Darrel Whitten's  Instablog

Economists and policy makers agree that a major contributing factor to Japan’s 10-year “Heisei Malaise” was the prevalence of “zombie finance”, where Japanese banks continued to provide support for highly inefficient, debt-ridden companies, commonly referred as zombie companies, and the government effectively allowed the banks to simply ignore their festering bad loans with lax accounting practices, including the absence of mark-to-market. Zombie financing in turn prevented the creative destruction necessary to clear the dead wood from various industries and prevented more productive companies from gaining market share, thereby cutting off a potentially important source of productivity gains for the overall economy.   

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Nikkei 225 Breaks 200-day MA

As pointed out by fellow Seeking Alpha blogger Clive Corcoran ("On the Nikkei's Break Below Key Negative Levels"), Japan's Nikkei 225 last week broke below two major support levels, completing a move below all three key moving average levels with a close below the 200 day EMA.  The most pressure is coming from domestic institutional investors, who have dumped over JPY1 trillion of Japanese stocks since July, almost completely offsetting the JPY1.45 trillion of net buying by foreigners, who have turned net sellers in the last couple of weeks.

DPJ's Communication Problems

The new Democratic Party of Japan-led government is showing their lack of experience communicating with business and the financial markets, exacerbating concerns about the sustainability of Japan's recovery.

Firstly, the new Finance Minister Hirohisa Fujii (as well as BOJ Governor Shirakawa) basically gave the green light for currency traders to test how far the yen could appreciate. Minister Fujii is now back-tracking and making noises about possible intervention.

Secondly, Financial Affairs Minister Shizuka Kamei promised a moratorium on debt
repayments for small businesses, which hurt the stock prices of financial firms beginning with the banks. The government is now trying to paper over these comments.

Thirdly, Transportation Minister Land and Transport Minister Seiji Maehara first
appeared to take a hard line vis-à-vis saving the national flag carrier, Japan
Airlines. The airline’s financiers were already balking at providing additional funding without government guarantees, and the Transport Minister rattled investors and overseas JAL partners by stating that the Company’s revitalization plan was “not acceptable” without indicating whether the government was committed to supporting the firm or not. He was forced to come out and publicly
state in an “emergency” press conference that the government was committed to
saving JAL after the stock price plummeted further and overseas business partners were beginning to withdraw credit. An overseas insurance company that provides coverage to travel agencies for such situations as grounded flights decided to exclude JAL from its coverage, and the credit card purchase of a JAL ticket was refused in the U.K.

Further, the perceived upshot of new DPJ policy measures is that they will first
hurt GDP growth, at a time when Japan can little afford to lose more economic
growth. The Nikkei estimated that the policies would shave GDP growth by 0.2%
in FY2010. Since Japan has come to expect economic stimulus in the form of
pork-barrel public works projects, the DPJ’s axing of public works expenditures
put in place by the Aso Administration, could trim GDP growth by 0.2% this fiscal
(FY09) year. Trimming a total of JPY8.5 trillion from public works budgets, ministry
operational budgets and government personnel expenditures by fiscal 2013
would ostensibly put a drag on growth of 0.1 point in fiscal 2010 and 0.6 point in
fiscal 2011.

On the other hand, new DPJ policies such as the child care allowance will be
provided at 50% in fiscal 2010, and at the full level from fiscal 2011. Free high
school education and the end of income tax exemptions for dependent children
and spouses will be implemented in fiscal 2010. In other words, the positive impact
of the DPJ policies will take longer to have a positive impact.

Moreover, PM Hatoyama’s bold promise for a greenhouse gas reduction target of 25% and the DPJ’s decision to principle ban temporary workers for manufacturing jobs has Japanese businessmen flustered and concerned.  Businesses claim that meeting the greenhouse emission targets would ostensibly result in domestic steel
production being reduced by 20%, according to the Japan Iron and Steel Federation, while it would force some ethylene plants to cease operations, say
chemical industry execs. The Japan Automobile Manufacturer’s Association is claiming that the ban on temporary factory workers would have “a serious impact on small and medium-sized parts makers”.

Some think-tank gurus are now predicting a new production shift, as these policy
changes coincide with the disappearance of the consumption boom in the US and
Europe that was driving exports and the surge in the yen—forcing Japanese
companies to again hollow out domestic production capacity.

