In this article:
Shinzo Abe, Japan's longest serving prime minister, is stepping down after eight years in office. His successor will be chosen later this month. In this note, we will discuss three key priorities for Japan’s next prime minister:
- Ensuring continuity during the transition
- Managing fiscal and monetary policy through the Covid crisis and beyond
- Implications for markets: equities, government bonds and foreign exchange
Background and macro outlook
Abe is both the Prime Minister of Japan and the President of Liberal Democratic Party (LDP), the ruling party in Japan together with its ally Komei Party, and he will be stepping down from both roles. His successor should first be elected as the LDP’s leader by the party’s internal election process, then elected as Japan’s next Prime Minister by the Diet. In terms of timing, media reports in Japan suggest the LDP could hold its leadership election on 14 Sept., which could mean the next Prime Minister being elected a few days after that.
Ensuring continuity during the transition
For now, we do not expect there would be significant changes to the current macro, fiscal and monetary policies under the next PM. Among the several LDP leaders floated in the press as potential Abe successors - including current Cabinet Secretary Yoshihide Suga; Fumio Kishida, the chair of the LDP’s Policy Research Council; and former LDP Secretary General Shigeru Ishiba - we don’t foresee any meaningful near term policy changes given that the top priority for the new administration should be focused on countermeasures to control the Covid-19 outbreak, as well as continuing with Abe’s macro policies designed to provide economic support and relief via fiscal measures.
At the same time, we do not think a change of monetary policy by the Bank of Japan (BOJ) is likely in the near term. Current Governor Haruhiko Kuroda is an Abe appointee and his monetary policy has been a key pillar of Abenomics (indeed, it is one of Abe’s original “three arrows”, which included aggressive monetary policy, flexible fiscal policy, and growth strategy including structural reforms). Governor Kuroda still has more than 2.5 years before his current term ends in April 2023, and we don’t see any reason for him to step down early. Currently, the BOJ’s extraordinary monetary policy under the framework of Quantitative and Qualitative Easing with Yield Curve Control (so-called QQE with YCC) focuses more on the stability of the financial system and liquidity support to the corporate sector, while the official 2 per cent inflation target looks ever more daunting as Covid-19 has depressed economic activity.
Managing fiscal and monetary policy through Covid and beyond
The top priority for the next administration is likely to be focused on containing the health and economic fallout from the Covid crisis. In terms of supporting economic activity, we think the new administration will likely opt to continue expansionary fiscal policies. Such an approach would dovetail with the exceptional monetary policies being undertaken by the BOJ to continue supporting liquidity, and extending its asset purchase program to bring down risk premiums not only in the fixed income but also in the equity market.
Over the medium term, though, we see potential for a shift in the fiscal approach. The new administration would need to start to consider a future path for policy normalisation, both from the fiscal and monetary policy perspective, once the Covid outbreak fades away. For the former, Japan’s fiscal deficits should increase substantially this year with incremental JGB issuance of JPY90 trillion or roughly 17 per cent of GDP, based on the two supplemental budgets for fiscal year 2020 compiled under Abe. That would come on top of an already very high government debt-to-GDP ratio in Japan. The next leader should consider whether and how to consolidate Japan’s fiscal balance into the post-Covid era. For example, this might require a meaningful increase to the tax rates for individuals and/or corporates (whereas Abe had lowered corporate tax rates to around 30 per cent as part of his growth strategy). If the new administration shifts to a tighter fiscal policy, this would have clear negative implications for macro conditions.
An exit from extraordinary monetary policy could be the next critical task on the future to-do list, assuming fiscal policy had normalised and macro condition improved. The BOJ has been conducting aggressive asset purchases over the past several years in order to try to achieve its 2 per cent inflation target, purchases that have targeted JGBs, domestic equity (via ETFs), corporate bonds, and REITs. Currently, the BOJ’s balance sheet has reached around JPY600 trillion (around $5.7 trillion at current exchange rates), which is larger than the size of Japan’s GDP. Balance sheet holdings of JGBs stood at around JPY480 trillion, accounting for 47 per cent of all outstanding JGBs.
Market implications and takeaways for investors
- Equity: The key to watch for equity markets will be maintaining political stability and carrying on with corporate governance reforms. Abe’s long run in the top office ended a multi-year period of tumultuous leadership changes in Japan, and the resulting political stability has been one of the key contributors to confidence levels in the country’s equity markets. This is important not only for consistency of policies regarding financial markets and macroeconomics, but also in terms of maintaining stable diplomatic relationships (especially with the US and China). In terms of corporate governance reform, the Abe administration took steps that positively supported the market by getting corporates to focus more on the effective use of capital. Lastly, should there be any changes to the BOJ’s ETF purchase program, this might negatively affect equity markets.
- JGBs: A shift in the BOJ’s policy stance as well as the new government’s stance on fiscal consolidation would have ramifications for Japanese government bond markets. While we do not expect a meaningful change in this regard, we acknowledge that at some point a discussion could emerge on what to do with the massive amount of JGBs held by the BOJ, and that this could create uncertainty. But it is still far too early to predict when that discussion might arise.
- Foreign Exchange: Extraordinary monetary policy by the BOJ has been a supportive factor for stabilising the Japanese Yen, and the market has an effectively assumed that the BOJ will take additional easing measures once JPY appreciates meaningfully toward the 100 yen/USD level. We think this policy is unlikely to change for now. However, if the pendulum were to swing in favour of policy normalisation, it could trigger a round of JPY appreciation.