Election’s outcome is bullish for financial markets
Japan held an Upper House election on July 10, two days after former prime minister Shinzo Abe was brutally assassinated while stumping on the campaign trail.
Abe’s Liberal Democratic Party (LDP) gained eight seats, winning 63 of the 125 of the seats up for reelection, not counting those won by its coalition partner, Komeito. Among opposition parties, the Upper House’s composition shifted toward the center-right, with the Japan Innovation Party gaining seats while the Constitutional Democratic Party of Japan suffered heavy losses. Additionally, parties and independent candidates in favor of amending the Constitution, including the LDP, Komeito, Japan Innovation Party and Democratic Party for the People, collectively won more than the 82 seats needed to secure the two-thirds supermajority required to initiate the constitutional amendment process. Discussions on amending the Constitution will likely heat up going forward.
In financial markets, the LDP’s bigger-than-projected victory will likely lead to equity market gains and further yen depreciation driven by expectations of greater political stability. With Boris Johnson recently resigning as UK prime minister and government approval ratings sinking in the US, Germany and France in the wake of mounting public discontent with policy responses to inflation, Japan may be the most politically stable DM economy by virtue of the LDP’s resounding electoral victory.
That said, the election’s outcome was largely priced into financial markets beforehand and therefore may not elicit much immediate market reaction.
Will Kishida Government put its own stamp on policy during three-year respite from national elections?
Since its inception last October, the Kishida Government has presumably been governing with an eye on last autumn’s Lower House election and this July’s Upper House election. To solidify its footings, it placed priority on winning these two elections while navigating the ideological diversity within LDP.
The LDP’s success in both elections has demonstrated that the Kishida Government has gained the public’s trust. The government will not face another national election until the next Upper House election in summer 2025, unless the prime minister opts to dissolve the Lower House before its term expires in October 2025. In other words, the government now has the latitude to implement bold policies based on its own convictions and a longer-term perspective, including policies that would entail public hardships, without having to worry about an impending election.
The Kishida Government’s economic policy may become more business-friendly and more conducive to financial market stability than it has been so far. From a financial market stability standpoint, the government might even place greater priority on fiscal consolidation. In terms of monetary policy, it may give the BOJ a green light to normalize policy at the BOJ’s discretion, in deference to the BOJ’s independence. Its diplomacy and national security policies, by contrast, may take a leftward turn.
Policy response to inflation will be first clue to economic policy direction
The first clue to whether the Kishida Government intends to put its own stamp on economic and fiscal policy after the Upper House election is its policy response to inflation. Calls for a huge inflation-relief package funded by a supplemental budget are expected to intensify within the ruling coalition.
The government is currently providing gasoline subsidies and considering a reward points program to promote conservation of electricity. The relief afforded by these programs is minuscule relative to the overall financial burden imposed on households by energy price inflation. Moreover, such programs would not really provide any net benefit to consumers because they are or would be funded through issuance of debt that taxpayers will ultimately have to service. The government may also consider distributing another round of cash benefits to all or most households, though such payments would be tantamount to recycling back to households money that was collected from households in the first place, which would not make much sense.
Core inflation-relief policies will likely be micro-targeted at the segment of the public and subset of businesses hardest-hit by energy/food price inflation. If so, they should be able to be adequately funded with ~¥500bn of general reserve funds without resorting to a supplemental budget.
In the absence of strong expectations of higher wage and revenue growth, personal consumption and capex could be heavily depressed to the detriment of economic stability if the sticky inflation narrative becomes consensus among households and businesses. The government should focus on boosting expectations of growth in wages and corporate revenues and making the Japanese economy more robust against inflation by increasing the labor productivity and potential economic growth rate through a national growth strategy.
Another key to economic stability is keeping households and companies’ medium/long-term inflationary expectations anchored, a task best fulfilled by monetary policy. It is important for the BOJ to commit itself to price stability by normalizing monetary policy and flexibly controlling at least long-term rates, thereby allaying households and businesses’ concerns about monetary policy rigidity prolonging pernicious inflation and/or yen depreciation.
Is government about to get more serious about fiscal consolidation?
Now that the election is over, increased defense spending coupled with an inflation relief package could drive more growth in government expenditures. The LDP aims to increase defense spending to at least 2% of GDP, double its current level, according to the LDP’s election manifesto.
The government may reaffirm its commitment to fiscal consolidation by funding the inflation relief package and/or increased defense spending in a deficit-neutral manner. PM Kishida has been a proponent of fiscal consolidation since long before he became prime minister.
The government may demonstrate it is serious about fiscal consolidation by pushing back against intra-LDP pressure to adopt a more expansionary fiscal policy, scaling down the inflation relief package or increases in defense spending, or finding a way to fund such spending without adding to the fiscal deficit. Such fiscal discipline should have a positive impact on the domestic bond market.
Economic policy shift already underway
In the FY2022 Basic Policy on Economic and Fiscal Management and Reform, approved by the Cabinet in June, the government shifted its economic policy mix away from income redistribution toward growth strategy. Another priority revealed in the Basic Policy is transformation of the Japanese public from savers to investors. The Basic Policy signals a pivot to a more business- and market-friendly policy stance that should be a strong tailwind for the equity market in particular.
The Basic Policy also outlines key investments to bring PM Kishida’s “new capitalism” to fruition. It would be preferable for the government to fund these investments in the FY2023 budget after fully fleshing out the details instead of rushing them into a supplemental FY2022 budget.
By year-end, the government intends to formulate a plan to double Japanese households’ asset-based income by inducing households to allocate more of their assets to equities. Promoting reallocation of household financial assets from savings accounts to risk assets has been on the Japan’s economic policy agenda since Junichiro Koizumi’s premiership (2001-06). During last year’s LDP presidential election campaign, PM Kishida expressly criticized Koizumi’s neoliberalism for exacerbating economic inequality, but he appears to have since changed his tune.
It is important to create a virtuous cycle between the household and corporate sectors by inducing households to invest in the equity market. Such investment would fuel corporate growth and, in turn, generate investment returns that would increase households’ disposable incomes. To realize such a scenario, both households and companies need to ratchet up their growth expectations. It is important for the shift from saving to investing to unfold in tandem with a national growth strategy.
Appointment of next BOJ governor is another focal point
Another area where the Kishida Government may deviate from its predecessor is monetary policy. Key to watch in this regard is who Kishida appoints to succeed BOJ Governor Kuroda next April.
The BOJ’s insistence on maintaining accommodative monetary policies is increasingly being blamed as a driver of yen debasement and pernicious inflation by politicians, companies and the public. Against such a backdrop, Kishida may very well appoint an orthodox central banker in the aim of facilitating policy normalization.
Monetary policy is not so important to the government’s policy agenda that the government would start vetting BOJ governor candidates immediately after the Upper House election. I do not expect the vetting process to get into full swing until autumn at the earliest and perhaps not until year-end.
In the interim, any further yen depreciation or bond market turbulence stemming from the BOJ’s rigid policy stance would likely make the government more careful to avoid conveying the impression that the next governor would continue the Kuroda BOJ’s policies.
At present, the leading candidates to succeed Kuroda presumably include former and maybe even current BOJ deputy governors but whoever is appointed, the BOJ will likely normalize policy under its next governor unless he or she is a hardcore reflationist. The Kishida Government is unlikely to appoint a reflationist.
Post-Kuroda policy normalization will be gradually priced into financial markets in advance. While this repricing will be a headwind for the bond market, it may be an even stronger driver of yen appreciation.
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