Some 40% of CEOs Now Fear a Double Dip

All of these concerns were recently reflected in a Nikkei (Japan Economic Journal) survey of 100 Japanese CEOs. Nearly 40% of these CEOs now see a "high to somewhat high" chance of a double dip in Japan's recovery, with over 69% seeing the impact of stimulus wearing off, over 38% seeing a negative impact from the strong yen and 36% blaming the possible double dip on the new government's policies.

Disclosure: No positions in EWJ, FXY

The Hatoyama cabinet has been formed, and we believe the credibility of the DPJ's election promises as well as the Hatoyama administration will hinge on a few key posts and their appointed ministers.

(1) Naoto Kan, deputy prime minister and state minister in charge of national strategy, economic and fiscal policy. With his experience fighting bureaucrats as an opposition politician, Mr. Kan is considered a good choice for the planned National Strategy Bureau, which will oversee policies and the budget.

(2) Hirohisa Fujii, minister of finance. Mr. Fujii is a recognized expert on the national budget and tax issues, and was the finance minister for the Hosokawa and Hata administrations from 1993 to 1994. His knowledge of the national budget and his connections in the Ministry of Finance will be important in achieving a smooth transistion for the budget formation process from finance ministry bureaucrats to the DPJ.

(3) Akira "Mr. Nenkin" Nagatsuma, minister of health, labor and welfare (MHLW). Mr. Nagatsume is energetically committed to administrative reform, and has been a sourge of the bloated Social Insurance Agency. The MHLW in particular is ripe for administrative reform, but Mr. Nagatsuma will have to successfully deal with the powerful doctor's lobby.

(4) Seiji Maehara, minister of land, infrastructure, transport and tourism (MLITT). Mr. Maehara has also been a vocal critic of the "amakudari" practice of ex-senior bureaucrats landing cushy jobs in government-sponsored corporations, as well as the historical waste in public works expenditures. His challenge will be to clean up 50 years of collusion and pork-barrel politics in public works construction.

(5) Yoshito Sengoku, state minister in charge of administrative reform. Mr. Sengoku's predecessors in the LDP, such as Yoshimi Watanabe, resigned in disgust and frustration after running into brick wall after brick wall in LDP-led regimes. Prior state ministers in charge of administrativve reform even in the Koizumi Cabinet also encountered fierce resistance to administrative reforms.

Mr. Kan will be in charge of forming the National Strateg Bureau (NSB), which is tasked with crafting key national policies including budget guidelines and a basis for a new foreign policy. It will replace the LDP's Council on Economic and Fiscal Policy, which was headed by the prime minister, and should be similar in function to the US Office of Management and Budget (OMB), although very likely a lot smaller in terms of staffing. The NSB will be a bellwether indicating how successful the DJP will be in reducing the role of Japan's powerful bureaucracy to "experts on tap but not on top".

Mr. Sengoku will be the point person for the formation of The Administrative Reform Council (ARC), whose task will be to assess budgets and programs with an eye toward squeezing out up to JPY10 trillion of wasteful spending over the next three years.The ARC will be similar to the US OMB in function although nowhere near as large, and will report to the prime minister instead of the Diet. The re-allocation of funds and cost savings achieved by the ARC are expected to be a major source of the funding needed for the DPJ's up to JPY16 trillion aimed at improving the livelihoods of Japanese consumers.

So far, the bearish scenarios painted by Japan's "bond vigilantes" have had little impact in bidding up Japanese government bond (JGB) yields, despite the fact that the Aso Administration committed the Japanese government to issuing JPY44 trillion of bonds this year compared to a promise under the Koizumi Administration that such issuance would be capped at JPY30 trillion, and the possibility that this issuance could rise to JPY50 trillion in the next couple of years.

However, should it become apparent that the DPJ's spending plans will not be debt neutral, i.e., they are not able to re-design the national budget to accomodate their expenditure programs without resorting to more debt financing, the bond vigilantes may yet have their way.

Disclosure: No positions in BWX, EWJ, FXY

New Democratic Party Leadership Puts FY2010 Budget Preparations on Hold

Unlike the US, where the Congress has the authority to formulate the national budget, the authority in Japan is the Prime Minister’s cabinet. Consequently, the DPJ has quickly put the FY2010 budget process on hold until they can get their Cabinet together and issue new budget instructions to the various ministries and the MOF.

