21 March 2019
Prime Minister Shinzo Abe is set on raising consumer taxes, even while the economy is still healing, in a bid to pare down Japan's massive debt buildup, which is twice the size of its GDP. Photo: Bloomberg
Prime Minister Shinzo Abe is set on raising consumer taxes, even while the economy is still healing, in a bid to pare down Japan's massive debt buildup, which is twice the size of its GDP. Photo: Bloomberg

Tough decisions ahead for Japan

Japan’s economy is in pretty good shape – second-quarter GDP growth jumped 1.9 percent from the previous quarter, a welcome respite after a weak first quarter (–0.8 percent q/q). Wages are growing at the fastest pace since the early 1990s, while inflation prints (core and core-core consumer price indices) continued rising in June and July. After decades of deflation and virtually stagnant growth, these mark notable achievements for the Japanese economy.

After a scandal-ridden year that saw his approval ratings dip below 30 percent on occasion, Prime Minister Shinzo Abe gains from the robust health of the Japanese economy much-needed proof points for his re-election as the Liberal Democratic Party (LDP) chief on Sept. 20. While Abe’s around 40 percent approval rating is not spectacular, it should be high enough to convince the LDP to extend his prime ministerial duties for another term; we only see a 10 percent chance of Abe losing his seat.

With the status quo likely prevailing, we expect Abenomics to live on and the administration to finally embark on two potentially market-moving moves: the implementation of the value-added tax (VAT) hike and the reformation of Article 9 in Japan’s constitution (which prohibits an offensive military force). But the success of both of these initiatives will depend on the Abe administration’s ability to shore up support for local (April) and Upper House (July) elections in 2019.

Why Abe is set on raising consumer taxes while the economy is still healing has to do with paring down the country’s massive debt buildup, which is twice the size of its GDP. Hiking the VAT is a perilous endeavor – it helped spark a recession in 2014 – hence the long deliberation between its announcement (late 2017) and planned implementation (currently October 2019). But Abe believes the VAT hike is necessary, especially as he has already promised to use the funds to provide education relief for families – reneging would be detrimental to the LDP’s electoral odds.

And the LDP is going to need a lot of support if it’s to successfully modify Article 9, perhaps the most controversial political issue in post-war Japan. The LDP and Abe seek to codify Japan’s Self-Defense Force into the constitution, the lack of which currently makes it a gray area of legality. The majority of Japanese people disapprove of the change, according to opinion polls, and even several people within the LDP oppose it. Yet Abe’s resolve remains resolute. This pursuit will be an arduous journey. A national reform will need to be held to vote on the issue, and doing so requires approval by two-thirds of both the Lower and Upper Houses.

The problem is Abe and the LDP have low approval ratings, and will most likely lose some seats in next year’s elections. So, with an upcoming VAT hike as well, the government will likely open its purse-strings to help bolster consumption in order to gain public favor and maintain its two-thirds Upper House majority.

One consumption-supportive policy change could be mandating mobile phone operators to slash costs by 40 percent. Cabinet Secretary Yoshihide Suga mentioned recently that Japanese households spend much more on mobile phone services than those in other developed countries, and that the government might provide guidelines on how to lower costs by early next year. Our estimates show that a 40 percent price cut could reduce consumer price index growth by around 1 percentage point.

With the likelihood of a VAT hike next year and the possibility of lower mobile phone rates (which would weigh on inflation), it’s likely that the Bank of Japan will proceed with its policy accommodation for a longer period of time.

While we expect the yen to rise against the US dollar in the medium to long term (our 12-month US dollar/Japanese yen forecast is 105), the pace of appreciation could be moderate because of fiscal easing ahead of the elections and the upcoming VAT hike. Lower inflation expectations could also present downside risks to our underweight position on Japanese government bonds (JGBs), which we maintain given our forecast for higher JGB rates in the months ahead.

– Contact us at [email protected]


Executive Director and Regional CIO Japan, UBS

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