The election was a clear endorsement of Abenomics and helped lift Japanese markets. But positive momentum will only be sustained if Japan moves to adopt major structural reforms that will support long-term growth and price stability.
However, Mr. Abe did not have the luxury of kicking off fiscal stimulus on a blank sheet of paper. His administration inherited a legacy plan of fiscal consolidation that sought to achieve a balanced budget by 2020, thereby leading to debt sustainability over the long term. As part of this plan, Mr. Abe’s administration hiked the value-added tax (VAT) from 5% to 8% in April 2014.
Over the following two quarters, the economic impact of the VAT hike proved much worse than expected. Private demand fell and did not recover as much as expected. The economy experienced technical recession with two consecutive quarters of GDP contraction. While headline inflation did go up, after adjusting for the VAT hike the rate of inflation was softer than the Bank of Japan (BOJ) had projected, with some weakness visible in inflation expectations as well.
On the same day, the Government Pension Investment Fund of Japan (GPIF), Asia’s largest public pension fund with ¥127 trillion in assets, announced a larger-than-expected shift in its asset allocation, moving some ¥23 trillion from JGBs into equities and foreign assets. (For deeper analysis, please see our November Viewpoint, “Bank of Japan’s ‘Audacious’ Easing Confronts Deflation, Boosts Balance Sheet.”)
After Japan announced in mid-November that its Q3 GDP had shrunk by an annualized 1.6%, Mr. Abe called a snap midterm election to seek a renewed mandate for Abenomics, and stated his intention to defer the next phase of the VAT hike from Q4 2015 to Q2 2017. This development caught markets by surprise – although investors reacted favorably, and heading into the election Japanese stocks climbed higher and the yen weakened further. The political calculus was that a renewed mandate would afford Mr. Abe enough time to aggressively pursue structural reforms, notably the much awaited “third arrow” of Abenomics.
The Lower House election gave the LDP/Komeito governing coalition 326 of a total 475 seats. In securing another two-thirds supermajority, the coalition maintained power to override the Upper House. The coalition does not have to call a general election for another four years.
However, the impressive results need to be taken with a grain of salt. Voter turnout was only about 52%, the lowest in postwar history. About 62% of lower house seats are elected from single-seat constituencies; 38% are elected in a proportional system from 11 block districts. The LDP won only 68 seats, or 38%, of the proportional vote. Given the 52% nationwide turnout, the LDP garnered only about 20% of the entire electorate. What does this mean?
Let’s start with the good news.
There is a great chance that Abenomics will enjoy extended longevity – or at least reduced tail risk that this great policy initiative will fade anytime soon. This is positive for Japan’s economy and risk markets over the medium term. It takes time and great political capital to end a decade-long deflation and move the economy to the path of sustainable growth. Political stability is key, and that is what Mr. Abe has got. His approval rating will rise again, and this should also iron out political event risks in 2015, including regional elections and the LDP’s presidential election. Mr. Abe has a great chance to remain as prime minister for the next years and pursue his economic agenda.
Mr. Abe’s political stability and the longevity of Abenomics would mean a continuation of the BOJ’s firm commitment to a 2% inflation goal and super easy monetary policy. Under Governor Haruhiko Kuroda, the BOJ has undergone a regime shift and been successful in raising inflation expectations while narrowing the output gap. Yet, it will still take time for the bank’s goal to be met: It remains challenged by Japan’s secular and structural headwinds, difficult initial conditions and a disinflationary external environment. Monetary accommodation will need to be firmly in place over multiple years to come, and that would require political stability and policy consistency.
Japan should be able to avoid further premature tightening as another VAT hike will likely be delayed and fiscal policy remain loose for now. Mr. Abe’s stated intention to seek to delay the next VAT hike until 2017 was very sensible, in our view. With his enhanced political capital, Mr. Abe can and should resist any near-term attempt by the fiscal authority to tighten policy prematurely. Japan’s fiscal situation no doubt is a problem, but it will never be resolved without ending deflation.
So what are the concerns?
The growth strategy, or “third arrow,” of Abenomics may still not hit some of the right targets. It could fail to lift potential economic growth unless Mr. Abe prioritizes and spends his political capital carefully and wisely.
To be fair, Abenomics is making some progress on growth strategy, for instance, with corporate governance reforms. It should also be noted that Abenomics has been sequenced smartly (with last April’s VAT hike a notable exception).
Without doubt, Japan’s problem is deflation, which needs to be dealt with first via demand-side policies, not supply-side policies. Effective supply-side measures – which a growth strategy ultimately should be – are no doubt necessary. However, the sequencing of policies is critical. Supply-side reforms should come only after demand-side policies have ended deflation. Without this sequencing, there is risk that the output gap could widen, further pushing the economy into deflation. This is particularly important in a democratic nation. Bungling the sequence of reforms would undermine public support and make Abenomics unsustainable.
Japan will ultimately need major structural reforms to raise productivity and hence potential growth. A more flexible labor system is necessary for better labor resource allocation. Corporate tax reforms that would benefit profitable firms at the expense of loss-making ones would improve capital allocation. Social security reforms that slow inter-generational wealth transfer would be critical to improving the younger generation’s work motivation and productivity.
To be sure, Mr. Abe has got the power to implement these reforms. But has he also gotten a mandate from the broad electorate to do so? Skeptics would point to the low voter turnout in recent elections to suggest not. What’s more, Mr. Abe will meet resistance from vested interests that would find the reforms painful. Let us hope that the prime minister will be persuasive on the need for reform, enhance his political capital and spend it wisely.
While the impact of the April VAT hike was worse than expected, both in terms of growth as well as inflation expectations, the response of Japanese policymakers has surpassed market expectations in every possible way. In line with our expectations, financial market participants have reacted favorably to these developments.
Yields on Japanese government bonds have fallen to all-time lows, led by the longest maturities and thus flattening the yield curve. Given the size and extent of the BOJ’s ongoing quantitative easing operations, and despite the decline in yields to very low levels, we believe this trend is likely to continue.
Since the BOJ/GPIF announcements at the end of October, Japanese equities have posted strong gains, with the Nikkei rising 15% and hitting the 18,000 mark earlier this month – a level last seen only briefly during mid-2007, and previously during the Nasdaq bubble period of early 2000! Despite a cumulative climb of almost 75% over the last two years, we believe Japanese equities still have potential to appreciate further in an overall environment of policy-led and coordinated asset reflation, especially if Abenomics is successful in unblocking Japan’s growth potential.
Turning to currency markets, we believe the Japanese yen is likely to remain on a weakening trend. The yen posted seven-year lows versus the dollar earlier this month when it briefly traded just shy of 122. While on some fundamental measures the yen appears to be at cheap-to-fair value, we believe that given the powerful and united monetary and fiscal policy mix in Japan, especially relative to its largest trading partners, the yen could continue to weaken even further from current levels. Additionally, this trend is likely to receive a further boost from the U.S. Federal Reserve as it edges closer to normalizing its extraordinarily easy monetary policy.
Mr. Abe now has up to four more years in power. While investors are likely to be patient in the near term, unless Abenomics gains a second wind – the way a tired athlete finds the will to pick up the pace and finish strong – there is a risk that this post-election market euphoria could be short-lived.
The time for him to act is now.