The wheels of Japan’s national budget process begin to turn in June, a mere three months after the current fiscal year’s budget is ratified. The process begins with the Cabinet issuing guidelines for budget requests. The guidelines set out expenditure ceilings for major programs such as public works and social security for the next fiscal year. These ceilings are usually expressed in terms of absolute or percentage increases (decreases) from the previous fiscal year. Submissions of budget requests by the various ministries are made at the end of August of each year, i.e., just as the DPJ was voted in power. In order for the budget to be passed by the Diet during the fiscal year (i.e., by March 31 the following year), it needs to be approved by the House of Representatives at least 30 days prior to the start of the new fiscal year. The Cabinet usually submits its formal budget proposal to the Diet in January to allow for sufficient deliberation. As a result, it takes five months or more to prepare the final draft government budget.

The Finance Ministry's Budget Bureau is responsible for incorporating the budget requests of the various ministries and agencies into a final budgetary framework. Budget requests are reviewed to calculate projected tax revenues versus expenditures. Adjustments to expenditure levels are worked out through negotiations with the ministries and agencies, after which the proposed budget is submitted to the Cabinet for decision. 

This year, the DPJ will assume control of the government just the Ministry of Finance was receiving FY2010 final budget requests from the various ministries. In order for the DPJ to implement the spending and waste elimination promises outlined in their manifesto, they have to scrap what was already in progress under guidelines set by the Aso Administration.

As it stands today, the proposed budget for FY2010 was heading for a new historical high of JPY92.13 trillion. While the budget process is on hold, the MOF is unlikely to receive new expenditure guidelines from the DPJ cabinet until October, leaving only two months within calendar 2009 to go back to square one and re-prepare a preliminary budget draft. This in turn probably means that the FY2010 budget proposal won’t be forthcoming until early calendar 2010, which would be the first time this has happened since the 1993 Hosokawa Administration, or the last time that the LDP lost control of the budget process.

Where Will They Find the Money? Look in the Special Accounts

The DPJ wants to include JPY7.1 trillion of additional expenditures in the FY2010 budget. To fund this, they will be scrapping some LDP-proposed programs under the Aso Administration’s guidelines, including a dam project in Gumma prefecture and former PM Aso’s infamous “comic book palace”. In addition, they will probably need to dip into the “hidden treasure” of funds sitting around in various special accounts, such as the fiscal investment and loan (FILP) and foreign exchange special account reserves, which ostensibly had reserves of some JPY1.3 and JPY1.8 trillion respectively in FY2009. Another target is JPY4.3 trillion in government transfers to government-sponsored companies and organizations as well as municipalities and prefectural governments. Dogfights could erupt as the regional governments have already budgeted these transfers, while efforts to scrap already promised public works will also elicit screams of protest from local governments and government contractors.  

Just looking at the proposed budget for FY2009, one would imagine that Japan has little leeway in its annual budget, as some 50.9% went to debt service (22.8%, or JPY20.24 trillion) and social security (28.0%, or JPY24.83 trillion) of a total JPY88.55 trillion of initial general account expenditures for FY2009. On the other hand, the DPJ says they would like to wring JPY10 trillion of wasteful expenditures out of the national budget, and many believe they could wring out as much as JPY20 trillion. How is this possible?

Basically, there are four types of budgets in Japan, (1) the general account budget, (2) the special account budgets, (3) budgets for government-sponsored organizations and (4) the Fiscal Investment and Loan Program (FILP). As these special accounts (including the FILP) and government-sponsored entity budgets are only subject to monitoring and oversight by ministries and agencies, these are the real playground of the bureaucrats and historically, the LDP.  Japan has no less than 31 special accounts that are subsidized by the general account. As of FY2006, MOF-estimated net general account expenditures of JPY33.4 trillion paled in comparison to net special account expenditures of JPY225.3 trillion. Consequently there is plenty of room for rationalization of Japan’s government finances, as Japan to date has had no organization similar to the US Government Accountability Office.

