.

The agency said it is concerned about large deficits and a sluggish growth outlook in Japan -- which currently ranks as the world's No. 2 economy.

S&P lowered its outlook on Japan's debt to negative from stable. The reduced outlook signals the risk of an actual downgrade in its debt in the future. S&P's rating on Japan's debt is AA, one step below its best possible rating.

A credit downgrade could raise the cost of borrowing for Japan, as investors demand a better return to protect them.

"Japan's economic policy flexibility has diminished as a result of increased fiscal deficits and government debt, persistent deflation and a prospect of continued sluggish economic growth," analysts at the firm said in a note.

Japan has apparently emerged from the recession that racked economies across the globe over the last two years, although growth there remains sluggish.

Its gross domestic product, the broadest measure of its economic activity, grew at a 1.3% rate in the third quarter, roughly half the growth rate in the United States during the same period. It is expected that when final GDP numbers for 2009 are reported, China will pass Japan to become the world's No. 2 economy.

The possibility of a downgrade of Japan also fed into rising concerns about the safety of government debt among the world's developed economies. Recently, the major agencies all downgraded the ratings for Greece, with one of them, Moody's, writing that the economic outlooks in Greece and Portugal are so troubling that they run the risk of a "slow death."

Worries about risk to U.S. ratings. There also are growing worries about the soaring deficits and debt levels for the United States due to the price tag of various bailouts, the drop in revenue from the recession and the long-term costs of entitlement programs such as Social Security and Medicare.

On Tuesday, the Congressional Budget Office issued a report saying that the U.S. government's fiscal outlook is "daunting," with deficits averaging at least $600 billion a year over the next decade. It expects debt accrued over the next 10 years will top $6 trillion -- $1.35 trillion of which will hit this year.

President Obama is expected to address concerns about the deficit and federal spending in his first State of the Union address Wednesday evening.

The U.S. rating at all the major firms still stands at the top AAA level though. The yield on the benchmark 10-year U.S. Treasury was little changed from Monday's close following the news on Japan's debt.

Officials with S&P and the other rating agencies have repeatedly pointed out that the United States' AAA rating is justified by the fact that government spending is still a smaller share of the economy than is the case in European countries that have the same rating, such as the United Kingdom, France and Germany.

And analysts at S&P say the nation's credit rating is helped by the dollar's continued preeminent place among global currencies, as well as by the economy still being "high-income, highly diversified, and exceptionally flexible.

"We judge these strengths to outweigh growing economic, fiscal and protectionism risks; and the country's large external debtor position," the firm said in its most recent note on the U.S. in late December.

Should U.S.A. still be AAA? But Sean Egan, managing director of Egan-Jones Group, a smaller rating agency, questions whether the U.S. still deserves the highest rating.

Egan said that despite the pressure that Congress and the federal government can bring to bear on the larger rating agencies in the upcoming financial regulatory reform, he believes the AAA rating will eventually have to be lowered.

"It's inevitable that will happen, given the current trends. The government is backstopping everything that is politically relevant and in any kind of difficulty," Egan said.

He added that despite the improving economy and repayment of loans by many major banks, he believes the cost of bailouts is likely to climb. He points to the virtual blank check that the Treasury gave to mortgage finance firms Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) in December.

The rescues of Fannie and Freddie have already cost the government $111.6 billion between them and losses are expected to climb on the roughly $5 trillion of mortgages they hold or guarantee.

But Egan said the bigger problem for the U.S. is the cost of entitlement programs and the cost to service the debt once interest rates start to rise from current low levels. That will only become a worse problem if the U.S. does lose its cherished AAA rating.

"Once you fall off the AAA pedestal, its' very difficult to get back," Egan said.