Upper House Elections in Japan and the Yen

Japan goes to the polls on July 29 to elect half of the upper chamber of the Diet called the House of Councilors. The Liberal Democrat Party, the main political party in Japan, with the New Komeito Party, is unlikely to hold on to their slim majority. However, barring a horrific showing which forces the LDP to dissolve the lower house and call for snap elections, macro-economic policy is unlikely to be impacted. The government will still likely press ahead with revisions to the nation’s tax regime and efforts to normalize fiscal policy. The BOJ will continue to raise interest rates and we expect the next 25 bp hike to be delivered in Sept, with the odds favoring another hike by the end of the year.

Recall that Shinzo Abe replaced Junichiro Koizumi as the head of the LDP last September making him also the Prime Minister. Public support for the Abe government has steadily eroded under the shroud of scandals, of which perhaps the most significant was the embarrassment of admitting that under previous LDP governments some 50 mln pension records have been lost. Two cabinet officials resigned and another committed suicide.

The opinion polls show support for Abe and his cabinet are continuing to sag and have now slipped below 30%. Ironically, the latest Japanese newspaper poll put Abe’s support near 28%, slightly below US President Bush’s public support, according to a USA Today survey.

The failure of the LDP and New Komeito Party to retain their narrow majority does not necessarily mean anything but some embarrassment for the LDP. One course of action would be to look for another coalition partner. The problem is that outside of the main opposition party, the Democratic Party of Japan, the other handful of parties has less than 10 seats in the existing Diet and some like the People’s New Party (5 seats) tend to resist a variety of LDP’s structural reforms.

There is some precedent for a prime minister to resign after being handed an embarrassing electoral defeat in the Upper House (Uno 1989 and Hashimoto 1998). The resignation of Abe is a distinct possibility if the LDP itself fails to secure around 40 seats. However, because of their lower house representation, there still will be an LDP prime minister. If Abe does resign, some observers have suggested that Foreign Minister Taro Aso would be a possible replacement. Aso has been a controversial foreign minister since assuming the post last fall mostly for his strident nationalism.

In terms of macro-economic policy, the die appears cast. The Bank of Japan remains committed to gradually raising interest rates. A survey conducted by the government-affiliated think-tank the Economic Planning Agency found 23 of 32 polled expect the BOJ to hike the 0.50% overnight rate target to 0.75% next month. BOJ Governor Fukui’s term expires at the end the current fiscal year. A rate hike in August may help deflect some criticism that will likely be levied against Japan at the next G7 meeting. The new French government has been quite vocal about the “misalignments” in the foreign exchange market.

The BOJ has not raised interest rates this year, but in his last nine months in office, Fukui may make up for lost time. The overnight rate will likely be 1.0% -1.25% by the time he steps down. Conventional wisdom often puts the neutral rate closer to 2.0%, but consumer prices are still hovering near-zero, despite the dramatic rise in oil prices and weakness of the Japanese yen, suggesting that more than a whiff of deflation persists.

Regardless of the outcome of the election, Japan policy makers will turn their attention more decisively toward normalizing fiscal policy. Here another potential successor to Abe, former Finance Minister Sadakazu Tanigaki is pressing his case for a sales tax hike as part of a larger revision of Japan’s tax system.

Despite the strongest growth in years and the longest economic expansion in modern times, Japan has been unable to normalize fiscal policy. The IMF projects Japan to record a general government deficit of about 3.6% of GDP this year. The accumulation of budget deficits has seen the level of government debt rise over 180% of GDP, easily the highest among major industrialized countries.

Consider that Japan’s public debt of about $6.8 trillion is roughly the size of the Asia-Pacific region’s next 13 largest economies combined. And many observers warn about the potential looming pension crisis. Indeed, one way to think about Japan’s massive reserves, that are approaching the $1 trillion mark, is that they will be a down payment on the government’s future social security payments.

There are some within the LDP like Tanigaki who are advocating a serious hike in the retail sales tax. At 5%, Japan’s sales tax is the lowest in the OECD. Tanigaki who competed with Abe to become Prime Minister last fall advocated doubling the tax to 10% over a few years. However, household consumption in Japan is in a precarious state, despite a tight labor market. Even with the lowest unemployment rate in eight years, wage growth has been practically non-existent. With the oft criticized reliance on exports, a retail sales tax hike seems counter-productive.

The electoral outcome is unlikely to be a decisive factor for the yen. The main weight on the yen continues to emanate from its relatively low interest rates and ample liquidity. Many countries in Europe have already raised rates this year and will likely raise rates again, so that the expected BOJ rate hike next month will simply return the spread of official rates back to where they were at the start of Q2. Surveys and indicative prices suggest the market is also expecting the euro-zone, UK, Switzerland, Norway, Sweden and Canada to hike rates again this year, which would seem to negate the narrowing of official interest rate differentials that might be suggested by a potential Nov-Dec BOJ rate hike.

Japan’s low return on domestic savings continues to provide powerful incentives for Japanese households to bring their savings overseas. It is somewhat ironic that as Japanese investors have been generally significant buyers of foreign assets, foreign investors have shown a nearly insatiable appetite for Japanese equities. Consider that in the first half of this calendar year, foreign investors have bought about JPY6.55 trillion worth of Japanese shares. In H2 06, foreigners bought about JPY4.9 trillion worth of Japanese shares and in H1 06 they bought JPY3.1 trillion of Japanese shares.

The current yen strength is not coming from what is happening in Japan, but the general investment climate. We don’t expect the current yen rally to be sustained in the short run. What is needed to put a solid floor under the yen is probably a more sustained re-pricing of risk, narrower interest rate differentials and a turn in the credit cycle (when credit is not so ample or readily available).

That said, when there is a run on the dollar in general, many speculative players are loathe of be long dollars against the yen. The US dollar has trended lower against the yen since late June, but preliminary technical indicators suggest that downside correction may be ending and in the coming weeks, the dollar will head back up to retest the multi-year high just above JPY124. A convincing break of that area would signal a move into the JPY125-JPY127 range.
Upper House Elections in Japan and the Yen Upper House Elections in Japan and the Yen Reviewed by magonomics on July 26, 2007 Rating: 5
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