The “hidden treasure” of unused reserves in all these special accounts has become a subject of debate and speculation as Japan’s public finances continue to rapidly deteriorate. As of FY05, the surpluses (assets minus liabilities) in these special accounts were estimated to be, (1) JPY26.73 trillion in the FILP, (2) JPY6.3 trillion in the foreign exchange special account, (3) JPY5.7 trillion in the forestry special account, (4) JPY2.6 trillion in the welfare insurance special account, and (5) JPY2.1 trillion in the airport facilities special account, for a total of JPY43.4 trillion, which equates to a cool 50% of Japan’s annual general account budget.

While there is room for debate regarding just how large these surpluses are now, it is also a fact that the special accounts responsible for these reserves are long overdue for massive rationalization. In FY2006, the government used a total of JPY13.8 trillion of such reserves to retire government debt and return some JPY1.83 trillion to the general account in an effort to repair Japan’s government finances. The global financial crisis and synchronized, deep global recession however has put such plans on hold as the Aso Administration pumped over JPY15 trillion of fiscal stimulus into Japan’s economy—the remainder of which of course the DPJ will have to scramble to re-allocate before the FY2010 budget bus leaves the station.

However, like OMB director David Stockman during the Reagan Administration learned the hard way, potential budget savings on paper and what is actually politically achievable are two distinctly different kettles of fish. Stockman's proposed budget savings were reportedly sandbagged by his own Congressional Republicans, and similar structural reform efforts in Japan since at least 1993 (again with party majority support in the Diet) have basically met the same fate. 

Either way, investors will be closely watching the DPJ's actions for hints about its ability to finance its new agenda without blowing up Japan's bond market. As for plays, International bond ETFs like BWX and BWZ hold anywhere from 13% to 23% of assets in JGBs (Japanese Government Bonds), which is quite a bit higher than the weight of Japanese stocks in most global portfolios, where the benchmark weight is more like 8%.

Disclosure: No positions

As widely predicted, the Democratic Party of Japan (DPJ) won Japan's lower house elections over the weekend by a landslide. The relative political party strengths now approximately stand as follows;


Thus the DPJ now has the majority in both houses of Japan's Diet, and Japan's fiscal stimulus focus is now expected to shift from "concrete to people", i.e., more direct support for people's livelihood rather than wasteful public works spending.
The DPJ is already eyeing how they can cement their power base by ensuring they further reinforce a stable majority in the upper house elections next July.

The reaction of Japan's benchmark Nikkei 225 was first positive, but Monday's sesson ended with the Nikkei essentially marking time as the election news was mixed with a stronger yen and a renewed selloff in China's Shanghai exchange.

Observers are concerned that the DPJ has promised more than they can deliver, and since voters have been waiting since the first attempt at a power shift in 1993 for real change, expectations may be higher than any new regime can meet. But our take on the vote results is that, a) voters recognized that there was no hope under the old regime and politically gridlocked Diet, and b) they threfore rolled the dice for change, while c) being fully willing to vote their dissatisfaction again in July 2010 upper house elections if the DPJ is not making any forward progress on their manifesto.

As to the new ruling party's first 100 days, we will be looking at progress in the formation of what should become two key organizations for the DPJ and new administration, i.e., the National Strategy Bureau, and the Administrative Reform Council.

The National Strateg Bureau (NSB) will be tasked with crafting key national policies including budget guidelines and a basis for a new foreign policy, and is expected to replace the current Council on Economic and Fiscal Policy, headed by the prime minister. It is similar to the US Office of Management and Budget (OMB) although it will probably be a lot smaller in terms of staffing. The NSB will be a bellwether indicating how successful the DJP will be in reducing the role of Japan's powerful bureaucracy's to "experts on tap but not on top". The Council on Economic and Fiscal Policy began with a similar intent, but becam rather toothless after former prime minister Junichiro Koizumi and his go-to finance man, Heizo Takenaka, left office.

The Administrative Reform Council will be tasked with assessing budgets and programs with an eye toward squeezing out up to JPY10 trillion of wasteful spending over the next three years. This council will be similar to the US Government Accountability Office although again nowhere near as large as the OMBs headcount of 400,000 and reporting to the prime minister as opposed to the parliment (or Congress, in the US case). These savings are ostensibly how the new administration can fund most of up to JPY16 trillion of expenditures in shifting the policy emphasis to improving the livelihoods of Japanese consumers.

New legislation and administrative orders to form these two new organizations should be forthcoming by mid-October, after a new cabinet is formed and a new prime minister chosen by mid-September.

Disclosure: No positions.

By September 1 (next month), Japan could well see the first real change in Japanese politics since the end of World War II. 

 

Recent voter surveys by the Asahi Newspaper and the Nikkei (Japan Economic Journal) are now predicting a landslide victory for the Democratic Party of Japan (DPJ, Japan's equivalent of the Democrats in the US) over the Liberal Democratic Party (LDP, Japan's equivalent of the Republicans), which has ruled Japan for all but a couple of weeks since the end of World War II.

The Nikkei survey between August 18 and August 20 of 210,000 voters nationwide with 110,000 respondents indicates that the DPJ could win over 300 seats in the Lower House, or easily more than the minimum 241 seats required to capture a simple majority. If so, the win will be even more of a landslide than when the extremely popular Junichiro Koizumi and his band of reformists won for the LDP in 2005.

One of the DPJ's main political platforms is administrative reform, which has become one of the Japanese electorate's consistent demands and was a major driver for the Koizumi Administration's popularity. Since Koizumi stepped down as Prime Minister in September 2006, the ruling LDP has substantially backed away from administrative reform.

The DPJ plans to strengthen its power to determine and implement policy by appointing more than 100 DPJ politicians to government positions, and bring leading party politicians into the cabinet. Favoring a Westminster-style (U.K.) parlimentary Cabinet, the DPJ not only wants to expand the power of the prime minister's office, but also to make the cabinet the center of national policymaking by wresting de-facto control from Japan's various bureaucracies, such as METI (Ministry of Economy, Trade and Industry, industrial policy), the MOF (Ministry of Finance) and ministries that have long aggressively resisted reform, like the Ministry of Agriculture, Forestry and Fisheries (MAFF) and the Ministry of Land, Infrastructure, Transportation and Tourism.

If they do gain power, the DPJ must be prepared for a long, hard struggle to implant not only formal policy making but new customs and informal practices into long-standing collusive relationships between governing politicians and bureaucrats, and they will very much need the support of voters for the freedom to experiment, float trial balloons and launch test programs to mold Japanese politics and policy, and to redeploy still substantial national savings away from extremely wasteful and often pork-barrel existing government programs and institutions in order to put Japan back on the road to sustainable growth and generate sufficient revenue to meet the Japanese people's need for social security.

The twin challenges will be re-inventing Japan's outdated growth model while repairing government finances to stem what will soon be government debt in excess of 200% of Japan's GDP. Even with strong voter support, the DPJ is unlikely to easily loosen the bureacracy's grip on pubblic coffers, which means comprehensive fiscal reform could take the better part of the next decade.

With Japan's growth potential now estimated to be a mere 1% versus twice that during the economic recovery to 2007 and 4% in the late 1990s, the first priority of the DPJ will have to be to get beyond mere government support for employment that is transitory and has a limited economic multiplier, and address declining productivity as well as re-trenching deflation. Basically, the DPJ will be faced with,

1) Cleaning up the government's debt-ridden balance sheet with deep administrative reforms to ferret out structural waste to streamline and make government more efficient. This would include the disposal of under-utilized government-owned assets.

2) With only half of Japanese large corporations paying taxes, the DPJ will need to broaden the corporate tax base to reduce the current burden to individual consumers, and incentivize companies to become profitable, particularly in the services sector, which is around 70% of GDP but is dominated by small and medium-sized firms with chronic low productivity and profitability.

3) Indefinitely postpone and even lower consumption taxes and income taxes to revive domestic consumption.

4) And finally, to address a ballooning fiscal deficit after by reinstating the abandoned goal of achieving a basic balance in the fiscal budget.

The initial reaction from both domestic and foreign investors is likely to be positive for stocks and the yen, but slightly negative for Japanese bonds (JGBs).

But it is far from certain that the DPJ can achieve such lofty goals on its first try, and the DPJ could in the worst case become bogged down in a war of attrition in trying to wrest control for Japan's government from the bureacracies, which of course would be a longer-term negative for Japanese stocks. That, said, the Japanese voting public for the first time since World War II will now have a real political choice, and a de-facto two party system that will eventually reinvigorate an out-dated, sclerotic political system.

Disclosure: No positions in EWJ or FXY.